Chipotle Mexican Grill: A Close Look

Chipotle Mexican Grill (CMG) went public on January 27, 2006, so they are a relatively new public company. Until recently, the majority of the company was owned by McDonald's. McDonald's took its major control of Chipotle in 1998, and held that control through Chipotle's IPO. But this past September, McDonald's let go of its stake by exchanging its 'B' shares onto the open market, so now McDonald's is not involved with Chipotle.

What's different about the B shares than the A shares (CMG, rather than CMG.B)? The B shares have ten times the voting power of the A shares (for every B share, you get ten times the vote you do with an A share). Both share classes have the same EPS, the same balance sheet, the same cash flow, the same financials, only the B shares have more voting rights. So the B shares are trading, or at least they should be, at a premium, right? You'd think so, but no. The A shares are currently trading at $58.98, several dollars above the B shares. Why is this? The best explanation that I can come up with is that it's just a plain goof-up by the market. The B shares should be trading at a premium to the A shares, McDonald's even said to expect the B shares to trade at a premium when they executed the share spin-off. So, I'm buying the B shares, because sooner or later, the market will realize its irrational ways. The separation from McDonald's will result in Chipotle losing some pricing benefits, but I this isn't anything that I think will hurt the company long-term.

Chipotle's growth has really been picking up over the past few years, but there's still an amazing amount of room for them to grow. For fiscal 2006 (which has one quarter remaining), management wanted to open 80-90 restaurants, so far in three quarters they've opened 69. For fiscal 2007, management plans to open 95-105. I believe this is a very sustainable pace for the next 5-10 years, maybe even longer. Chipotle has barely saturated any markets, but they are building up a strong reputation, a very strong one. They've got a similar advantage that places like Starbucks and Panera Bread have, people go out of their way to eat at a Chipotle (their draw isn't as much as Starbucks, but it is still more so than you'd see with other restaurants).

Chipotle's quality is remarkably consistent in all of its market, so with the good reputation they have today, if they can keep the quality consistent, I think they'll do wonders in the world of Mexican food. True Mexican food has only started to get popular in the eastern part of the United States, the market is opening up around the U.S., and Chipotle is taking advantage of the opportunity. There has never been a national fast-food-type Mexican food chain that actually tastes like Mexican food, and I think Chipotle is going to fill that gap. There's clearly a market for Mexican food, and Chipotle's got the financials to take advantage of it.

Chipotle's balance sheet is in excellent shape; $157.57 million in cash with minimal debt. This serves as a huge advantage, because it only costs them $900K to open a restaurant. These new restaurants start adding to the bottom line quickly, so they've got this low-cost advantage making expansion not easy, but pretty darn close to that. If they open 100 restaurants in fiscal 2007, it'll cost them approximately $90 million. Over the past four quarters, the business has produced $98.35 million in cash flow. So, with the superb balance sheet and strong cash flow, Chipotle has the resources to keep this fast expansion pace up. The large cash position will easily allow Chipotle to have a rough quarter or two, even a rough 5 or 6 quarters they could handle smoothly. I don't expect any real major problems to come up, but if they do, Chipotle will be able to handle them.

Cash flow from operating activities has been very strong, fueling growth and increasing at a good pace. Since fiscal 2002, it's increased approximately 16 times, and fiscal 2006 could market the first time it breaks $100 million. Pretty much all of the cash the business produces is going to expansion and CapEx, so free cash flow is minimal. I don't think cash should be going anywhere else, so I like to see this and want to see this in the future.

The high P/E may scare some people away from Chipotle. It did make me weary at first, but then I got to thinking. Growth has its price. Very rarely will you be able to find a company with a product like Chipotle growing like Chipotle at a low P/E. Starbucks has never had a P/E that you'd call low, simply because they've been able to keep growing. Chipotle has so much room left to expand, I don't mind a high P/E. Growth has its price, and I don't think we'll see Chipotle at a real low P/E anytime soon. Even with the fast growth rate, Chipotle has margins above the industry average, which says a lot about the kind of advantage they have. Very few companies can expand at a fast rate and have better-than-average margins, but Chipotle is one of those few companies.

