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Chipotle Dissection Down to the Beans

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

How do we find the next Chipotle (NYSE: CMG) 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 point us to the next great restaurant chain?

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

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 its $22 IPO price in January 2006. CMG doubled to $44 the first day. At a recent $295 per share, it is well off the 52-week high of $442, but that does not necessarily make them a great bargain. It almost always trades at premium PEs to the rest of the restaurant sector, hitting a high of 57 in 2012, higher than its usual range between the mid-20s to the high-30s.  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 fast. The ingredients are fresh and prepared onsite and not at some great factory thousands of miles away and shipped out in microwave bags.

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 resonate 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 the four premium priced restaurants that compare to Chipotle in price and relatively high valuations. Gross margins can be dissected into cost of food and cost of food plus labor.  If food costs are high, it shrinks gross margins before labor is included. 

Annual margins

<img src="/media/images/user_69/11_5_large.jpg" />

Gross #1 includes only cost of consumables

Gross #2 includes consumables and labor

Gross margins #1 are 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 commodity prices that have been rising.

Panera Bread (NASDAQ: PNRA) also serves food focused on wholesome alternatives and has margins a little over 70% for 2012. Unlike CMG, Panera franchises its stores and has its own dough distribution business. Panera is another premium priced restaurant stock rarely selling at a discount.  BJ’s Restaurants (NASDAQ: BJRI), with a menu famous for deep dish pizza and beer, has higher gross margins at 75%. And Buffalo Wild Wings (NASDAQ: BWLD), with no pretensions of wholesomeness or eco-friendly chicken farming, has slightly better margins of 69% in 2012. Chipotle pays more for its ingredients but does not lag its peers by much.

Chipolte’s combined gross margin is comparatively high with its self-service model bypassing the expense of a waitstaff needed at the other three full service restaurants.

Quarterly margins


<img src="/media/images/user_69/22_5_large.jpg" />

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.


Annual growth

<img src="/media/images/user_69/33_4_large.jpg" />

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 even with the recent disappointing pre-announced Q4 results, CMG bounced back from the 52-week low of $233 to right around $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 to profit 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. 

Quarterly growth

<img src="/media/images/user_69/11_6_large.jpg" />

Chipotle has to perform flawlessly to make money for investors buying at today’s PE of 34 and price at $295. If growth continues to drop from 20% into the teens, lower share prices will become the new normal and the PE should begin to search for a less exalted premium. 

Q2 and Q3 2012 slower growth may just be a pause, but in preannounced earnings, revenue growth was only 17% and same stores sales came in at 3.8% (mostly traffic) -- down from comps of 11% one year ago.  While these metrics would be acceptable and even good for most restaurants, Chipotle has always done better than most. The company has guided to lower growth in 2013 with mid-single digit comps -- uncharacteristically low. Store openings will remain brisk with 60 new stores opened in Q4 2012 and an estimated 165 to 180 2013 openings.

Is the high growth story intact? Investors appear to have made their peace with two quarters of missed earnings, missed expectations in Q4 and conservative guidance for 2013. Analysts anticipate the company will reach 3,500 Chipotle 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 (NASDAQ: SBUX) 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 yawning stress fractures at present, but there are a couple of cracks developing in the last three 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 have stayed high and until recently, the increases were largely from higher traffic -- the highest quality growth.

Same store sales

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. However, 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. 

<img src="/media/images/user_69/55_3_large.jpg" />

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 3,500 restaurants may be pushing the envelope and if they only manage to meet guidance in mid-single digits for the next 5 quarters that may be the first crack signallng slowing growth.  Future growth may come from Shophouse should the concept take flight and from the newly launched catering business. Both of these are are unknowns and too early to call.

The store base in 2012 is over 1,400 and the 180 new stores in 2013 is a growth rate of 13%. If the mid-single digit comp 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.

Store growth

Annual store growth,  weekly sales and comps

<img src="/media/images/user_69/666666666_large.jpg" />

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 along with declining average weekly sales suggest too many stores and new stores diluting revenue growth. Each new built unit added to the base makes it harder for that base to continue high revenue growth. Chipotle is not here yet.

Through 2011, average weekly sales (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 beginning to take sales from the year-old base. If CMG is begins to saturate its market, the company will have to decide to slow addition of new stores to preserve margins and the integrity of its business.   

Quarterly store growth and comps


<img src="/media/images/user_69/77_1_large.jpg" />

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 the 2011 increase. While revenue increased in Q2 and Q3, it lagged the store increase plus comps indicating the weekly sales are weaker.

Last four quarters of weekly sales


<img src="/media/images/user_69/88_1_large.jpg" />

*company provides annual sales and weekly sales were estimated dividing by 52 

 What expectations are priced in to the $295 per share price today?

Using a discounted cash flow, it’s possible to find the growth rate that a $295 price per share implies.

The growth rate required 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 and revenue will have to reach roughly $20 billion.

If CMG can build 3,500 profitable stores, that’s a 2.6X increase from the current store base.  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 deeper into overvalued territory quickly.

Chipotle's share price is relatively rich even at 25% off its 52-week high. It’s the definition of a brilliant restaurant concept carried out nearly perfectly over the years and priced as such, but not in value territory. The easy money has been made on the $22 IPO price. There is no doubt more profit to be made in buying Chipotle shares, but it comes with the attendant risks of buying at high prices and high volatility.

Finding the next Chipotle early in its fast growth phase is a tall order. Chipotle may be one of a kind. At present BJ's, Panera, and Buffalo Wild wings are probably not the answer to an investor's prayer to find the next Chipotle before the crowd. That restaurant is still waiting to be discovered.

LeKitKat 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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