Chipotle: Freak of Nature?
Board: Value Hounds
How do we find the next Chipotle early in the growth phase? Out of the billions of bytes that have been written about the company what can we pick out that will show us who the next great restaurant chain is?
The best restaurants have:
• Food that creates high traffic—-at present high quality ingredients are a successful fast casual concept
• Positive same store sales –higher is better
• Traffic increases that are higher than price increases make stronger comps – hard to do
• Stores that are relatively inexpensive to build with low pre-opening costs
• Increasing average weekly sales
• Ability to add a substantial number of stores without saturation
• Low costs/high margins
• Increasing average weekly sales
Chipotle is unique in the universe of restaurants and that singularity of vision and purpose has rewarded the company with a share price run of nearly 10-fold from it’s $22 IPO offering price in January 2006. CMG doubled to $44 the first day. At a recent $300 per share, it is well off the 52-week high of $442, but that does not necessarily make it a great bargain. It almost always trades at premium PE’s to the rest of the restaurant sector hitting a high of 57 in 2012 higher than its usual range between the mid-20’s to the high 30’s. What type of growth supports its valuation and keeps investors paying higher prices?
Investors will pay for growth and CMG has been the definition of high-priced high growth.
In the beginning it’s all about the food. A restaurant will go nowhere if the public refuses to eat what it serves.
The Chipotle food concept is simple – serve a few things well and very fast. Chipotle uses a stable palette of environmentally sound and eco-friendly local vegetable produce and meat (when possible) and combines them into burritos, tacos and salads as the customer directs. The customer has the power to sculpt his own preferences into a meal and it is done in plain sight and very fast. The ingredients are fresh and prepared onsite and not at some great factory thousands of miles away and shipped out in microwave bags.
Paraphrased from the 10-K
Because our menu is so focused, we can concentrate on where we obtain each ingredient, and this has become a cornerstone of our continuous effort to improve our food.
We serve naturally raised meats in all of our restaurants in the U.S unless supplies are constrained.
We’re also investigating the use of more sustainably grown produce. A portion of some of the produce items we serve is organically grown, or sourced locally while in season (by which we mean grown within 350 miles of the restaurant).
A portion of our beans is organically grown and a portion is sustainably grown using conservation tillage methods that improve soil conditions, reduce erosion, and help preserve the environment in which the beans are grown.
All of the sour cream and cheese we buy is made from milk that comes from cows that are not given rBGH (recombinant bovine growth hormone). Also, milk used to make much of our cheese and a portion of our sour cream is sourced from dairies that provide an even higher standard of animal welfare by providing pasture access for their cows.
Food costs are high, but service is minimal. The concept brings in impressive traffic numbers quarter after quarter keeping same store sales increasing. New store growth is high and has not damaged the concept with cannibalization and saturation. Since the IPO in 2006 the store base has grown from 573 to 1,350 in Q3 2012 or 2.4X. Revenue over 6 years has increased 3.2X.
The taste and the philosophy obviously resonates with the consumer as evidenced by the growth.
Growth and margins
With the focus on higher cost ingredients, gross margins might be expected to be lower than competitors. That was the case across four premium priced restaurants in the sample group.
Gross margins can be dissected in to cost of food and cost of food plus labor. If food costs are high, it shrinks gross margins before labor is included. The gross #1 does not include labor.
[See Post for Tables]
Gross margins #1 were below 70% over the past six years and dropped to 67.5% in 2011 where they remained for 2012. The cost of food and consumables is higher due to the higher quality ingredients they buy and commodities are rising.
Panera’s also serves food focused on wholesome alternatives and has margins a little over 70% for 2012. BJ’s restaurants with a menu famous for deep dish pizza and beer compares at 75% margins and Buffalo Wild Wings with no pretensions of wholesomeness or eco-friendly chicken farming has gross #1 margins of 69% in 2012. Chipotle pays a premium for its ingredients but does not lag its peers by much at its recent 67%.
Chipolte’s combined gross margin is comparatively high with its self-service model bypassing the expense of a waitstaff.
Over the years, Chipotle has become proficient at leveraging operating expenses and operating and net margins are now at historic highs. The rapid expansion of restaurants has increased operating efficiency not diminished it.
With 2009 being the only year in the past five with revenue growth under 20%, it’s not difficult to see why CMG almost always sells at a premium to its peers. Third quarter 2012 growth dipped below the magic 20% mark and CMG dropped in mid-July from $400 to $300 per share on a small revenue miss and a couple of downgrades. It fell again in October after David Einhorn made his case for shorting shares along with another miss in Q3. Well-loved momentum stocks don’t stay down long and CMG bounced back from the 52-week low of $233 to over $300 currently. Momentum stocks are hard to time and value, since they make big price moves fast on small hits or misses and news like Einhorn’s short. You have to be ready to move quickly and understand the potential at the given price.
The Q2 revenue miss that sent the company down 25% still represented over 20% growth and by any normal standards would be considered a great quarter. Chipotle is held to higher standards and expectations. Momentum stocks magnify small disappointments into major moves and stock prices swing in big percentages both up and down.
Chipotle has to perform flawlessly to make money for investors buying at today’s PE of 35 and price at $300. If growth continues to drop from the 20% into the teens, lower share prices will become the new normal and the PE should begin to search for a less exalted premium. The last two quarters slower growth may just be a pause, but the company has guided to lower growth for the rest of 2012 into 2013. Store openings will remain brisk. They expect to hit or exceed the high end of the store opening guidance in 2012 of 155 to 165 new restaurants (ytd 123). In 2013 they estimate 165 to 180 new restaurants will open. New store openings continue to accelerate.
