Chipotle Is Reaching for New Heights

Gaurav is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Chipotle Mexican Grill (NYSE: CMG) just celebrated its 20th birthday. What started as a small Mexican food joint two decades ago is now a national food chain with over 1,500 restaurants and a company with a market capitalization of more than $12 billion. 

Chipotle has been a market out-performer all along. It is trading at 30.9 times its forward earnings and showing no signs of slowing.  It recently reported a strong second quarter, beating both revenue and earnings expectations. The stock is up 32% through the year and should see more upside over the coming periods.

A quick look at the second-quarter trends

Chipotle reported a 10.2% increase in earnings, which moved to $2.82 per share and beat analyst expectations by a penny. Overall revenue was up 18.2% to $816.8 million, and same-store sales increased 5.5% or 4.5% excluding the extra trading day. Analysts had projected total sales of $802.8 million and comp growth of 3.8%.

What is encouraging is that this growth was fueled by solid transaction growth. There were 25 more daily transactions per store on average during the quarter. Operating margin was 27.6%, down from 29.2% in the year-ago quarter owing to higher food and marketing costs. It added 44 new restaurants, bringing its overall store count to 1,502.

An ace up its sleeve

There has been lots of speculation over whether or not Chipotle will raise prices. With fast-food chains focusing on budget meals, there were doubts as to whether a price increase would deter the company’s growth prospects. But, subsequently, most industry experts agreed that Chipotle has sufficient pricing power and the market began looking forward to the price increase as a significant driver for margins and the stock.

The burrito-maker has, however, deferred its pricing decision by at least two more quarters, saying that it will exercise this option when its non-GMO initiative gathers more steam. Eliminating GMOs, or genetically modified organisms, from food ingredients is a key brand-building -- and at the same time costly -- initiative. The pricing room will support margins when the company implements this and will also be a valuable option just in case the company's cost situation gets out of hand.

Room for margin expansion

Chipotle’s decision not to raise pricing does not dampen its margin growth prospects. Management is confident that if it can drive its comps well, there is adequate room for margin expansion. Around half of the costs that determine restaurant margins are fixed in nature, which means that comp growth trickles down to the bottom line fast.

If Chipotle can achieve around mid single-digit comps supported by transaction growth, it can sustain and even grow its margins. And anything above this can result in a much wider increase. So, comp growth becomes very important.

Catalysts for comp growth

Chipotle is doing all that it can to boost traffic. After testing in California, it is rolling out the new tofu-based Sofritas in the Pacific Northwest. Then there are the premium Patron margaritas that it introduced in April. But that’s not all.

Management has linked the semi-annual bonus of its managers with restaurant throughput during peak hours. The company believes that if the customers are served faster, the queue would move faster and the sales loss arising from the occasional customer who is deterred by the long wait will be avoided.

Chipotle also started a catering service in January and already 200 stores in 12 markets offer this service. The number will double by the end of August. The company estimates that catering brings an incremental 1% of total sales in the restaurants where it is offered. And this is a very profitable business given that after the initial equipment is set up in the stores, there are almost no incremental costs associated with this service.

Formidable competitor

Chipotle’s competitive strength comes from its unique healthy food concept. It is already much ahead of Qdoba, a similar Mexican chain owned by Jack in the Box (NASDAQ: JACK). Despite serving similar food and having a similar assembly-line model, Qdoba has not had the same results as Chipotle.

Last month, Jack in the Box announced that it will close 67 under-performing Qdoba restaurants, which is about 10% of its total store count, or 20% of its total company-owned store count. Investors welcomed the restructuring, as this was a good move from Jack in the Box’s overall perspective.

The company's valuation of 18.8 times its forward earnings is appropriate as selling of the unproductive stores will bolster its future profits and cash flows. However, the closure of the Qdoba stores is a significant conquest for Chipotle.

Taco Bell, owned by Yum! Brands (NYSE: YUM) is a bigger challenge. Chipotle can never match Taco Bell's prices and Taco Bell can never match Chipotle's quality. It is an interesting duel going on between the two and both players are holding their ground well.

With no claims of superior quality food, Taco Bell is creating a solid position among Mexican food chains. Its Cantina Bell menu and Doritos Locos Tacos are a major hit. The chain saw same-store sales growth of 2% in the recently reported second quarter, which comes over 13% growth in the second quarter of 2012. Taco Bell contributes 60% of Yum!’s US operating profits.

Amid the China problems and softness in both KFC and Pizza Hut in the US, Taco Bell has been a bright spot for Yum!. With its forward price-to-earnings ratio of 18.5 times, Yum! offers investors a good entry point to leverage Taco Bell's success. 

Last word

Chipotle has a number of growth boosters, like pricing power, for good comp growth and margin expansion. The company is also regularly opening new stores and stands to gain from Qdoba’s store closures. These factors justify the stock’s high valuation and promise excellent shareholder returns.

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Gaurav Basu has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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