Ever since going public, Chipotle has beat analyst earnings estimates. In the 1Q 2006, they beat estimates by 116.7% (the largest margin they've ever done), reporting an EPS of $0.26 when analysts were expecting $0.12. The lowest margin they've beat estimates by was in the 2Q 2006, when they reported an EPS of $0.33 when analysts were expecting $0.26. In the latest quarter, the 3Q 2006, Chipotle beat estimates by 33.3%, reporting an EPS of $0.36 when analysts were expecting $0.27. For the coming 4Q, the 15 analysts following the stock are expecting an EPS of $0.28. I think this is a low estimate, and I expect Chipotle to beat it. If they do meet it, though, it'd be tremendous growth YOY from an EPS of $0.16 in the 4Q 2005. I think analysts are underestimating Chipotle's potential both in the short- and long-term, particularly the short-term.

Now to management. Chipotle has an incredible management team. Founder Steven Ells is the CEO and chairman and owns 909,850 shares and is the largest inside owner of the company. Best of all, Ells is only 40 years old, he started Chipotle in his late 20's. I think he'll be with the company for a long time. The benefit Chipotle got from having McDonald's on board is that they now have several directors who previously were with McDonald's for 15-20 years. These directors were with McDonald's during its great growth period, they saw what it takes to bring a restaurant chain to a national level. For example, CFO Jack Hartung joined Chipotle in 2002 after 18 years of working at McDonald's in several management positions (including CFO). Having Ells heading the action is great, I'm glad he's in charge, and he's got one of the most experienced management teams in the industry. If anyone can take Chipotle to the national level, it's these guys.

What's interesting is that Chipotle doesn't franchise its restaurants, all are company owned. I think this is overall a good move for the long-term for them, because the bottom line is that they've got a great concept, and I don't think the company would benefit nearly as much through franchise restaurants. All owners of their company-owned restaurants are promoted from inside the company, so all of Chipotle's restaurants are run by experienced individuals. I feel Chipotle could operate several thousand restaurants in the U.S., and international expansion is always an option. For now, though, the U.S. offers huge opportunity, and I don't think we'll see international expansion begin for quite a few years.

Risks / What to Look For

-- Competition: Even though Chipotle seems to be ahead of the game with its restaurant and brand foundation, there's a very good chance that more competitors will enter in when they see how well Chipotle is doing. With the strong balance sheet, Chipotle will be able to handle this, but more competition could mean less expansion opportunity, and that'd hurt. I feel Chipotle has enough of a head start that they'd be able to fend off competition, but crazier things have happened. As long as management is somewhat prepared (I'm sure they aren't expecting this to be an easy ride), the strong cash position will be a useful weapon to keep their market share. Plus, the business is producing very strong cash flow, so Chipotle shouldn't have any shortage of cash. They've got smart management to deal with that cash, so I don't see Chipotle losing too much of its market over the long run.

-- Market: The Mexican food market may not have as big of a market that I believe it does. I'm judging my long-term expectations based on management's expectations and the amount of restaurants that Chipotle owns and has been so successful with. If Mexican food doesn't have a big market in areas like New York, Pennsylvania, and Midwest/Northeast areas like Utah, Oklahoma, and Idaho, that'll take a chunk of Chipotle's opportunity away. But, even if some states don't offer much potential, I think Chipotle still has a huge opportunity and could largely expand its base of restaurants.

Valuation

Management long-term expects to grow earnings at an annual rate of 25%. I think this is very doable. If Chipotle opens 100 restaurants a year for the next five years, they'll nearly double their restaurant base (they're currently on track to possibly even more than double it). I think they'll open approximately 550 restaurants over the next five years, and since it takes about three years for new restaurants to become profitable, I think margins can stay steady and possibly expand. This isn't a management team that fools around with estimates, they're going to meet their fiscal 2006 goal of 80-90 restaurants, so I believe them when they say they believe they can growing earnings at 25% annually for the long-term.

As for the P/E, I don't think we'll see it get too far below 40 over the next five years. But, let's assume that it does go down below 40 to 35. For my most expected estimate, I'm expecting 25% annual earnings growth and a P/E of 35. The current EPS is $1.13.

1.13 * (1.25^5) * 35 = 120.70

For my low estimate, I'm going to expect annual earnings growth of 17% and a P/E of 25. This is a pretty grim outlook, but it shows what happens when a company priced for high growth doesn't grow where people though it would.

