Sunday, October 1, 2017 0 comments ++[ CLICK TO COMMENT ]++

First Look: Chipotle Mexican Grill (CMG)

This isn't my type of company.

It isn't in my circle of competence...but I've been researching and studying the industry.

It doesn't have the valuation I like... but that depends on what one thinks is normal earnings.

What it is, is a contrarian, broken, growth stock with very good backward-looking numbers and uncertain future.


Chipotle Mexican Grill (CMG) is a restaurant chain that apparently pioneered and popularized "fast casual" dining--basically a cross between fast-food (e.g. McDonald's, KFC) and casual (eg. TGI Friday's, Chili's, Boston Pizza). The food is Mexican, prepared similar to fast-food restaurants and priced in between fast-food and casual (a burger at a fast-food place might be $4 whereas a burrito at Chipotle will be something like $6).

I don't know much about restaurants and am not really into food--sometimes I wonder if I should even be looking at this company--but from reading numerous articles, it seems that some of the things Chipotle does is somewhat unique and appears to be hard to duplicate (might write more about this and its possible moat (if any) in the future). Chipotle focuses on fresh, organic, ingredients while avoiding processed foods and attempts to prepare as much of the food in the restaurant as possible (this is not the case with fast-food restaurants). I don't know how much this matters to customers but it does appear that Chipotle is on the right side of the organic/healthy-food trend (not sure if  this is a fad or a long-term trend).

Unlike a casual dining restaurant, Chipotle is set up more like a fast-food restaurant and serves customers much faster and at slightly lower prices. Thus, it has very strong profitability and high throughput (orders per minute can be really high).

It's hard to say for sure, and I don't have any solid insight, but my guess is that Chipotle's food category (Mexican/ethnic) is probably a growth area. The US population is becoming a bit more Hispanic and I suspect there is an increasing demand for this type of food. The Mexican-type food is also something "new" and fresh and probably has room to capture market. Strictly speaking, it is nothing new--this stuff seems to be already popular in Southern US; and companies like Taco Bell have been around for decades--but compared to burgers and fries, or pizza, or sandwiches, or whatever, it looks like a different alternative, at least to me.

Why Look at This Now?

Chipotle was a high-growth stock in the mid-2000's up until a few years ago. It was flying high until e-coli sickened numerous customers in 2015 and the stock crashed and burned. Actually it has had several food-safety-related crises, including one norovirus outbreak in mid-2017, so the situation is a bit worse than it seems (it doesn't seem to be just one situation). If you believe this company cannot overcome the food safety issues--say it is systematically related to their business structure and is unfixable--then you should not look into this stock. I'm still researching this to see if they have actually instituted procedures to avoid the same problems in the future.

This is definitely a contrarian stock. The stock is trading near 5-year low and about 60% off its all-time high in 2015.

(As usual on this blog, you can click on any image to get a bigger, more legible, image.)

Pre-crisis, when earnings were not depressed, the stock used to trade at obscene multiples--something like P/E of 50! So the fact that the stock is down so much doesn't necessarily mean it will go back to what it was. I doubt growth investors will be coming back to this stock, and even if they do, they probably won't attach such high multiples.

The stock is trading at the following ratios (note: figures are rough estimates (I usually just do round numbers and sometimes computed over a period of time). Figures will change depending on what current price is, etc):

P/E: 65
Forward P/E (Wall Street analysts): 27

P/FCF: 54
Forward P/FCF around 25

P/Sales: 2.1
P/Book: 6

Earnings are depressed due to the crisis but even with optimistic forward-looking earnings, P/E and P/FCF are 25+. So it isn't exactly cheap. This is not a classic Graham value stock.

So why still investigate this stock if it seems to trade at high multiples?

Does History Repeat?

Chipotle's sales fell due to the foodborne illness crisis but appears to be recovering. However, note that store count went up quite a bit so some of the revenue increase is from that. Average store sales have declined from what they were in 2015. In any case, the fact that total revenue is sort of getting back to what it was pre-crisis, shows that customers still visit the stores and we may be seeing early stages of the recovery.

