Chipotle Mexican Grill: Spicing Up Fast Casual

Chipotle Mexican Grill (CMG) operates fast-casual fresh Mexican food restaurants in 28 states throughout the US. Its menu includes burritos, burrito bols, tacos, and salads. Customers can choose from 4 types of meats, 2 types of beans, and many different extras, such as guacamole: in total, 65,000 choices available. Founded in 1993 by Steve Ells, Chipotle currently operates 705 units.

We view Chipotle as “best of breed” operator and margin expansion story in the troubled restaurant sector. Shares have taken a beating due to toxic subprime-related headline risk that has tarred the stock even as the fundamental story remains intact. Through a combination of menu prices increases and labor efficiencies, the company is posing phenomenal restaurant level EBIT margins that we think will continue to expand. Given the 5x return in the stock over the last 24 months – and comps deceleration, which is expected of any restaurant looking at unsustainable double digit SSS – a buying opportunity will arise as “first round” investors dump the name, at which point fresh capital should get interested in the longer term 25% EPS growth story CMG is capable of. Net-net, we are midway the 5h inning, there will be some growing pains, but the longer term outlook remains colorful: we’d view pullbacks as rare buying opportunities.  

• The baby boomer generation, time-pressed Gen Ys, and the rise of dual- income families means more people are dining out.

• The fast causal segment remains the fast growing slice of the restaurant sector and its “middle ground” status provides a compelling alternative for both customers and investors looking to park cash among differentiated companies that can survive the stagflation cycle.

• Chipotle is remarkably keeping their ~$900K store opening costs flat in a rising construction environment and capable of modest  1-3% annual price increases.

• Rampant private equity and asset sale activity in the space (WEN, DRI, OSI, APPB) should sustain investor focus on the restaurant industry even as the space comes under pressure from high gasoline prices and the housing market debacle.

• Management has proven to be conservative with guidance, creating room for upside to consensus.

• Viral marketing approach is proving to bears that the Chipotle concept “travels well” – confirmed by our channel checks.

• Well positioned to capitalize on the “Whole Foods effect” and secular drive towards high quality ingredients.

• Greater than expected SSS deceleration will hammer the stock given the metric’s importance among restaurants.

• Soaring commodity costs are Chipotle’s biggest nightmare in the event they cannot defray them through price increases: the ethanol boom has popped corn prices, which have impacted chicken prices to the upside.  

• Rivals are pushing a low cost, “value meal” approach that CMG does not pursue and unlikely will given the management team’s commitment to quality.

• A protracted consumer shakeout would thwart our “P/E re-expansion thesis” and keep the stock range bound.

• Founder Steve Ells is responsible for Chipotle’s brand build-up and rapid growth: if he leaves, so will investors.

CMG possesses $5 cash/share and its $150M in CFO is enough to cover all CAPX needs, which continue to be deployed towards new store openings, which throw off a 40% ROI and remain the company’s best use of cash.

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Comments

[punksgt]

Did you buy at $150?

[DanielJacome]

Getting a lot of emails today, glad people liked the bullet point format. We also have models and more detailed research for those looking for it. For SeekingAlpha readers, we prefer to offer the "short version"

[DanielJacome]

Comments we sent to a reader:
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Basically CMG can raise prices < 2% and keep margins flat. So they'll raise prices more than that in 08 assuming they cannot leverage G&A more. I think the EBIT margin has more room to expand assuming the new labor efficiencies come to fruition and they jack up prices 2-3% in 08, which is not unreasonable. A 1.5% increase on your basic chicken burrito is ~11c - personally, I would never notice a 11c hike on a 6 dollar burrito. The CMG story is fascinating, but if they miss the next quarter, the market will NOT forgive them. The best way to look at the stock is to look at other "hi growth" concepts like PNRA, BWLD, dare I say CROX. 37x for a restaurant is insane, but if managements is planning to blow the St's EBIT margin estimates, 37x will look like a gift in 12 months - 07 was a bone crushing year for Chipotle. That's the key bet for 08: the story is not near saturation, mgmt is being conservative, and food costs will be offset by adequate menu increases. Not for those with weak stomachs, that's for sure.

[DanielJacome]

Thanks to JK @ Siren Capital for all the insight he gave us on CMG @ a recent student/advisor meeting here @ Kelley. Thanks, Jeff!

[DanielJacome]

disclaimer - since a reader asked in a comment above.

Student Fund @ Kelley is long @ 99. Will watch position like a hawk with a tight stop - the bet is riskier than lighting firecrackers up close and the market will hammer it on a missed Q - on the flip, a beat will help propel the stock to a potential 52WH reclaim.....

[User 149022]

"toxic subprime-related headline risk"?????

Silly me. I just thought they sold off b/c of bad earnings.

[DanielJacome]

"Silly me. I just thought they sold off b/c of bad earnings."

1c of it was non-recur. The market forgave CMG in a heartbeat - the last quarter was non-event, the heat will be on the next one.

[DanielJacome]

We just finished a longer, more substantial and detailed report on CMG.

Readers that would like a copy can email a request to [e-mail] and we'll email it you you right away

thanks,
Dan

[DanielJacome]

Jefferies initiated today and sums up some of the things we wrote about in our longer report (don't forget to email us if you want a copy!)

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Jefferies initiates Chipotle Mexican Grill (CMG 96.38) with a Buy and a $110 tgt saying Chipotle's best-in-class business model drives its industry-leading unit-level economics, EPS growth, ROIC expansion, SSS, and FCF growth. Firm says the quality gap between CMG and its peers will become more apparent in a weakening consumer environment, and expect the valuation premium for CMG vs. the peer group to grow..

[DanielJacome]

Stock rocking here for +21 pts (~16% rtn) since initiation; for those that got our detailed report, you know we reit our $136 price target. With the nice run in the last week or so, it wuld not hurt for traders to trim 1/4 positions to lock in gains.

Let the rest run; we'll keep you updated.

[mafernan]

Please excuse mu ignorance but what does "sss" stand for?

[DanielJacome]

mafernan, "SSS" stands for same store sales, a leading metric for the retail and restaurant industry as it pinpoints what level of sales are coming from stores/units open for at least a year?

Why is this important? This statistic allows investors to determine what portion of new sales has come from sales growth and what portion from the opening of new stores. Ultimately, firms will not be able to expand past a saturation point and the Street will be looking strictly as what sales growth is coming from the store base already out there...

[DanielJacome]

CMG rpts EPS on Wed 4/23; here's what we posted an Zach's awesome article from
seekingalpha.com/artic...

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"I think if you have a longer term view, CMG has a ton more room for growth, but as you say, the market will eventually pay a lot less for that growth as comps get harder and harder to beat as 2008 progresses.

You'll recall that a lot of people dismissed CMG in early 07 and then CMG came and crushed bears as it doubled its EBIT margin and cranked out on the top line, as well. So you are dead-on: the high PE comes from investor belief in current management to execute on another blockbuster year....

With EPS on Wed, we're long the common and would suggest hedging with puts...."