Should Investors Go Crazy for El Pollo Loco?

El Pollo Loco (LOCO -0.35%) became the latest hot IPO in the restaurant world as shares quickly soared from an offer price of $15 last Friday to over $30 on Monday, and up to $38 as of this writing. The fire-grilled chicken chain follows Potbelly (PBPB -2.03%) and Noodles & Company (NDLS -7.14%), two restaurant chains that also popped on their debuts -- but their stocks have since fizzled. Should investors go crazy for El Pollo Loco, or is this stock bound to come back to earth like Potbelly and Noodles?

First let's take a look at some key facts:

• The company was founded in 1980 and as of March 2014 it had 401 locations in just five states -- California, Arizona, Nevada, Texas, and Utah -- with an average unit volume of $1.8 million. Nearly all of its 352 locations are in California. 
• The company operates company-owned stores and franchises. Of the 401 locations, 168 were company-owned and 233 were franchised. The distinction between the two is an important one because franchises are better for overall profitability, lifting profit margin, but company-owned locations add more money to the bottom line. In other words, franchising can be a better way to lift profits in the short term, but in the long run, company-owned stores will produce more profits.
• Comparable sales have been positive for 11 straight quarters. That streak shows organic growth and reflects increasing demand for El Pollo Loco's product, which will make it easier to open new stores.
• In its last fiscal year, restaurant-level operating margin from company-operated restaurants was 21%. In its most recent quarter that figure was 22.1%. 

For investors looking to invest in restaurant IPOs, three key factors to look at are growth opportunities, profitability, and valuation. Let's take a look at each of one of these.

Source: El Pollo Loco.

How far can this bird fly? 
In its S-1 filing, management said it expects to open 12 to 16 new restaurants this year, which would increase the store base by just 3% to 4%, but long-term the company hopes to expand its store base by 8% to 10% a year, and sees room in the U.S. market for as many as 2,300 locations. The chain is heavily concentrated in Los Angeles, which could be an opportunity or a weakness for the company. There is plenty of room for new locations across the country, but L.A. may have more of a taste for Mexican-inspired chicken than other parts of the nation. Importantly, the company had expanded on the East Coast previously, with as many as 12 stores, but those had all closed by 2012.

With only a modest expansion planned this year and the former expansion gone awry, I'm skeptical that the chain will be able to hit its goal of 2,300 locations nationwide. Its next new market is Houston, which it plans to open in this year. I'd pay attention to its success there for clues on future growth.  

How juicy is this chicken?
One of the best indicators of profitability in restaurants is restaurant-level operating margin, which shows the percentage of sales the company keeps before corporate expenses. Last year, El Pollo Loco's was 21%. How does that compare to its peers? Take a look at the chart below.

As you can see, El Pollo Loco's current restaurant-level operating margin puts it more in league with Noodles & Co. and Potbelly, both of which have disappointed after strong IPOs. Chipotle, the industry leader, is significantly ahead of all three, showing in part why the burrito chain has been so successful. To its credit, El Pollo Loco's first-quarter restaurant-level operating margin improved to 22.1%.

There is some good news for investors, however. In 2013, the company made over $42 million in operating profit on $314 million in revenue, giving it a substantial 13.3% operating margin, but unfortunately, a heavy debt burden caused over $36 million in interest expenses. The company plans to use proceeds from its IPO to help retire some of its debt, but the $107 million it raised would not even cover the $286 million in debt on its books. In other words, interest expense should continue to be a thorn in El Pollo Loco's side, though it refinanced recently to get a lower interest rate.

Is it a good deal?
After shares doubled in the last two sessions, El Pollo Loco's stock now trades at a P/S ratio of 3.1, higher than that of Potbelly or Noodles. Analysts have not yet provided earnings estimates for the chicken chain, but with its high interest expense, earnings have been slim to nonexistent in recent years. Adjusting for a loss on the extinguishment of debt last year, the company would have made $4.7 million in profits, giving it a sky-high P/E near 200 based on last year's earnings. Forward earnings will be difficult to project, but in its first quarter the company made $5.5 million in net income. Extrapolating that figure for the year gives it a P/E closer to 40, which is reasonable for a company with high growth expectations.

Foolish takeaway
After looking at El Pollo Loco's growth prospects and profitability, I am skeptical that the chain can deliver on its promise to open 2,300 locations and continue driving comparable sales growth. I am concerned about the previous stores that have closed outside its core market as well as profit margins that more closely resemble the recent flops of Potbelly and Noodles. While the chicken chain looks poised to deliver a solidly profitable year, I would like to see it successfully demonstrate its ability to succeed in new markets, namely Houston, before becoming an investor. The recent doubling of the stock price seems to have made the usual weight of IPO expectations all the more heavier and given the company much to prove.