Sunday, October 1, 2017 3 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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