Chipotle Mexican Grill: Multiple Mania

| About: Chipotle Mexican (CMG)

Summary

Investor focus on earnings multiples is misguided when long-term earnings potential is not considered.

Since its IPO, McDonald's achieved above-average long-term growth that warranted a high earnings multiple, despite never achieving 20-30% growth.

Giving equal weight to MCD-like and JACK-like outcomes still shows CMG to be a worthwhile investment.

In Part 1, I ended the diabetes epidemic by causing consumers to completely swear off food. I also shared some pretty compelling evidence, in my mind, that Chipotle Mexican Grill (NYSE:CMG) can overcome its recent troubles on the way to continued success.

Black Bean Burrito Down

But even if CMG can return to its former glory, isn't it overvalued anyway? After all, it's trading at ~30x trailing 12-month earnings, which doesn't include the lean quarters on the horizon in 2016, and its growth has slowed significantly in the last year. CMG's historical financials are highlighted below.

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After a staggering 10-year run of 20% top-line and 30% bottom-line growth, CMG has apparently entered the ho-hum reality of high single-digit growth. Even before the E. Coli outbreak hammered Q4, CMG's same-store sales were in a steep negative trend that clearly signaled the end of yet another momentum story gone wrong. Never mind that this exactly same negative trend occurred in 2012, only to be followed by two of CMG's strongest same-store sales years ever…

For argument's sake, let's accept the premise that CMG's days of 30% EPS growth are behind it. What growth is reasonable to expect going forward and does the current price provide an investment opportunity? I will answer all of your burning questions... just humor me for a moment.

Value Investing: Not Just a Clever Name

"I believe life is simple. People make it complicated." John Bassett, USFL owner (apparently plagiarizing Confucius; I give him a pass because, honestly, who hasn't plagiarized Confucius)

Valuing any asset is a relatively simple matter. Add up ALL the net cash flows to be generated by that asset over its entire life, then discount the cash flows to the present day. That's it. No need for high-powered supercomputers or artificial intelligent algorithms or Elliott Wave Theory or the orangutan that went 8-0 during the 2016 NFL playoffs (terrible Super Bowl pick notwithstanding). That's why it's called "value" investing: you actually have to value the investment!

Yet this simple, albeit unglamorous process is all-too-often abandoned in favor of a voodoo-based, stick-your-finger-in-the-air-to-judge-which-way-the-wind-blows, driving-while-blindfolded approach; an approach that permeates the entire investment industry from professionals to die-hard hobbyists to people who don't understand what those "mutual fund thingies" are in their 401-Ks. I am, of course, talking about the Multiple. The Multiple is called by many names and wears many disguises, though lurking underneath is the same sinister face. The Multiple most commonly manifests as the price-to-earnings (P/E) ratio, but also masquerades as P/CF, P/FCF, P/FCFE, EV/EBITDA, Lynch P/E, Economic Value Added, PEG, Replacement Value, etc., etc., etc. Am I the only one that realizes these ALL measure the same thing?!?! Sometimes I feel like I'm taking crazy pills.

The typical, poorly-laid investment thesis utilizing the Multiple is a derivative of the following: "30x P/E seems like a lot to pay for a business only growing earnings at 8% this year." Some, recognizing the Multiple's flaws, will half-heartedly attempt a proper valuation by estimating actual cash flow for a short period, only to lazily fall back on a random Multiple selection at the end of said short period. Others will compare the Multiple of one company to another company, as though watching a stranger eat would make you go to the bathroom. Still others believe the Multiple is a marker leading the investor in the right direction, sort of like how a buoy rope indicates where it is safe to swim. Unfortunately, the Multiple does a terrible job of identifying the shallow water, and all too often people swimming inside the rope still get eaten by sharks.