As seen above, before the crisis, the company was earning about $400M in profit or FCF (both are close), which is about 10% of sales.

Right now the profit or FCF margin is in the 3% range (based on the Morningstar figures I am looking at, FCF margin is about 3.9% and profit margin is 3.2%).

The question for potential investors is whether the company can go back to 10% profit margin. A lot of qualitative analysis needs to be carried out but I think the company may be able to achieve 7% margin.

The other question to ask, especially for growth companies that are not cheap, is whether it can reinvest profits back into the business and if so, at what rates? Basically, what is the ROE? Or strictly speaking, what is its return on incremental reinvested capital, and what percent of its earnings/free cash flow can it reinvest at those rates?

Chipotle had amazing ROE (20%+) in the past (pre-crisis). This is very good for a company with no debt (i.e. ROE not boosted by debt leverage), but like all restaurants and retailers, it does have sizeable operating lease obligations (so it is being boosted by leases--but this is common for the industry).

Furthermore, it paid no dividends and barely bought back any stock (only material purchase was recently, after the crisis). So it is able to reinvest most of the earnings back into the business. The rapidly increasing store count (pre-crisis) sort of proves that. I need to dig deeper into the SEC filings to make sure it is investing properly but at first glance, this seems like it is able to reinvest almost all its earnings.

It is very rare for a company with an ROE of 20%+ being able to reinvest most of its earnings. No wonder the stock market attached a P/E multiple of 50, or whatever, to the company in the past.

The current market cap is something like $9B so Chipotle can't continue this for very long. However, it does have room to grow and I think if its business is intact and customers desire the food then it can grow for a solid 5-10 years. Compared to established restaurant chains, it is still moderately sized. For example, McDonald's has a market cap of around $100B, while Restaurants Brands International (Canada; Tim Hortons and Burger King) is around $36B, Yum Brands (KFC) is $25B, Starbucks is like $77B, and so on. The business models of these chains are all different--many are franchised whereas Chipotle is not; food types are different; etc--so it isn't a direct comparison but nevertheless, it does sort of give an idea of the potential.

More Homework to Do

Hopefully this post gave a sense of what we are looking at and why Chipotle may be worthy of an investment. I remember briefly looking at this about an year ago when William Ackman made a big investment--his firm owns around 10% of shares--but the stock seemed expensive. It has fallen maybe 20% since then and, although the valuation is still high, it is attractive. I think there are two key things one needs to answer:

i. What caused the food safety problems and will is happen again? Chipotle has rolled out new procedures and altered some food is prepared so what is the impact of this? Costs are probably higher now that there are more food safety procedures. But has the final product been altered to the point that consumers don't value it like they used to (taste? less fresh? etc)?

ii. What is the long-term profitability and growth potential? Can it really reinvest most of its profit at, say, 15% ROE? Is it really worth paying a P/E multiple of around 20-25 for this company?

I'll be thinking about these questions. Stay Tuned...

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Wednesday, September 27, 2017 0 comments ++[ CLICK TO COMMENT ]++

Sold: Cabela's (CAB) Merger Successfully Closed

I haven't had much time to blog and the highly-valued markets are frustrating for any contrarian or anyone waiting for low valuations. I have continued to research some companies and hope to write something up soon but the valuations are not compelling. If anyone has some stock ideas I should investigate, leave a message below or email me (If I am interested in them, I'll research it and write it up).

In any case, the Cabela's (CAB) merger went through. This was a low return, short time-frame, situation and it worked out as expected although it went through a turbulent period. The stock sold off quite a bit after I bought it, possibly due to risk of the financial division sale not going through. That would have been the best time to enter this risk arbitrage position. It kind of seemed like this deal might not close and I would take a loss but fortunately it didn't turn out that way. As is usually the case with risk arbitrage, in hindsight the market always looks like it was wrong (at least for deals that close).

As I mentioned when I first took the position, I made some currency computation errors and ended up with a much larger position than I would have liked. I'm glad the deal closed given that there was a real risk of taking some big losses due to the position sizing mistake.

