• In the past year, LOCO has multiple documented failures in court that are poorly understood by the market and require the company to restructure its franchise agreements/disclosures
  • LOCO has previously admitted in court/SEC filings that being forced to abide by the aforementioned injunctive relief would be a “nightmare scenario” for its growth prospects and cause “irreparable harm”
  • We expect LOCO to take a $9mm charge imminently and to also restructure its 273 franchise agreements (representing essentially half of all LOCO stores and >100% of LOCO cash flows)
  • We find it extremely concerning that LOCO’s SVP of Operations (who oversaw franchise ops) abruptly left the company very recently (announced in Friday night 8-K dump).
  • 45%+ near-term downside on looming litigation charge-off, franchise restructuring, and growth halt

Intro and Summary – The ‘Nightmare Scenario’

First the basics. El Pollo Loco Holdings Inc. (“EPL” or “LOCO”) is a restaurant operator with the majority of its operations in California. Based on our analysis, the company generates essentially all of its free cash flow from its franchise segment. Since its IPO, LOCO has been an operating mess but finally showed some signs of life in recent quarters as a result of a new turnaround plan. We show in this report that the turnaround is likely dead in the water.

LOCO has consistently been on the wrong side of one lawsuit that has three very significant potential impacts to their business model which include: 1) a ~$9 million liability due immediately, 2) a potentially, permanently-broken growth story, and 3) the end of their nascent turnaround under a new CEO. We think the stock is heading back to $9/share (~45%+ downside) in the near-term, with a good chance of incremental downside if the company cannot work its way through the brewing legal mess surrounding it.

So how did we get here? Bryman, a single Franchisee, sued LOCO in 2016 for infringing on its franchise territory rights and won. Not only did Bryman win $9 million in damages, but in unprecedented action, the jury also required LOCO to renegotiate each and every franchise agreement it has in California. The combination of these damages (which if extrapolated to all of its franchisees in California could spell hundreds of millions of potential go-forward liability), plus the franchise agreement modification requirements suggest that LOCO is on the verge of an operating and growth disaster. Personnel movement at the company only further confirms this position.

But do not take it from the Friendly Bear. LOCO itself stated that abiding by the jury verdict “would create what could only be described as a ‘nightmare scenario’. LOCO went on further to state “the trial court issued injunctive relief requiring us to revise our franchise agreement and franchise disclosure document in a manner that substantively changes our rights and obligations, including with respect to territorial exclusivity and the locating of new restaurants… If we delay entering into franchise agreements for new restaurants while we await the appellate court rulings, our growth in 2019 and beyond may decrease our expected franchise revenue (10-Q). One last admission from EPL: “It would also cause irreparable harm because it will require EPL to create exclusive territories for franchisees where none currently exist…this would result in EPL’s potential violation of its existing 273 franchise agreement and ten franchise development agreements… This will cause irreparable harm to the franchisees and expose EPL to liability for violating these development agreements”.

So there we have it. LOCO is sitting on an unreserved liability of $9 million PLUS no growth in their core business driver (franchise revenue), and a business model that is being turned upside down by an unfavorable court ruling. And despite all of this, LOCO did not talk about the Bryman case at all during ICR in January 2019…

Getting to the Meat of the Taco

Can a chicken live without its head? According to ModernFarmer.com, Mike the Headless Chicken lived for 18 months without a noggin after a farmer, in a failed attempt at slaughter, axed off his head and missed the jugular vein.

Can a “story” stock live without its unit growth? That question we believe the securities and trial lawyers for El Pollo Loco already answered for us in their various briefings and disclosure modifications over the past several months. They leave us limited room for speculation – and in this report, we will let LOCO speak for itself through its court briefings and carefully worded disclosure modifications. We also note that the company will soon have to provide an audited 10-K, a process that will require a more rigorous and third party analysis of the litigation reserve and disclosure issues.

