El Pollo Loco Holdings, Inc. annual report, FY2016

Business context and reporting period

El Pollo Loco Holdings, Inc. operates and franchises quick-service restaurants specializing in fire-grilled chicken and Mexican-inspired food. This Form 10-K covers the 52-week fiscal year ended December 28, 2016; it is an annual filing, not a standalone Q4 report. The company ended the year with 460 restaurants: 201 company-operated and 259 franchised.

Financial and operating performance

Annual revenue rose 7.1%, mainly from new restaurants; company-operated comparable sales grew 0.6% and system-wide comparable sales grew 0.9%. System-wide sales, a non-GAAP measure, were $795.4 million. Restaurant contribution margin, also non-GAAP, declined to 20.5% from 21.7%; GAAP operating margin fell to 9.1% from 13.8%, and net margin to 4.8% from 6.8%. Adjusted EBITDA was $65.6 million, approximately flat with $65.5 million in 2015.

For the December quarter, unaudited revenue was $92.5 million, operating income $1.9 million, and net income $0.4 million, versus $86.3 million, $9.7 million, and $5.4 million, respectively, in the comparable 2015 quarter. The filing does not identify these quarterly figures as a separate formal Q4 earnings report.

Changes, liquidity, and unusual items

• Revenue growth was accompanied by higher costs: labor and related expenses rose 15.7%, and labor costs increased to 27.4% of company-operated revenue from 25.4%, reflecting wage increases and new-store staffing.
• Food and paper costs declined to 30.2% of company-operated revenue from 31.9%, primarily due to lower commodity costs, including chicken, and menu pricing.
• Operating cash flow decreased $8.7 million. Investing used $35.2 million and financing used $18.0 million; cash declined by $3.9 million.
• At year-end, the $200 million revolving facility had $104.0 million drawn, $8.1 million of letters of credit outstanding, and $87.9 million available. The company reported compliance with debt covenants. Borrowings were variable-rate; a 1 percentage-point rate increase was estimated to add $1.1 million in annual pretax interest expense.
• Operating lease commitments totaled $283.1 million; contractual commitments, including leases, debt, TRA payments, and specified purchases, totaled $483.7 million. The TRA payable was approximately $38.7 million; $3.2 million was paid in 2016.
• The company recorded $8.3 million of impairment expense for nine restaurants (total impairment and closed-store expense was $8.6 million). Two previously impaired restaurants closed in February 2017, with an expected $0.8 million reserve in Q1 2017.
• Insurance recoveries related to a 2015 restaurant fire included $0.5 million for lost profits and $0.7 million for property, equipment, and expenses; the restaurant reopened in March 2016.

Outlook, commentary, and risks

Management planned 15–20 new company-operated restaurants and 8–12 franchised openings in 2017, with a long-term unit-growth objective of 8%–10% annually. These are plans, not guarantees. The company said liquidity sources should be sufficient for at least 12 months and does not anticipate paying dividends in the foreseeable future.

Key risks include geographic concentration (about 75% of 2016 revenue came from the greater Los Angeles area), rising minimum wages and labor costs, chicken and other input-cost volatility, dependence on a primary distributor and concentrated poultry suppliers, execution of expansion, franchisee performance, competition, and substantial lease and debt obligations. Securities class-action and related derivative litigation remained outstanding; the SEC closed its inquiry in July 2016. A California wage-and-hour class settlement had been submitted for court approval.

Management concluded disclosure controls were ineffective at year-end because of material weaknesses involving shared accounting-system access and employees using others’ credentials to approve transactions. Management reported no identified inappropriate charges or financial-statement changes and outlined remediation steps. The independent auditor gave an unqualified opinion on the financial statements but did not audit internal-control effectiveness.

Important facts for investors to verify

• Whether comparable-sales momentum and restaurant-level margins recover, particularly amid wage increases.
• Progress and returns on planned openings, remodels, and restaurants in newer markets; follow-up on the impaired and closed locations.
• Cash generation, capital spending, revolver borrowings, covenant headroom, and the capacity to meet lease and TRA obligations.
• Completion and independent testing of the material-weakness remediation, and any subsequent control findings.
• Developments in securities and employment litigation, and the financial exposure, if any, from claims or environmental contingencies.