I'm kind of backing off risk arbitrage positions now (if I like the company being bought out, I will probably still take a position). In some sense, it sort of reminds me of what happened in 2007 when there were a lot of deals being done in late stages of a bull market at high valuations. If you are into risk arbitrage, you should be extra cautious for several reasons:

  • Market valuations are high: One can't generally tell how overvalued a market is, or if it is even in a bubble, except in hindsight. But my opinion is that the market is highly valued and possibly in a big bubble. Risk arbitrage deals are kind of dangerous right now because the buyout deals are happening at high valuations (prices will fall a lot if deal fails), and purchasers will try to weasel their way out of deals (using any legal language permitted in the deals) during bad times (such as when the stock market falls and they realize they have bought something at really high valuation, or if they can't get financing).
  • Unpredictable American presidency: The Trump administration is hard to predict and deal decisions almost seem arbitrary. I would definitely be cautious with foreign buyouts (especially from China, India, Korea, etc).
  • Currency fluctuations: Might not apply to you but if you are Canadian, you have to be careful since the C$ has appreciated against the US$ recently and possibly may continue if FedRes doesn't raise rates but BOC does. It looked like I would lose money on this deal because the US$ fell quite a bit within the last few months, but it rallied in the last few weeks so I ended up only losing about 1% on fx.
  • Risk with numerous sectors: Several industries are facing problems and it's not clear if you are taking positions in areas with potential secular declines. For instance, the retail sector has deteriorated way more than I imagined and I suspect the Cabela stock would have fallen way more than I initially estimated if the deal had broken.

Overall, satisfied with how things turned out.

Price Sold: $61.50
Total Return: 3.8% (annualized (estimate): 25%--not meaningful)
Total Return (C$): 2.8% (annualized (estimate): 18%--not meaningful)

When I was starting out and had smaller portfolio, these small returns would not be worth it but with a moderate portfolio, it can be ok.

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Sunday, September 3, 2017 0 comments ++[ CLICK TO COMMENT ]++

Warren Buffett's Timeless Investing Advice

Even if we are familiar with it or even if it seems blatantly obvious, it is always good to remind ourselves of fundamentals. Here is a short clip I ran across that captures Warren Buffett's timeless advice on his investing philosophy. Pretty much captures the key tenets of his approach: circle of competence, patience, and concentrated portfolio.

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Wednesday, July 19, 2017 0 comments ++[ CLICK TO COMMENT ]++

Purchase: Cabela's (CAB) - Risk Arbitrage Position

Cabela's (CAB) is being bought out by Bass Pro Shops (private) in a cash deal and I took a position in Cabela's. Deal is expected to close by end of Q3. The spread is around 4% and my expected return (based on my probabilities and downside) is about 2%. Not that great but if the deal closes within 3 months, then return is ok.

This deal is a bit risky since it is a buyout of a retailer that has seen declining revenue and profits in the last few quarters. The whole retail industry is getting clobbered--the street blames Amazon and emergence of online retailing but I think the core problem is a likely decline in consumer spending (consumers have too much debt and have been living outside their means for a decade or more and we may be seeing an adjustment--and Cabela's is no exception. It has been so bad that the buyout price was revised down--goes to show the risk in these arbitrage situations; good thing I didn't take a position earlier--so things are definitely not good. Offsetting the poor performance is the fact that their business is somewhat unique (outdoor/hunting/etc) compared to most retailers. In any case, this is not a company that I would like to own if the deal fails.

Since the spread is so small, this deal is not worth it for you if your holdings are in a different currency and you don't hedge; or have a US$-denominated account. US$ has been weakening recently against C$ and currency fluctuations can wipe out any gains.

After purchasing the stock, I realized that I made a mistake with portfolio sizing (didn't realize some figures were in US$--I work with C$ and US$ and have to combine multiple accounts and it can be confusing--and came to the conclusion my position size is too big). I'm going to try unloading a portion of it if the price rises a little bit.