In fact, based on our review of court filings, we believe that El Pollo Loco will now have to take an $8.8 million P&L hit in either 4Q18 or 2019 (which LOCO reserved absolutely nothing for, representing >100% of 9/30/18 cash balance and >100% of FY17 net income) and may have to embark on a wholesale operational restructuring of its franchise agreements in California (the vast majority of LOCO’s overall business). As a result, we think the LOCO growth story in 2019 is dead in the water and the company is on the cusp of potentially huge cash burn. Put simply, how can a company grow without the financial resources (in this case cash)? And incrementally, if they are renegotiating all franchise agreements, that will put a material damper on franchise growth.

Individual & Collective Potential Path’s to Win on the LOCO Short

Source: Friendly Bear Analysis

An Intro to the Current State of Affairs and the Potential Business Impact

With the 10-K on the horizon, we must assess and understand how disclosures might change at this juncture. For a quick background, every year, auditors that enter the door, are required per audit methodology, to complete a legal confirmation whereby they directly receive from company counsel a view on any potential legal exposures the company may have (PCAOB AU Section 337 Source). In this regard, we expose, through the direct words of EPL in their legal filings, that they have a very serious issue at hand. We expect EPL’s auditors may require EPL to take the $8.8M write-off that the company thus far refused to book on its P&L. However, that is only the tip of the iceberg. There has been a recent exodus of key personnel that should significantly concern investors. LOCO lost a bid to stay an injunction that effectively will require it to modify its franchise agreements for all franchisees. Although the company has been playing fast and loose with its disclosures for months given the timing of the court cases in the background, the company could not go forward without amending its 3Q18 risk factors to draw attention to this injunction and indicated that if the injunction is NOT stayed, the company’s growth prospects would materially suffer. In other words, if the company needs to go and renegotiate each and every franchise agreement, growth will be stalled for the foreseeable future, and the growth-like multiple being afforded to the company will disappear. The company has now effectively been forced to abide by the injunction at least temporarily (pending a second appeal which, based on our review of the case itself and case law history appears unlikely to be successful). We therefore believe that the “nightmare scenario” that EPL described to the court in the course of the Bryman litigation may begin to play out (note: “nightmare scenario” were the words that EPL chose to describe the situation).

Let us Party in Denial

Judging by LOCO’s strong price performance over the past year, we believe investors are in the dark as it relates to a landmark jury verdict – and major victory for El Pollo Loco franchisees – in the case Michael D. Bryman et al v. El Pollo Loco (hence forth “Bryman v. Loco” or “Bryman”). In fact, as we previously mentioned, as recently as late January 2019, EPL management touted its growth prospects and turnaround success at the ICR conference without discussing the Bryman litigation.

This infographic provides a timeline of events in the Bryman litigation:

Source: LOCO 10-Q, Friendly Bear Analysis

This excerpt from the 10Q shows that LOCO – likely in conjunction with securities counsel – determined that it needed to amend its disclosures to reflect its losses in court ahead of filing the 9/26/18 unaudited 10-Q:

Source: LOCO 3Q18 10Q

Bryman Litigation Background and the Shortcomings of EPL’s Disclosures

The Brymans, a SINGLE franchisee, sued EPL as they believed that EPL encroached on their territory. EPL defended itself by asserting that nothing in the franchise agreement prohibited El Pollo Loco from this encroachment. How many other franchisees could have been impacted by encroachment that now might be set to request material payments from LOCO?

Long story short, the jury verdict held that a franchisor has a duty to act in good faith and deal fairly with franchisees and that this duty overrides any explicit, yet legally and factually unconscionable terms (see this article). In other words, the jury decided that El Pollo Loco’s franchise agreement itself was in violation of the California Unfair Competition Law. The Brymans were accordingly awarded $8.8 million and the jury also ordered injunctive relief requiring that El Pollo Loco restructure its franchise agreements to address the encroachment issues they found in the Bryman case. The latter portion of the verdict – the injunctive relief – was unsurprisingly a major point of contention for EPL given that unlike the cash verdict, this was something that would have ongoing ramifications for its business model. In summary, EPL is required under the terms of the agreement to re-negotiate each and every franchise agreement, which itself will be an extremely cumbersome affair. Until completed, the company has already admitted that it will be on the sidelines for any future growth plans.