At its core, the Multiple does not provide a method for comparing price to value. It is a method for comparing price to price. When you are buying a car, do you only consider the price? What about all the options? i.e. what is the seating capacity/storage space/repair cost/fuel efficiency/useful life/horsepower/ handling capability/interior aesthetic/exterior aesthetic, etc., etc., etc.? Options create value. And that additional value can justify a higher price. Compare, say, a Tesla Model 3 to my old, beat-up 1985 Ford Tempo. The base Model 3 will run $27,500 after federal incentives. Back in the day, I would have sold you my beloved Tempo for $250. Does that mean my Tempo was a better deal? Does that mean the Model 3 is 100x more valuable than my Tempo? Stocks are like cars; if you never look under the hood, you can't know if you are getting a good deal.

*For the record, I never did find a buyer for my Tempo. Had to drive the poor thing straight to the graveya- ... er, scrapyard.

Come With Me If You Want to Live

In the business world, the rearview mirror is always clearer than the windshield." -Warren Buffet

I have a confession. I lied to you; I lied to you in order to make my earlier point more dramatic. Valuing a business (usually) isn't that easy. To determine future cash flows, you have to predict the future, which has proven very difficult for anyone that can't travel back in time to deliver a sports almanac to their younger, dumber self. Most investments have a broad array of possible outcomes. On one timeline in the 5th dimensional universe, the business goes bankrupt tomorrow and your investment has a -100% return. On another path, the R&D department stumbles across the process for cold fusion and you become God. Then there's every other outcome in between. As an investor, you have to consider the possible outcomes and the likelihood of each outcome. Thankfully, in some situations, there are plenty of historical timelines that can be used as a guide. To go forward, we must look back.

This brings me back to the Multiple. Perhaps the most sinister result of Multiple worship is the focus on short-term earnings growth. You might model, say, a 2-stage Discounted Cash Flow (DCF) with a 5-year growth rate on the fair assumption that earnings beyond 5 years are inherently difficult to predict. So you tack on a terminal value using, say, ***gasp*** a freakin' market multiple or a terminal growth rate. The terminal rate is usually presumed to be 2%-3% per annum, which effectively says that in the long run (technically infinity), the business will regress to the average performance of the broad economy.

But this is very often not true. Businesses can outperform the terminal rate for very long periods and they don't need to outperform it by much in order to create substantial additional present value. And there are numerous examples in history.

Take the path followed by McDonald's (NYSE:MCD), the world's premier purveyor of non-decomposing fries. MCD was founded way back in 1940 and went public in 1965. A more enterprising researcher likely could have found annual reports since the IPO, but EDGAR only goes back to 1985, and I think that's enough to prove my point.

The only data point I could easily find for pre-1985 came from MCD's Canadian website, which suggests it had 700 stores when it became public. MCD opened its first international store in 1967 and by 1985, it had almost 9,000 stores in more than 20 countries. More detailed store and financial figures for MCD are below.

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Click to enlarge*Stores figures are simple mean, not CAGR.

A full 30 years after MCD was founded, it has a 50-year track record of above-average alpha. This continued even into the last decade with net income growth in the mid-to-high single digits. Yahoo's first share price point is Jan. 01, 1970, since which MCD is up ~38,000%, demolishing the S&P 500 and whatever supposed Multiple or terminal rate silly investors elected to use in their valuations back in 1970. Yet at no point in the last 30 years has MCD achieved the sexy 20%-30% growth apparently reserved for companies trading at 30/40/50x P/E.

Back to the Future

History seldom repeats, but it often rhymes" - Mark Twain (at least it sounds like something he would say)

Hypothetically speaking, if CMG were to rebound from its current travails and go on to match MCD's performance from the last 50 years, what would the company be worth? Funny you should ask; I put together a 50-year, 6-stage model that tells us just that. Talk about complicating things.