Purchase price (CAB): $59.25

Return Expectation

Takeover price: $61.50
Purchase price: $59.25

Probability of success (my estimate): 95%
Return on success: 4%
Probability of failure (my estimate): 5%
Return on failure (my estimate): -32% (assume it drops to $40 (sort of the low over the last 5 years--not absolute low)
Expected Return: 2.0%

Buffett's Four Key Questions 
(1) How likely is it that the promised event will indeed occur?  
Deal price was revised down on April 17 2017 from $65.50 to $61.50 due to poor earnings so I think deal will close.

(2) How long will your money be tied up? 
Companies expect deal to close by Q3 2017. The only delay risk I see has to do with Cabela's requirement to sell off its bank division (they have agreement with a bank but it needs to be completed).
(3) What chance is there that something still better will transpire - a competing takeover bid, for example?  
Low probability of anything better materializing. Cabela's is slightly better than other retailers (given its target market) but its business hasn't done too well recently so suitors likely to be limited.

(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?  
Trading at a really high P/E of 22. Will suffer maybe 30% loss if deal fails. Company revenue and income have declined in the last few quarters. In fact, the deal price was revised down due to its recent performance so things are definitely not good. However, this is a somewhat unique retailer (that caters to outdoor/hunting/country lifestyle) with less competition than other retail businesses.

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Saturday, July 15, 2017 0 comments ++[ CLICK TO COMMENT ]++

Bought: Monsanto (MON)

I bought Monsanto (MON) as a risk arbitrage position a few days ago. Potential return is pretty good if you believe the risk is low (spread of about 9%, my expected return of around 7.7%). Deal expected to close by end of this year (maybe worst case Q1 2018).

I find it really hard to invest in this environment. Everything just looks highly valued and there aren't too many areas that are beaten down or appears cheap. I have been researching some out-of-favour industries (like retail, radio broadcasting, oil & gas) but they are not good industries in the long run. I hope my impatience doesn't end up hurting me but I took a really large position in this deal.

I was researching the position for almost an year when the merger spread was much higher (18% as recently as January of 2017). In fact, it looked like an attractive position ever since Berkshire Hathaway took a small position late last year (likely as a risk arbitrage position but with spreads likely more than 20% at that time). However, I didn't take a position since I already had a position in the Syngenta (SYN) merger and this was highly correlated to that one (i.e. if regulators blocked that deal, chances are the Monsanto merger might have been blocked too).

The spread is largely due to regulatory risk as the companies are waiting for European and American regulators (others not expected to be an issue) to approve the deal. I also believe that the spread is a bit larger than what it should be because risk arbitrage funds can't fully participate in this deal (the size is way too big and given the blow-ups last year of some prominent funds, I suspect there is a shortage of capital).

Purchase price (MON): $116.64

Return Expectation

Takeover price: $128
Purchase price: $116.64

Probability of success (my estimate): 95%
Return on success: 10%
Probability of failure (my estimate): 5%
Return on failure (my estimate): -31% (assume it drops to $80 (P/E of 17 on 2017 consensus EPS of $4.70))
Expected Return: 7.7%

Buffett's Four Key Questions   
(1) How likely is it that the promised event will indeed occur?    
Given that regulators already approved the other two agricultural mega-mergers, Syngenta buyout and the Dow-Dupont merger, there is a very high likelihood of this deal closing. If the deal does run into problems, the companies have the option of divesting assets to satisfy regulators (although sometimes this causes the bidder to lower their buyout price). Furthermore, some analysts quoted in the press have suggested that there isn't that much overlap between the Monsanto and Bayer businesses so there shouldn't be as much concern regarding anti-competitive or monopoly power (I haven't done my own research so not sure how much the businesses overlap). There is additional risk this year from the Trump administration in USA which is more politically driven than past Obama or Bush administrations. The CEOs of both companies met the US president early this year and came out with positive views but Trump always flip-flops and gives a message to suit the audience so not sure how supportive the US presidency is for this deal (it results in a major American agricultural power disappearing and being run by Germans). 