Bryman v Loco, which started off as a case involving one single franchisee, has turned into something that appears to be turning EPL’s entire business model upside down. And this represents a devastating loss for El Pollo Loco. We also wonder why LOCO did not take the charge on the Bryman verdict given that it was aware of the loss as early as May 2018. Worse yet, in August 2018, LOCO appealed the verdict and moved for a new trial – and took no reserve for the loss along the way. This appeal was lost in October 2018! So despite losing in a jury trial and losing in a first round of appeals, LOCO still took no charge on its income statement! We question how this is legitimate treatment under ASC 450.

We also found this article that suggests appeals are rarely successful in civil cases (according to the article cited, only 17% of cases are successfully appealed in California courts). From our vantage point, given that EPL was more likely than not to fail its appeal, this strongly suggests that the loss and verdict should have been viewed as “probable” under ASC 450 at the time it was handed to LOCO…yet still no disclosure. Given that the loss has been known for a long period of time – and apparently probable given appellate level losses are already in the rearview, why did LOCO not book a charge?

The Forever Appeal

As is stated in the company’s Q, the company did appeal yet again after its October 2018 loss, this time under a different legal theory. That appeal remains pending as of January 28, 2019.

Source: LACourt.org Case MC026045

However, as a result of the jury verdict that included injunctive relief, LOCO was required to amend its franchise disclosures and agreement for all new franchise deals. In other words, in order to grow its franchise business without violating the injunction handed down by the jury in Bryman, LOCO is now required to amend ALL its agreements. The company therefore, recognizing the precarious position it was in, moved the California Supreme Court to stay the injunction pending review of its second appeal. We have provided this incremental information as the additional support shareholders needed to see to show that the company appears to be playing games with a MATERIAL disclosure event.

Note: we retrieved a filing made by EPL at the CA SC (Docket S251583) through a court runner using Bloomberg Law’s court runner service. If you are interested in reviewing this docket yourself, please either use a BLAW court runner or refer to this page from the State of California.

This is when things get very interesting. When LOCO moved the CA Supreme Court to set aside the injunctive relief portion of the ruling (i.e. the portion that required the EPL to re-cut its franchise agreements), the company admitted that it had posted a bond against the jury verdict. Despite even going as far as posting a bond, the company decided to reserve nothing against the verdict in its 3Q18 10-Q (see 10Q, top of page 42) – as a reminder the briefing was filed on 9/28/18 (received 10/1/18) meaning that LOCO had to have been aware that it posted the bond at the time that it moved the Supreme Court to set aside the verdict. Is this not the equivalent of putting a down payment on a house, but ignoring the rest of the liability associated with the purchase of the house? We find LOCO’s double talk – saying/doing one thing in the courts and disclosing another to the investment public – highly suspect.

Source: Retrieved via court runner – this was LOCO’s own filing “Petition for Review” filed on 9/28/18 and formally received by the court on 10/1/18 under docket S251583. If you are interested in reviewing this docket yourself, please either use a BLAW court runner or refer to this page from the State of California.

Under ASC 450, a company must take a reserve when a loss is probable. In fact, according to IASPlus, one of the conditions for loss accrual being probable is that “a liability has been incurred”. We think the posting of a bond by definition is a liability.

From our review of a California Supreme Court docket on the case, we note that the Supreme Court of California denied LOCO’s petition to stay the injunctive relief portion of the verdict in November 2018:

Source: CA Court Info

Taking a step back – why was the CA Supreme Court decision to NOT grant EPL’s stay on injunction motion relevant? We see this as pretty straightforward. As we previously stated, the injunctive relief required EPL to amend its agreements with franchisees. EPL had already lost on first appeal but was now again – in a sign of what we view to be desperation – trying to appeal its verdict a second time. While this appeal was pending, the injunctive was still in place. EPL therefore wanted the CA Supreme Court to set aside the injunctive relief at least temporarily while the second appeal was pending. However, the CA Supreme Court denied this motion. So as long as the appeal is pending and does not go EPL’s way – which is the case right now and may very well be the case for an extended period throughout 2019 if not indefinitely – EPL will have to materially amend its franchise agreements and disclosures in a way that the company itself has admitted in court represents a “nightmare scenario”.