The first few years of the model obviously have to run contrary to the MCD story given the recent E. Coli outbreak, so I set the first 5 years somewhat analogous to the Jack In The Box (NASDAQ:JACK) experience. In my model:

  • Sales decline a full 20% in the first year and remain flat for the next two.
  • Sales grow in 6 separate stages thereafter.
  • EPS margin is set to crater in 2016 and not reach the 2015 high watermark until 2020 as per below.

Beginning in 2019, I replicate MCD's performance from 1965, adjusted for inflation. 1965 seems like a decent (not perfect) year to start the comparison given that MCD had 700 stores and had not yet expanded internationally, fairly similar to Chipotle today. This results in revenue growth as per the following separate stages:

Items of Note:

  • For 2019 to 2035, revenue matches MCD store growth from 1965 to 1985. This is not an ideal comparison, but I believe it is conservative, given that MCD's actual revenue growth was very likely greater than its store growth.
  • For each stage thereafter, I started with MCD's revenue growth, subtracted the prevailing inflation rate for the period, and added the 30-year TIPS rate to get CMG's projected revenue.
  • EPS margin increases gradually over the entire 50-year period, such that it reaches 20% in 2065. This is a relative match to MCD, which recorded 20%+ profit margins for a stretch from 2009 to 2013.
  • I conservatively use EPS as an analogue for owner earnings, even though CMG's capex is likely lower than its ongoing amortization, which further enhances value.
  • The 6th growth stage, at the end of 50 years, uses a terminal value of 3%. Yes, how lazy of me.

The models outputs are as follows:

Wait… What?

Some of you might be losing your minds at this point, exclaiming "50 years! How can anyone predict 50 years into the future?!?!?!" A couple of retorts: 1) When you use the Multiple to value a stock, you are technically predicting an infinite number of years into the future. From that perspective, 50 ain't so bad. 2) You're right! It is very difficult to predict that far into the future, which is why it behooves you to stick to businesses with predictable long-term earnings. With respect to quick service restaurants, there are numerous examples of such long-term performance (outlined below).

Just for fun, I also calculated two truncated values, assuming the modeled growth for 30 years and 5 years respectively, with a 3% terminal rate applied thereafter.

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We can see from the above that the additional 20 years of back-end alpha adds 16% to the CMG's intrinsic value. That's a substantial margin of safety built out of long-term outperformance.

And as you can see from the table below, the further out we can model, the less we rely on a terminal value. If you can only model 5 years into the future, a full 83% of the valuation relies on a complete guess.

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Long story short, if CMG can become the next MCD, we have a massive winning investment on our hands. CMG is worth at least $902; it trades at half that.

You Ain't No Ronald McDonald

The most obvious counterargument to the above valuation is that CMG is not MCD. MCD is a unique event, a six-sigma fluke that is unlikely to be repeated. The vast majority of restaurants that big cannot maintain long-term growth that high.

Not exactly. In fact, essentially all of the top quick service restaurant chains in the world are examples of chains that have achieved substantial growth many years after they were first founded.

  • Subway: significant growth in the last 10 years, snatching tile of largest restaurant chain
  • MCD: see above
  • Starbucks (NASDAQ:SBUX): 10% average revenue growth in the last 10 years, even after it had so saturated the market that this happened.
  • YUM! (owner of KFC/Pizza Hut/Taco Bell): 8% average EBITDA growth since 2006, even in the face of secular headwinds for its core brands.
  • Burger King (NYSE:QSR): Sucks.
  • Domino's (NYSE:DPZ): 11% average EPS growth over the last 10 years.
  • Dunkin' Donuts (NASDAQ:DNKN): 11% average EBITDA growth in the 5 years since becoming public.

There is some survivorship bias in the above cohort, but the key takeaway is that all these years after they were founded, Burger King is really the only top chain that has recently sucked.

Still not convinced? Here are a couple more arguments against the CMG = MCD thesis... and my counters.

Population growth was way higher in the 20th century, supporting greater sales growth.