(2) How long will your money be tied up?   
Companies expect deal to close by end of 2017. My worst case assumption is Q1 2018.  
(3) What chance is there that something still better will transpire - a competing takeover bid, for example?    
Monsanto went through prior takeover offers and has been rumoured to be under takeover discussions for several years. Unlikely any better deal will materialize.   
(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?    
I wouldn't mind owning this business if deal fails so I am taking a larger position than someone who doesn't care for the business would. Obviously there will be big short-term loss if the deal fails but the underlying business is very solid and I think it has a very large moat (but growth really low). Based on 2017 consensus EPS forecast ($4.70), Monsanto is trading at a P/E of 25. Given Monsanto's dominant position in the world and its intellectual property and history of continuous innovation, it has generally traded above a P/E of 20. Even if you assume the future is worse than the past--likely true given its size--I am assuming its long-term P/E is around 17 (versus S&P 500 long-term around 15). You are only looking at a short-term loss of around 30% if deal fails and the stock trades down to a P/E of 17.

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Sunday Spectacle CCXXIX

Central Bank Money Printing

Central banks generally increase assets by printing money and buying them, so the charts below are indicative of their money printing. Historically, increase in central bank balance sheet (i.e. increase in money printing and supply of money) has led to inflation in goods and services (this is offset by deflation or wealth destruction and a bunch of other factors). Recently most of the money printing has been used to buy financial assets--for instance, the JCB is a big owner of Japanese stocks--so it is not clear to me if the situation will be similar to the inflationary busts we have seen in the past. Beyond inflation, too much central bank asset purchases also distorts the market and crowds out the private sector--not a good thing from a capitalist point of view (private sector makes better capital allocation decisions than the government).

It's interesting how the main 3 developed country central banks have behaved over the last decade.

source: "Central Bank Cash Flood Swells Bond Danger" by Lisa Abramowicz,, June 2 2017

Not visible in the chart below but looking at the interactive chart in the Bloomberg article, we see...

(figures are rounded to nearest 0.1 trillion)

  • In June 2007, ECB assets were $1.6 trillion, JCB was $0.8 trillion and FedRes was $0.9 trillion.

  • As of March 2012, ECB had ramped up its assets to $4.0 trillion, while FedRes was at $2.9 trillion and JCB was $1.7 trillion.

  • By September 2014, FedRes assets had gone up significantly to $4.5 trillion, while ECB was $2.6 trillion and JCB was $2.5 trillion.

  • Interestingly, jumping to the present (May 2017), FedRes has not increased its asset base which is still around $4.5 trillion, while ECB has gone up to $4.7 trillion and JCB to $4.5 trillion.

The things that stand out to me are:
  • FedRes balance sheet was clean and had low "economic leverage" before the financial crisis. Relative to the size of the economy, FedRes has less assets than in Europe or Japan (do note that I'm being very simplistic here and there are many other things and operations undertaken by central banks which are unique to that region and won't be properly captured in these asset figures). Some people find the FedRes balance sheet alarming (because they look at how it was a decade or two ago) but it actually is the better one of the three above. If I'm not mistaken, the US Federal Reserve has also not intervened directly in the stock market and purchased stocks en masse like the JCB or Swiss Central Bank (not shown above)--this is a good thing for US corporations and the US economy (the less central bank involvement, the better IMO).
  • Once the FedRes hit around $4.5 trillion in 2014, it has stayed the same. In contrast, JCB has significantly ramped up its assets.
  • The ECB seems to tweak its assets more so than others. For instance, its assets were $4 trillion in 2012 but then dropped to $2.6T in 2014 and is now back up to $4.7T in 2017. I'm not sure if this is due to economic events (such as Greek crisis a few years ago) or for some political reason or something else. I also haven't looked to see if the changes are due to currency fluctuations (for example, Euro has declined against the US$ recently).
  • JCB assets seem really high compared to the size of the economy. Japan has always been a mystery and it's not really clear how it is going to play out.

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