Perhaps some insiders have recognized the potential for a ‘nightmare scenario’

There are signs in the operational side of LOCO that there is trouble brewing as a result of these rulings. The SVP of Operations – Gus Siade – who in his own Linkedin profile indicates that he oversees franchise operations – abruptly departed in a Friday Night Dump announcement very recently. Essentially, the person responsible for operations left the ship as the operations’ hands were tied behind its back on any potential growth.

Furthermore, LOCO appears to have worked with its securities counsel on hedging itself in its SEC filings based on this newly added disclosure in the 9/30/18 10-Q that specifically spells out how devastating the Bryman ruling is for the company and how bad it would be if the CA Supreme Court did not stay the injunctive relief (spoiler alert – the CA Supreme Court did NOT stay the injunctive relief):

Source: LOCO 10-Q (highlights for emphasis)

As you can see above, the company essentially banked on being able to stay the punitive injunctive relief portion of the original verdict at the CA Supreme Court level. This obviously did not happen.

So what’s the net of it all?

So we now believe that LOCO is likely going to have to take a charge in the amount of essentially its entire net income in 2017 (FY17 net income was ~8.62M according to Jefferies). We expect the charge is likely to hit the P&L in either 4Q18 or for the 2019 guidance. However, that is just the one-time impact of the court ruling. We point investors to this excerpt from LOCO’s own admission in front of the CA Supreme Court to help them understand how LOCO itself describes the impact of the Bryman injunctive relief on their business going forward:

If we comply with the injunctive requirements related to territorial exclusivity and the locating of new restaurants while the appeal is pending, and/or if the appeal is unsuccessful, the revised franchise agreements may limit our ability to open restaurants in certain desirable locations.

Source: LOCO 10Q

The language in the now denied EPL petition itself is instructive because it lays out LOCO’s own perspectives on the impact of the injunctive relief on their business. For example:

Source: Retrieved via court runner – this was LOCO’s own filing “Petition for Review” filed on 9/28/18 and formally received by the court on 10/1/18 under docket S251583. If you are interested in reviewing this docket yourself, please either use a BLAW court runner or refer to this page from the State of California.

Note that 273 franchise agreements is nearly all franchised stores, quite scary!

In the excerpt above, El Pollo Loco sums everything up in one sentence – if the injunctive relief is allowed to stand (which it was as of November 2018) then EPL would be forced to revise its standard 20-year franchise agreements. One small note that we found particularly damning is that El Pollo Loco will also no longer be able to use alternate dispute resolution mechanisms (i.e. arbitration) – a non-court mediated system of justice that tends to be very corporation friendly. In other words, the injunctive relief leveled the legal playing field between El Pollo Loco franchisees and the company by forcing more cases into the traditional court system. It is not a secret in legal circles that arbitration tends to be corporation-friendly.

Source: Retrieved via court runner – this was LOCO’s own filing “Petition for Review” filed on 9/28/18 and formally received by the court on 10/1/18 under docket S251583. If you are interested in reviewing this docket yourself, please either use a BLAW court runner or refer to this page from the State of California.

The company’s lawyers also lay out in detail that their franchise growth plan will be harmed if the Supreme Court of CA does not lift the injunctive relief, as can be seen below:

Source: Retrieved via court runner – this was LOCO’s own filing “Petition for Review” filed on 9/28/18 and formally received by the court on 10/1/18 under docket S251583. If you are interested in reviewing this docket yourself, please either use a BLAW court runner or refer to this page from the State of California.

Again, as we now know, the CA Supreme Court did in fact decline to stay the injunctive relief.

California Dreamin’

Obviously, the California-based ruling should only apply to California franchises. At first blush, one would think that makes this less of an issue for LOCO. However, LOCO’s growth remains heavily tied to California and since its IPO – in fact, ever since its entry into the United States in the 1980s – LOCO has and remains a primarily California concept. Below we borrowed a chart from a separate Seeking Alpha story that lays out the stores by state as of 2016 and note that LOCO is in fact heavily levered to California making the jury ruling even more onerous for the business going forward and puts all of the company’s California locations at risk of requiring new franchise agreements and massive restructurings:

As one can see above, LOCO remains almost entirely a California story (over ~80% of locations), with almost all of the company’s franchise restaurants located in California. Furthermore, LOCO’s own company restaurants are also heavily concentrated in California. As a result, if LOCO wants to further expand in California in either its franchise business or its company owned business, it will have a hard time doing so without violating the new court orders regarding competitive territory encroachment.

