In previous installments of the Buy It Like Buffett series, we looked at valuations and expected returns from Microsoft (MSFT) and Pepsi (PEP). Moving forward I'll be expanding the scope of the analysis to include qualitative factors in addition to number crunching. Buffett first looks for great businesses. The math is important but secondary. For anyone interested in performing a similar analysis on their own, you can reference "The Buffettology Workbook" by Mary Buffett and David Clark.
So what constitutes a great business? What we're looking for are consumer monopolies. Buffett uses the analogy of a toll bridge - if you want to buy a particular product, you have to purchase it from that one company and no one else. He avoids commodity type businesses, which lack pricing power and often require high levels of capital spending. In the first half of this article, we'll be asking a series of questions to determine if Chipotle Mexican Grill (CMG) qualifies as consumer monopoly.
Chipotle operates a chain of fast-casual Mexican restaurants. Its menu includes south-of-the-border food made from higher quality ingredients (at a higher price point) than its competitors. Taco Bell's CEO Greg Creed admitted as much when he compared Chipotle to BMW and his own brand to Hyundai. I believe Chipotle qualifies as a consumer monopoly. It's important to remember that this doesn't mean there's no competition. It simply means the brand has differentiated itself enough to capture taste share in the category and carve out a meaningful niche. Morningstar believes Chipotle is in the early stages of developing a narrow moat.
A strong and rising earnings trend often indicates a business benefiting from a consumer monopoly and profit-minded management.
Chipotle Earnings per Share
Earnings per share at Chipotle are clearly in an uptrend. The minor decline in 2006 was insignificant and not a concern. Though potentially vulnerable to declines in spending by cash-strapped consumers, earnings remained positive at the height of the financial crisis.
Great businesses typically generate strong cash flows and require little debt financing. Buffett believes the most effective way to evaluate a company's financial position is not via the debt-to-equity ratio but by comparing earnings power to long-term debt. Chipotle is a slam-dunk in this regard since it carries zero long-term debt. You can't finance growth any more conservative than that.
Return on Equity
Companies that consistently deliver high returns on shareholder equity are true wealth creators. Average businesses typically offer a 12% return on equity while great businesses return over 15%.
Chipotle Return on Equity
Chipotle's returns on equity have generally tracked earnings growth, moving out of negative territory in 2004 when the company's growth began gaining momentum. While it's too soon to tell where long-term returns will settle for this young company, the current ROE of 23% is above our 15% minimum and trending nicely.
Whether it's via share buybacks or new investment in the core business, Buffett wants to own companies that are free to reinvest retained earnings at high rates of return. What he doesn't want to see is high research and development costs or capital expenditures in the form of plant and equipment replacement. In Chipotle's case, there are no R&D costs and even though capital expenditures are high compared to net earnings (63% over the trailing 12 months), cap ex is attributable to new store openings and expanding the current business. Free cash flow is positive.
From 2001 to 2009, Chipotle had cumulative retained earnings of $8.53 per share (see EPS table above). Over that same time, EPS grew from -1.49 to 3.95, or an increase of $5.44. So utilizing the $8.53 that was retained between 2001 and 2009, management produced $5.44 in additional income for 2009, or a 64% rate of return on retained capital. Such are the economics of a new, dynamic brand on the move.
Though the company is early in the growth cycle and still proving itself, Chipotle does indeed constitute a consumer monopoly and has excellent economics working in its favor. However no company is a buy at any price. In part two of this analysis, we'll look at Chipotle's valuation and decide on a desirable buy price.
I am long CMG.