Tortilla Mexican Grill (MEX.L)
Coverage Initiated
Welcome to my Substack, British Investing, with a focus on UK small-cap/micro-cap investing, built on the fundamental belief that to excel in an investment environment where information is abundant and instantly accessible, you have to look in places others aren’t looking. Achieving alpha with large-cap investing is, in my opinion, only possible if you have an emotional edge over the crowd and a bit of luck; using the recent performance of Meta Platforms (NASDAQ:META) as a prime example.
I understand small-cap companies may be undesirable to some, especially with the average small cap in the UK being multiples smaller than across the pond, bringing with them low liquidity and high volatility. However, I am 22, a recent graduate and have ample time for my theses to play out.
We begin with a look at a recent holding that makes up roughly 7.5% of my individual stock portfolio. The idea was conjured from the wisdom of Peter Lynch who famously talked of investing in what you know and looking at the world you observe daily for investment opportunities.
Business Overview
Tortilla Mexican Grill is the UK’s largest and fastest growing casual Mexican food chain (think Chipotle but British). The company was founded in 2007 by an American named Brandon Stephens who decided he missed his Southern Californian burrito diet. Sales have grown from £10m in 2013 to £57.7m in 2022 while the store count has grown from 13 to 82. This is divided into 59 Tortilla owned stores, 3 Chilango stores (acquired in 2022), 3 delivery kitchens, 9 UK franchised stores and 8 franchised stores in the Middle East. Management believes there is a market for 200 stores in the next decade and aims to open 10-12 per year.
During my time at Loughborough University, I have frequented the local Mexican casual restaurant and witnessed its incredible success, allowing it to set-up a store in both London and Scotland. The overall popularity of Mexican food is growing among both the younger demographic and older generations and our investment thesis is largely based on this. In my opinion, the business is fairly easy to understand. Burritos and tacos are an inherently simple, yet customisable food offering and the cheap nature of the ingredients affords Tortilla an impressive 76% gross margin in 2022 (Chipotle has 40% gross margins). The price of a burrito sits around £7-9 and is relatively healthy, appealing to both the consumers appetite for value-for-money and healthy eating.
Financial Overview
Ownership – 74% of the shares are not publicly held. 20% are owned by Quilvest, the private equity firm that owned Tortilla prior to its IPO. Founder Brandon Stephens owns 8.3% and current CEO Richard Morris owns 3.5%.
Revenue for 2022 grew 20% to £57.7m but profit dropped from £1.4m to a loss of £0.6m. Tortilla benefitted a lot from one off subsidies and reduced VAT rates in 2021 as the UK government aimed to revive the hospitality sector after COVID (a total of £1.8m in government grants). As a result, the company has decided to compare 2022 to 2019 in their most recent investor presentation. Like-for-like sales grew 16.4% compared to the UK average of 5%. The channel mix is split 29% delivery, 71% in-store. As an aside, it would be beneficial to investors if Tortilla provided clearer information of how the LFL sales are divided between volume and price.
Tortilla opened 10 owned stores in 2022 at an average cost of £350k per store. The stores reached c83% of mature sales level and are all expected to mature by FY24. The aggressive store opening, management says, is due to the abundance of UK white space and former retail units. So far in 2023 they have opened a further 2 stores in Derby and Greenwich with the Derby store already exceeding the average weekly sales required for a 30% ROCE. All new store openings are funded from operating cashflow.
Management says profitability for the year was affected by inflation. The biggest impact being from rising protein costs and utility and packaging costs. The business has more recently secured a hedge for utility costs until September 2023. Tortilla closed 2022 with a cash balance of £2.4m and debt of £2.9m. More importantly, while slightly unprofitable for the year, free cashflow was +£0.9m.
Sources of Competitive Advantage
Brand/Scale – while Chipotle does operate in the UK, they have 12 locations all based in London and none of which are profitable. Something about the success of the US brand has not transferred to the UK and management doesn’t seem to care about trying to change that. With Tortilla therefore being the biggest UK Mexican food chain, they have built a trusted, reputable brand with 5x more units than the nearest competitor. The central production unit based in Tottenham Hale supplies all menu items sold in restaurants and has the capacity to support 120+ stores. Looking at google reviews of Tortilla locations all over the country there is a recurring theme of hundreds of 4- and 5-star reviews. On a recent trip to Gatwick airport, where Tortilla added a location in 2021, I observed a queue out the restaurant at 5am. While mentioned briefly, the company recognises potential for continental Europe expansion.
