Ticker: Chipotle Mexican Grill, Inc. (CMG)
Rating: Maintain at Buy
The bottom fell out on the momentum trade in Chipotle after its latest quarterly earnings, but the long-term investment prospects have never looked better for this fast-casual dining franchise.
The company's Q3 earnings fell short of expectations at 2.27 EPS. Most analysts were expecting to see earnings come in at 2.30 or better. Revenues also came in light at $700M versus the $703M estimates. For a highly valued stock with a PE nearing on 35, the company has to perform above expectations to maintain such strong valuations. The misses caused a large drop, but we see this weakness as an opportunity. Looking more closely at the earnings, Compare sales grew nearly 5% out West, expanded operating margin to 17.4%, and opened another 36 new restaurants. The company is expecting to expand another 160 stores in 2013 at least, and we saw the earnings as very enticing. The company has tough competition, low consumer confidence, and rising food costs. Yet, they still grew earnings by 20% and increased margins.
The important question, though, is where is CMG headed from here now, and we have high expectations. Our most aggressive model sees CMG being able to reach just under $700 next year. How so? In that model, we are expecting to see around 20% growth in operating income YoY. That model is not completely outlandish as well. In the past five years, the company has grown operating income by an average of 44%. The 20% is very obtainable with the company increasing stores by 10% in 2013 and some new prospects that we believe that could give CMG a shot in the arm.
First off, the company is expecting to see 3-6% increase in food costs in 2013. That rise is probably a worst-case scenario. Produce prices have been negative in 2012, and we will need an economic rebound to see that type of rebound in percentages. Further, CMG is experiencing some of its lowest future PE ratios we have seen in years. The current 2013 future PE is about 25 for us, and while that may seem high, that number will only get smaller as EPS will increase due to a share buyback plan the company is undergoing currently. The company's $100M share buyback plan will bring shares outstanding from 31.5M to around 31M. That dip will be very impactful in fact. When looking EPS right now, it would actually be at 8.83 vs. 8.60. That would bring the PE ratio to just over 31, and it brings future PE to 25 as we expect EPS to be 10.75 with 20-22% growth in earnings and the stock buyback plan. For a company growing earnings by 20-22%, that valuation is very attractive.
The other aspect of CMG that we like a lot is ShopHouse. The idea takes the Chipotle-model and pushes into Asian cuisine. The company has opened its first store in Washington DC and second in Los Angeles. More stores are expected in 2013, but the exact number has not been divulged. What we like about ShopHouse is that it's modeling off of the Yum! Brands (YUM) ideology of multiple cuisines. Yet, CMG is operating them all in the fast-casual dining atmosphere. While ShopHouse is far from being a success, the potential for it to explode onto the scene will develop in 2013, and we believe that will add a lot of premium to shares as well. Additionally, we believe that the cuisine is drastically different enough from Mexican in that it can provide new clientele, while at the same time not stealing business from its main line.
Finally, the fast-casual restaurant business is expected to grow by 12% in 2013. This industry includes companies like CMG and Panera (PNRA), and the trend continues to develop away from quick-service restaurants. We can see fast-food restaurants like YUM and Wendy's (WEN) moving in the fast-casual direction. They are increasing the quality of their foods, and McDonald's (MCD) in their latest store style offered a more relaxed environment that invites clientele to use free Wi-Fi and stay for longer periods of time. People are enjoying the restaurant midpoint between fast, greasy food that offers convenience with food that is more expensive and higher quality that is offered at slower moving "sit-down" restaurants. YUM's move towards menu offerings like the Cantina bowl and better ingredients shows that trend. We believe the trend shows more movement towards the CMG-model and ideology in 2013, and we believe that this is a positive for CMG not a negative, especially as they are set to unleash another venture in ShopHouse.
Our $700 price target is definitely aggressive, but even in our most conservative models, we see CMG moving towards $500 in 2013. We believe next year is a turnaround year for the company, and its time to get involved.
The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.
Here is how to calculate price targets using discounted cash flow analysis:
(all figures in millions)
Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.
Available Cash Flow
Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).
WACC for CMG: 6.00%
PV Factor of WACC
PV of Available Cash Flow
* For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.
For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate.
Cap Rate for CMG: 1.0%
Available Cash Flow
Divided by Cap Rate
Multiply by 2016 PV Factor
PV of Residual Value
Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:
Sum of Available Cash Flows
PV of Residual Value
Interest Bearing Debt
We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.
Divide equity value by shares outstanding:
In the end, we have found that CMG is worth around $689, which we believe accurately reflects the company's five-year projections.
Q1 - Q3 2011
Return on Equity
So much for profit concerns at CMG. The company continues to expand profits. While the coming year, will likely see some dip in these levels, we believe this is priced into the stock. How do these numbers compare to the competition?
MCD operates with operating margin at 32%, gross margin at 45%, and ROE at 11%. Sonic (SONC) operates with operating margin at 16%, gross margin at 79%, and ROE at 61%. YUM operates with 22% operating margin, 71% gross margin, and 55% ROE. WEN is at 5% operating margin, 24% gross margin, and ROE at -1%. CMG lags quick-service fast-food chains in some aspects due to the fact that many are enfranchised and have large scales. At the same time, CMG has better ROE than MCD and WEN, better operating margin than SONC and WEN, and better gross margins than MCD and SONC. They are in the middle of the pack, and they are very strong in profits for having no franchises. For this reason, we believe they are actually more attractive than their competitors, and given the quality of food, they are much better at being able to pass on costs to consumers.
We have talked a lot about the company's valuation in the main thesis, and we see these levels as obviously that of a growth stock. While not cheap, the company is outpacing much of its competition in growth. The company is expected to grow by 20% at least in revenue in 2013. That compares to 8% for YUM, 2% for MCD, 3% for WEN, and 0% growth for SONC. The company is outpacing most of the public companies it competes with for consumers in growth, so the higher valuations make sense. We see them as actually fairly cheap for that growth, and these levels may seem quite cheap if ShopHouse gets going and the company can successfully pass costs to consumers.