Chipotle B Shares: The Proof is in the Taco

Chipotle Mexican Grill (CMG) operates fast-casual Mexican restaurants (the company does not franchise locations). In the interest of background, CMG shares have performed very well since their IPO in January 2006 and are up over 100% in 2007, driven by strong operating performance (i.e., same store sales – 'SSS' - up nicely buttressed by new store openings and good cost control). However the shares are down nearly 10% from their peak due to recent downgrades on valuation (analysts believe the price is rich at ~50x forward earnings). Despite the surge and given current macroeconomic concerns combined with the recent correction, MADreturns™ believes CMG is a good buying opportunity and sees upside assuming continued strength in SSS and new unit growth. Moreover, we prefer the less visible Class B shares (CMG.B) that are trading at nearly an 11% discount versus the A shares (CMG).

Attractive Growth Story

At the end of the second quarter, CMG operated 640 locations (no franchised locations). The number of units has grown in the high 20% range per year over the last five years. Analyst believe the U.S. can support between 2,800 to 3,000 Chipotle locations and expect the company to open 100 to 200 units per year over the next several years, which translates into annual growth of 15% to 20%. We also believe the company will be able to maintain healthy SSS growth given the rising popularity of the Fast Casual segment versus the Quickservice (Burger King (KING), Wendy's (WEN), etc.) or Casual Dining (Olive Garden, Red Lobster, etc.) segments. Within Fast Casual, we view the Mexican concept favorably. We also believe that the company can raise menu prices without materially affecting traffic, especially given the new organic menu. SSS growth has ranged from 10% to 27% since 1998. Going forward, SSS growth should moderate from double-digit levels but continue to benefit from favorable industry dynamics and price increases.

Upside

We believe investors will flock to growth stories such as CMG in 2008 and 2009 given the macroeconomic concerns (slowing M&A deals, weak housing market, weak dollar, etc.). As such, CMG should be able to sustain its rich valuation. CMG has generally traded in the 36x to 50x forward 12 months earnings range. Assuming earnings growth in the high 20% range and a multiple of 40-50x forward EPS, CMG stock is arguably worth $120 to $150. (It is worth noting that some analysts believe investors should pay 2x the growth rate of a high growth company, in which case CMG should be able to sustain a 50-60x earnings multiple.) Given this range and other factors discussed below, we prefer the B shares versus the A shares.

Buy the B shares

The Class A shares are currently trading at $123 which implies 19% upside at the high end of the range (high 20% EPS growth and 50x multiple). However, there is much more upside (5% to 30%) to the B shares which are trading at $111. The B shares trade at a discount to the A shares despite having MORE voting rights (the current discount is almost 11%). The super voting shares of other publicly traded issues with two classes of stock typically trade at PREMIUMS of 5%. The discount relates to liquidity as the average daily volume of the B shares is lower than the A shares. We expect the volume and valuation disconnect to merge in 2008 as this is becoming a more publicized issue on the Street. In addition, there is a chance the two classes are merged in the future. Given these factors (A vs. B), the growth potential of CMG, and the current economic concerns, we view the Class B shares of CMG as a good buying opportunity.

Disclosure: none

Comments

[RHEii]

Great article. I can't believe that CMG investors fail to understand the unexplainable discount that the "B" shares have experienced, given that the "B's" have a 10 to 1 voting advantage versus the "A's". Why are these knowledgeable investors willing to pay a very large premium (currently about $15 per share) for the "A" shares when the "B's" should trade at a premium to the "A's", and not visa versa? Is it because they don't realize that the "B's" have roughly the same total shares outstanding as the "A's"? This defies logic. Your article finally sheds light on this unexplainable phenomena.