Same store sales guidance is conservative and instead of high-single digit to mid-teens is expected to be mid-single digit for 2012 and 2013. This is historically on the low end for them and it’s surprising the price has recovered so quickly from recent lows on such muted guidance. Investors may be expecting better numbers.
Q4 comps are expected to be lower than Q3. And overall for the year, we reconfirm our full year sales comp guidance of mid-single digit for 2012.
As we look to 2013, we expect comps in the flat to low single-digit range, excluding the impact of any future menu price increases. We don't have any specific plans to increase menu prices next year, but with inflationary expectations related to the summer drought looming, which I'll talk about later, we remain open to possibility of a price increase next year.
Price increases could further slow the already dwindling traffic. If management is conservatively under-promising and can over-deliver, $300 could be a profitable entry. The investor’s dilemma—what to believe, who to listen to and when to buy.
Is the high growth story intact? Investors appear to have made their peace with two quarters of missed earnings and CMG has made a remarkable recovery since the July-October lows. Analysts anticipate the company will reach 3,500 restaurants in the U.S.-- more than double the current number. Will this increase begin to take business from established stores and saturate the market? Consider the Starbucks on every corner model that eventually had to be forcefully scaled back to return SBUX to profitable growth. Rapid growth is a blessing up to a point and a curse after that.
Chipotle is not showing any major stress fractures at present, but there are a couple of cracks developing in the last two quarters. Revenue growth is still in the high- teens and margins are steady. In spite of rapid expansion of the store base over the years, same store sales (comps) have stayed high and until recently, the increases were largely from higher traffic. Growth from traffic is high quality and price increases less so.
The large decreases in traffic in the second and third quarters (near 50% year-over-year) along with declining same store sales may be signaling a plateau in growth that no longer supports premium valuations --two quarters do not necessarily make a trend. If traffic continues to lag, price increases to create higher comps will not work forever. Customers resist rising prices and traffic begins to drop. As traffic drops, restaurants begin to offer promotional pricing cutting into margins. It’s a vicious circle best avoided. Chipotle burritos are already a pricey fast food and they do run the risk of losing guests. Price increases should be reserved to offset commodity inflation – not feed analysts needs to see high comp numbers every quarter.
While it’s premature to call Chipotle a victim of too many stores and too few customers on numbers from just two quarters, growth to 3500 restaurants may be pushing the envelope and if they only manage to meet guidance in mid-single digits for the next 5 quarters it may signal slower growth will be the norm. They are continuing the rapid expansion with 180 new stores in 2013.
The store base in 2012 will be around 1395 (excluding new closures) and the 180 new stores in 2013 is a growth rate of 13%. If the mid-single digit comps is the norm for the next year, is the pace of expansion is beginning steal sales from the comp base? A long run of five quarters of mid-single digit comps is far below their historical norm (excepting 2008-2009 recession). They don’t discuss the reason for this 50% decrease over 2010,2011 and part of 2012 other than to say traffic and transactions are leveling off.
Revenue increases come from new restaurants and positive same store sales. As long as comps continue to rise it’s unlikely that new stores are draining sales from the established base. Flat and declining same store sales suggest growth is spread over too many stores and new stores are diluting revenue growth. Each new built unit added to the base makes it harder for that base to continue high revenue growth.
Through 2011, average weekly (AWS) continued to increase after the recession until Q3 2012 where it began to slow. Taken along with lower comps, this measure of sales for stores open at least 12 months could be indicating stores open less than 12 months are taking sales from the year-old base. If CMG is saturating its market, the company has to decide to slow addition of new stores to preserve margins and integrity of its business. It’s premature to think Chipotle business is flattening based on two quarters but it’s something to consider when paying a premium price for a high growth momentum stock.
Sales can be converted to weekly by using a 52-week year.Since most restaurant chains report average sales using weekly numbers, it is useful when making comparisons. For instance, in 2011, Panera had average weekly sales of $44,071.
Weekly sales increases year-over-year for 2012 continued the 2011 trend at more than 9%, but by Q3 they began to fall. Sequentially increases are weaker with very little gain in Q3. The increase for year to date is 5.3% and may finish the year below 2011 gains.
What expectations are priced in to the $300 per share price today?
Using a discounted cash flow, it’s possible to find the growth rate that a $300 price per share implies.
The growth rate is between 21%-22% over 10 years every year. The price includes the present value of lease debt. The terminal growth is 3% Earnings before interest and taxes will have to reach $1.4 billion from a TTM $331.4 million in 2012 for an increase of 4X. If CMG can build 3500 profitable stores, that’s a 2.6X increase from the current store base. At $400, the market expected 25% growth.
The assumptions are optimistic and that level of growth for the next 10 years is unlikely. The four-fold necessary increase in EBIT also appears unlikely. Given this, the current price is at least fully valued. However, with momentum stocks, fair value has no place in buy and sell decisions. These companies move on news and short-term trends disregarding value estimates. CMG beating estimates and cruising past management’s guidance will send the price into overvalued territory quickly.
Momentum stocks make for difficult investments. Chipotle is expensive even at 25% off it’s 52-week high. It’s the definition of a brilliant restaurant concept carried out nearly perfectly over the years and priced appropriately but not in value territory. The easy money has been made on the $22 IPO price. There is no doubt more money to be made but it comes with the attendant risks of buying at high prices and a lot of volatility.
Finding the next Chipotle early in its fast growth phase is a tall order. Chipotle may be one of a kind.