1.13 * (1.17^5) * 25 = 61.94

For my high estimate, let's say 26% annual earnings growth with a P/E of 45.

1.13 * (1.26^5) * 45 = 161.49

I expect a double in five years, but I have no intention of selling in the next 15 years. Chipotle simply has too much opportunity in front of it for me to even consider selling anytime soon.

Conclusion

Very few companies like Chipotle come along. Their margins are better than the industry average even while opening so many restaurants, they've got a tremendous balance sheet, and they've got one of the most experienced management teams I've ever seen. Chipotle has a huge opportunity domestically that should keep them busy for at least the next 10 years, and international growth is certainly possible. In any case, I think Chipotle offers a tremendous long-term opportunity.

Business

Chipotle Mexican Grill operates as a fast-casual, Mexican-theme restaurant. The ordering process is most like Subway's, you have a layout of food, beans, toppings, etc., and you choose your choice of toppings. Chipotle's food is fresh, natural, it tastes like real food that you don't regret eating (i.e. Taco Bell). The food is among the highest quality you will find with a fast-food restaurant. According to Reuters, Chipotle's menu extends to 65,000 variations. Something unique is that most of Chipotle's restaurants offer beer and margaritas to go along with your normal soft drinks. Chipotle was founded in 1993 with one restaurant by Steven Ells in Colorado, and currently there are 547 Chipotle's in 26 states.

Disclosure: Author owns CMG shares

CMG 1-yr chart:

Comments

[dhmd1]

My small city of 100,000 people has 2 Chipotles (no Qdobas), which seems about right. They are generally busy but not impossibly so. Since the US has 300 million people, my very rough estimate for domestic expansion of the fast-casual mexican concept (Chipotle, Qdoba, Rubios, and the like) is 6000 restaurants.

[WC Whiner]

Good note on the 'B' shares.

Decent analysis overall. CMG's product may be a pale, flavorless and overpriced equivalent of my local burrito smorgasboard, but east of the Rockies, that may well be enough. One note: Mexican food is eaten by Mexicans in Mexico. The burrito is American, like Chow Mein and the fortune cookie. Call it 'Tex-Mex' or more accurately, 'Southwestern', since the US Southwest is where it's at home.

If Rubio's had CMG's management, I'd bet on their concept first. As they don't, betting on the old MCD hands may work out okay.

FD: no position, long or short

[RichardHanson]

My "Kids" are 25 and 23 and they love it! I have noticed their affectations for similar companies with youth appeal like aeropostale, abercrombie, cold stone creamery,american eagle, etc.

[GregCalderone]

Cramer loves this stock as well. Just said to buy it last week. Explained the subjective side to the multiplier for stock price. If you are in, congrats.

[borisb]

i am impressed by the high traffic during a recent WPB Sunday lunch time, and the president's recent interview on fast money, cnbc, where the main message is " we are able to raise prices" without resistance, which is a big deal. the uniquish menu-ingredients profile improves the chances of a 6000 unit market.

[SixPackPablo]

Hey, David, did a little searching and found that you had already explained the difference last year...so now the discount for B shares has increased even more...$130 for CMG and $103 for the B's as of 1/4/08 giving discount of 20%...wow, that's huge.

"What's different about the B shares than the A shares (CMG, rather than CMG.B)? The B shares have ten times the voting power of the A shares (for every B share, you get ten times the vote you do with an A share). Both share classes have the same EPS, the same balance sheet, the same cash flow, the same financials, only the B shares have more voting rights. So the B shares are trading, or at least they should be, at a premium, right? You'd think so, but no. The A shares are currently trading at $58.98, several dollars above the B shares. Why is this? The best explanation that I can come up with is that it's just a plain goof-up by the market. The B shares should be trading at a premium to the A shares, McDonald's even said to expect the B shares to trade at a premium when they executed the share spin-off. So, I'm buying the B shares, because sooner or later, the market will realize its irrational ways. The separation from McDonald's will result in Chipotle losing some pricing benefits, but I this isn't anything that I think will hurt the company long-term."

[DavidKretzmann]

Yeah, but eventually the true value of the B shares will be reflected in the share price. As I said in my other reply to your comment, there are several ways it could come about, but it will probably take awhile. Because I plan on holding Chipotle for the long haul anyway, I'm willing to be patient and wait for it.