LOCO can’t exist without its franchise business; and this historic court case puts a huge damper on LOCO’s franchise business

LOCO Investors may also take some comfort in thinking that the franchise piece of LOCO’s business is relatively small. However, we have conducted our own fundamental analysis and note that while small in revenue $, LOCO’s franchise business is likely at least 35-40% of the company’s EBITDA, and likely more than all of the company’s free cash flow given that it is essentially a fully converting fee stream. Our analysis is laid out below:

Source: Friendly Bear analysis, CapIQ historical Financials

So what are we left with? LOCO is overly concentrated in California, has always had dubious growth prospects as evidenced by its oversaturation in California decades after its entry into the United States and years after its IPO, and faces the natural headwinds that come from being a restaurant concept in California (think minimum wage, competition, etc.). Comps have recently been very anemic and were only recently turning stronger under new management – we cannot imagine the operating mess that arises from this lawsuit could possibly help at a time when the company was just starting to get on more stable footing. The company’s unusually heavy reliance on dinner (due to its rather involved family-style chicken meals) has always made it somewhat of a fast casual oddity with 50% of the company’s sales coming from dinner time. The company just tried for essentially the past 18 months to set aside a devastating jury verdict that the company itself admits will have a materially negative impact on its growth algorithm going forward. The company did not reserve for an $8.8 million verdict and is likely on the cusp of finally taking the proper reserve it should have taken years ago which will effectively evaporate all net income for an entire year. In our estimation, more than 100% of the company’s free cash flow comes from the franchise business – that is largely based in California and that appears to be on the verge of a significant restructuring based on EPL’s own court filings. The company’s head of operations who oversees the franchise business left the company after 20 years and after the Supreme Court of CA denied EPL’s motion to lift the injunctive relief component of the trial court verdict. Despite all of this, LOCO trades at a rich ~11x trailing EBITDA – likely because the market still ascribes a higher multiple to the company’s asset-light franchise fee stream that we have established is likely to come under substantial pressure.

Simply put, we think EPL’s days of “livin’ la vida loca” are over.

Conclusion – this chicken chain that can’t live without its head (or growth)

We therefore expect LOCO to retrace all of its massive gains over the past year, reversing back to $9/share (45% downside) in short order where growth is hampered and the aforementioned liabilities are finally realized. We think the core restaurant business – that appears to be generating significant negative free cash flow based on our franchise mix math – is essentially worth very little. LOCO traded up materially after new management came in with a new vision and turnaround plan. While the company had regained some footing in the past few months, we believe the litigation challenges are likely to undo much of the nascent turnaround’s success. Therefore, we expect LOCO to retrace its momentous turn-around and therefore set a very near-term target price of $9/share with more potential downside as LOCO works through its legal woes.

Final food for thought, if things were so stable at LOCO, would this many key employees leave the company over the last year:

Name Position Departure Date Source
Gustavo Siade SVP Operations Feb-19 Source
Ed Valle Chief Marketing Officer Jun-18 Source
Steve Sather CEO Mar-18 Source
John Dawson Chief Development Officer Jan-18 Source
Elana Hobson VP of Franchise Operations Oct-18 Source

Disclosure: I am/we are short LOCO. All information for this article was derived from publicly available information. Investors are encouraged to conduct their own due diligence into these factors. This article represents the opinion of the author as of the date of this article. The information set forth in this article does not constitute a recommendation to buy or sell any security. This article contains certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential,” “outlook,” “forecast,” “plan” and other similar terms. All are subject to various factors, any or all of which could cause actual events to differ materially from projected events. This article is based upon information reasonably available to the author and obtained from sources the author believes to be reliable; however, such information and sources cannot be guaranteed as to their accuracy or completeness. This article reflects the author’s opinion at the time of publication. The author makes no representation as to the accuracy or completeness of the information set forth in this article and undertakes no duty to update its contents. The author may also cover his/her short position at any point in time without providing notice. The author encourages all readers to do their own due diligence.