Growth Stocks for a Value Investor: Green Mountain Coffee Roasters, Chipotle Mexican Grill

This is the story of two great growth stocks, one that I bought and one that I should have bought. Both companies just released blowout earnings of (coincidentally) 38 cents a share.

The one that I bought is Green Mountain Coffee Roasters (GMCR), one of my all-time favorite companies. The one that I should have bought is Chipotle Mexican Grill (CMG), one of my all-time favorite restaurants.

Green Mountain Coffee Roasters
GMCR reported fantastic numbers this morning for its second quarter. Net income doubled over the year ago quarter on sales growth of about 77%. Analysts had expected EPS of $0.34, and GMCR came in with $0.38. This represents a ttm ROE of 13.4%. The stock shot up 10% this morning. As I have written about before, this company has some of the most level-headed and seemingly honest folks running it of any company with which I am familiar. After a decade of watching the company grow at a fast, but not ridiculous, rate I am now witnessing a true explosion of value.

There are at least two factors at work here. The first is that GMCR has created itself a niche that is protected by intellectual property rights. This gives it a wide moat that competitors, even those as strong as Starbucks (SBUX), will have trouble penetrating. I am referring to their development and acquisition of the patented Keurig K-Cup brewing system. A K-Cup is plastic container, about the size of a shot-glass, that is filled with Green Mountain Coffee and sealed on the top with foil. When used with the (also patented) Keurig brewers, the cup is pierced and the coffee is brewed in the cup, producing one serving of perfectly brewed coffee. This has proven extremely popular in office settings, where the dreaded “coffee-burn” phenomenon has hindered the appeal of coffee pots for years.

The second factor is the company’s new relationship with McDonald’s (MCD). McDonald’s launched its “Premium Roast Coffee” campaign last summer with great success, immediately challenging Starbucks on taste and convenience. The coffee is usually branded under the McDonald’s name, but in a select number of stores in the northeast McDonald’s actually sells Green Moutain’s Newman’s Own Organic Coffees as such. Not only does this position Green Mountain to potentially supply the largest restaurant chain in the world, it also gives the coffee exposure to a constituency it otherwise wouldn’t.

The market seemingly has high hopes, as the stock has traded at very lofty multiples for several years now. This can be difficult for the value investor to accept. GMCR must grow at its current clip to justify its valuation, and that simply introduces a great deal of risk in to the investment. Should I, as a value investor, really take a position in a company that trades at PEs upwards of 50? Usually I won’t. In fact, this is exactly the reason I failed to dive in to the stock of my favorite lunch destination, Chipotle Mexican Grill.

Chipotle Mexican Grill
At the university where I work, I think most people would agree that Chipotle is unequivocally the most popular place to eat on or around campus. Every day a long line stretches around and towards (sometimes out) the door – both at lunch and dinner time. Friends of mine eat there every day. I even recall an article in the student newspaper entitled something like “I love Chipotle.” The food is delicious and the customers are loyal. I know this because when a similar Mexican food competitor opened next door, hardly anyone switched. The lines at Chipotle remained just as long as they had ever been.

So when I heard McDonald’s was selling its interest in Chipotle, I was immediately interested. For several months I watched for updates at chipotleipo.com, but was disappointed when the IPO was announced. The stock would go public at about 30 times earnings. For a company posting a return on that new equity balance of only 10.5%, this seemed to be too dangerous. High multiples like this make the cost of equity very high, and force comparably high returns if value is to be created.

Nevertheless, I have watched from the sidelines as the stock nearly doubled. It doesn’t take much research to figure out that the reason is that the company continues to expand and grow at rates higher than even Wall Street’s lofty expectations. Compounding the stock’s growth is the treasured “multiple expansion,” the market’s reaction to its realization that growth may be even better than it thought. Whereas the P/E of 30 sounded high to me a year ago, CMG now trades at a ttm P/E of over 50! The forward P/E may look more reasonable, but is still high at about 44.

So am I just hardened by the tech-bubble crash when high-multiple stocks suddenly fell to more normal levels, or should I really be considering these high-growth, but correspondingly high-priced, stocks? It is a test of discipline. CMG is very expensive, but it also is a very strong company. Thus, I need to convince myself that it is creating value despite its lofty price. I cannot convince myself of that, since the returns that it is earning are simply not high enough to offset the high cost of equity capital implied by the current stock price.

Full Disclosure: I own shares of GMCR, but have no position in CMG or MCD.

GMCR vs. CMG 1-yr chart:

Comments

[borisb]

Andy you make good points on CMG. why dont you consider 2 metrics.
Number 1 you have the B shares available at a redicious $7 discount despite
no eps or other diluative compromise, per management.
Second, what about the fact the B shares trading at about 2x 2007 sales,
which might be "modest" if this is indeed
a rapid growth mini-mcdonlads franchise the likes of a sbux-wfmi. I have seen
these situations go wild to 3x with retail investors, but you have to
know for sure this is that type of concrete franchise.
disclosure i had a super sized stake until wednesday's blowout towards 80.

[borisb]

By Tuesday the 5th day after earnings, a small $4.80 dip comes up, 80.80 > 76.00,
and the B shares follow suit. i wonder if this is enough of a dip to be rewarding or should we stay on the side lines waiting for more. thoughts?

[rileydawg]

Although I appreciate your investing discipline, standing on the sideline on a stock of a restaurant that you have such positive personal experience from does not make sense to me. Although CMG does carry a lofty PE, the growth and the company's competitive advantage make it trade at a true premium. This stock is an outperformer in the short term as now is the time it is adding over 100 plus stores a year.
Disclosure: I recently sold on August 6, 07 into the strength. I'm pretty sure that Ill be able to buy back before next quarter for cheaper.

[CapitalistLisa]

I think Chipotles in trouble. They just hired a new area manager here in Northern California 2 weeks ago. Up and down Northern CA they performed management audits and just today Sept 16 they have suspended many managers. Capable, high integrity people have been placed on suspension tonight. For me personally it makes no sense AND considering in the past few months they've made major changes management requirements with little feedback or give and take I can only believe there's problems at the Mexican grill.