Actually not true. For example, during the 1965 to 1985 stretch when MCD opened more than 8,000 stores, US population growth was ~1.02%. From 2001 to 2010, US population growth was ~0.94%. Offsetting this slight decline is the fact that an ever-greater proportion of people are eating out rather than at home.

MCD has a more diverse product offering leading to more unit demand and higher margins: breakfast, McCafe, Kid's Playground, 24-hour drive thrus, and dessert!

This is currently true. But CMG has the ripe potential to expand its product offering or perhaps extend its market-leading nutrition-focused approach to new concepts. CMG is currently exploring this with ShopHouse, Pizzeria Locale, and the Better Burger trademark (a brand that doesn't even exist yet and is getting everyone, including my evil twin, The Inconsolable Investor, all fired up).

MCD was a first-mover in international expansion, giving it a leg up on the competition. CMG will have no such advantage.

Probably true to an extent, but perhaps those international markets will follow America's lead in changing tastes. Greater competition could also be offset by a more integrated global community where foreign brands are more readily accepted. Also, the increased competition in the American market hasn't seemed to hurt CMG in any way.

CMG's menu is effectively twice as expensive as MCD's, creating a much smaller potential market.

Here's where I believe the two secular trends of eating out and nutrition consciousness are coalescing into a big time benefit for CMG. CMG may be more expensive than MCD, but it is still more convenient and less expensive than the next option, which is cooking at home. By the time all the fresh ingredients are purchased and prepared, consumers cannot make the same meal at home for less than what CMG offers. Think its absurd people would pay $10 for a burrito? People once scoffed at the idea that anyone would pay $5 for a coffee.

BACK to JACK

Despite all the angling and spirited arguments I've made above, the "CMG is the next MCD" path is admittedly only one of a myriad of paths the company could follow and, more than likely, it is the best possible path.

What's the worst path? In Part 1, I showed JACK had the absolute worst E. Coli outbreak of all time, by an order of magnitude. That strikes me as a comfortable lower bound. Below is a quick snapshot of JACK's performance before and after its 1992/93 affair.

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By 1997, JACK had clawed back and, thereafter, achieved a 4.7% EBITDA CAGR over the next 18 years. Not great, but certainly not the dire straits that one might have expected.

I applied this performance to CMG. The first 5 years are as follows (the only material difference from the MCD model being that sales remain flat for 2 additional years):

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Thereafter, growth follows a 2-stage model, with a 14-year period of 4.7% EPS growth and a terminal rate thereafter. EPS growth ends up as follows:

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With NPV as follows:

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Some of you may argue that JACK's performance was saved by Qdoba, its entry into Fast Casual, and I wouldn't argue. Obviously it has. The point is that JACK survived as a business and was able to pursue future growth opportunities, wherever it might have been.

Two Become One

Armed with the best and worst possible outcomes for CMG, we can weight these two scenarios, according to taste, to determine a rough intrinsic value. I have chosen to weigh both outcomes equally, a great way to keep both sides of the argument happy.

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A quick aside on discount rates. With the 30-year bond currently trading at ~2.5%, a 10% discount rate affords a 7.5% risk premium, among the highest in history. This accounts for a lot of variability in potential negative outcomes before we even have to lift a finger. As Charlie Munger notes, not all opportunities are created equal and neither are all discount rates, so choose wisely.

At any discount rate and even with significant weight given to the worst possible outcome, CMG still looks like a solid buy.

Conclusion

The sell-side downgrades have poured in for CMG in the last month, and all ears will be tuned to the earnings call Monday after close. CMG's sales may outperform. They may underperform. Either way, we can be assured they will be bad. We can also be assured that, over time, they will rebound. And we can be assured that, more than likely, CMG is a good investment opportunity at the current price (and at lower prices, should upcoming news be worse than expected). Finally, we can be assured that after all this writing, I'm famished. Time for a burrito.

I look forward to all the commenters that did not read the article and use the Multiple to support their position.

Disclosure: I am/we are long CMG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.