Economic/Social Tailwinds – my experience of living in the UK for 22 years has seen the decline of the high street and town centres and the conversion of former retail shops into restaurants. I think the British public has seen their economy and standard of living gradually declining and enjoying a good meal remains one of the best ways to lift spirits. More recently, the ‘cost of living’ crisis has put a focus on value-for-money which is an itch that Tortilla scratches. Additionally, with a much more health-conscious generation now reaching maturity, Mexican fast food has benefitted from an increase in popularity and this trend is evidenced by 74% of Tortillas customers being 34 and under.
Flexible Business Model – with the nature of the food offering provided Tortilla has been able to adapt easily while maintaining the same quality of service. Stores can be adapted to various footprints, eat-in or takeout, ghost kitchens for delivery, high-streets, shopping centres and transport hubs. Additionally new staff can be hired and trained to be versatile at minimal cost due to the simple nature of the food. The business has also been quick to adopt a loyalty program and social media marketing.
Risks and Mitigation
Economy – while we’ve seen UK unemployment fall to one of the lowest readings in 50 years, there is still very much the expectation of a global recession sometime in 2023/2024. With the business not having experienced a true recession since scaling up it is unknown what impact a considerable drop in consumer spending could have on financials. I would like to think its food offerings are fairly recession proof considering their price but at the same time I’m definitely being ambitious. While London is, and probably always will be, the biggest market for Tortilla I am questioning what impact the shift to work-from-home may have on the restaurant sector.
Balance Sheet – Tortilla currently has £14m of current liabilities and only £5m of current assets (£2.4m of cash), putting it at a 0.35 current ratio. The business has another £7m it can draw from a £10m credit revolver but also wants to add 10-12 new locations to the group this year. So the question is where do they get the money from to cover this deficit? Management are confident that the cash-generative nature of the business will allow them to self-fund. Considering they made £7.5m in operating cashflow last year this makes sense, but only with the implication of opening less new stores this year. The other option is to continue with planned openings but opt for a capital raise. With only 25% of the current shares publicly traded, an increase in liquidity could benefit investors long term but any announcement will undoubtedly impact the share price short term.
Valuation Model
Above are key financials for 2013-2022.
Our valuation model for Tortilla is simple yet requires some explaining.
Store count grows to 150 by year end 2032, with gradually less stores being opened each year. Revenue per store grows by 2% per year, in line with inflation.
We have assumed that each new store does 20% of the revenue of an existing store in its first year and then 100% in its second year, we think this is a good estimate based on what management has said. This gives us revenue growing from £57.7m in 2022 to £146m in 2032. We have used a similar process for estimating operating cashflow per store.
From here working out free cashflow is simple. Capex is divided into ‘new store capex’ and ‘maintenance capex’ which were £4.8m and £1.5m, respectively, in 2022. 10 company owned stores were opened giving us a new store capex of £480k, maintenance capex is divided between the number of stores in the previous year, presuming a new store doesn’t need maintenance capex until after 1 year of operating. We grow this maintenance capex per store by 2% a year. The combined total capex is subtracted from operating cashflow to yield free cashflow. We have FCF growing from £0.9m to £13.9m by 2032, with a FCF margin of 10% in 2032. Closest comparison business Dominos Pizza has FCF margins of 11%.
DCF Valuation:
From here I use a DCF valuation forecasting 5 years ahead, to 2027. Cost of capital is 12% and our resulting price target is 171p, with current price at 105p, giving us a 67% margin of safety.
FCF Yield Valuation:
Alternatively, we can base the valuation off the 2027 FCF and a mature restaurant business FCF yield. In our opinion the UK listing for Dominos Pizza Group is the best comparison as it is a mature, pure-play eat-in/takeaway fast-food restaurant with simple, high margin food. Dominos currently trades at a 5% FCF Yield. We assume that Tortilla will trade at a 10% FCF yield in 2027 and that they make £7.99m in FCF, giving us a 2027 market cap of £79.9m, an ARR of 15.04% from today’s market cap.
A recent equity research report by Liberum gave a 170p price target.
Conclusion
From a financial perspective and considering managements aspirational plans, the future of the business appears promising. When I combine this with the first-hand experience of seeing busy stores (at ungodly hours in an airport) and reviews raving online, I’m confident that in 5-10 years I will have made a decent return on investment. Most of all, I like the simplicity of the business, it’s not some fancy, regulated technology company - they serve simple food with about 20 ingredients to choose from, keeping margins high and the potential for future profits to follow. While there are some arising questions about the balance sheet and the UK economy, I think that if Tortilla, in any way, follows the success and size of Chipotle then we could have a serious investment return on our hands and a future cashflow machine. I look forward to following up on H1 2023 results.
Disclosure: I own a position in the stock mentioned. This is not advice and is purely for entertainment purposes.