Chipotle Mexican Grill (CMG) is a stock that has stymied its critics for some time, as evidenced by its price chart. The stock has risen by more than 392% in the past 5 years, and is now valued at almost 54 times earnings (per Google Finance). Chipotle's critics have argued for some time that its share price is too high relative to earnings and growth, and so far that argument has not panned out.
In addition to valuation, Chipotle's critics have argued that the company will succumb to competitors in the fast-casual Mexican space. In the past, competitors cited as ending Chipotle's free reign in this space have included various private companies, as well as Qdoba, a unit of Jack in the Box (JACK). But now, a potential new competitor has emerged, one that Chipotle's critics believe presents the strongest threat yet to Chipotle.
On July 5, Taco Bell, a unit of Yum! Brands (YUM) is set to launch its Cantina Bell line of Mexican food nationwide. The goal of Cantina Bell is to provide a more upscale offering at Taco Bell, long known as a more mass-market, lower class establishment. Cantina Bell has received a good deal of press, and is backed by a $20 million marketing campaign. Cantina Bell is positioning itself as the inexpensive alternative to Chipotle, with meals priced at $5 and below.
Critics have argued that with Cantina Bell, Chipotle will finally be ousted from its position as the leader of the Mexican dining sector, and that a plunge in the stock will follow. As long-term investors in Chipotle, we disagree with such a conclusion, and lay out our thesis as to why we believe Chipotle will retain its leadership position. Before we delve into our thesis, we believe it would be prudent to let readers know just exactly what kind of position we have in Chipotle. In addition to holding the shares, we hold options in Chipotle as well. We are bullish on the company's long-term prospects, but a desire to protect our gains in the shares has led us to buy put options on Chipotle as well, specifically July puts (at the $375 strike), in order to hedge against a negative earnings release, which is currently set for July 19. Chipotle has been able to sustain its valuation due to outstanding execution, and only outstanding execution going forward will sustain the stock. As a result, we wished to be prudent and have bought put options to protect our investment.
While we may reference Chipotle's financials in this article, we will not be formulating a call to buy the stock based on that. Our analysis will focus on Cantina Bell and Chipotle's market position, for we believe that Chipotle will not be adversely impacted by Cantina Bell. Before we discuss Cantina Bell, we would like to first explain a feature of Chipotle that we believe should not be ignored.
The Apple of Mexican Dining: A Profitable, and Secure Niche
In our previous article on Chipotle, published in October 2011, we made a comparison between Chipotle and Apple (AAPL). And aside from our recommendation that readers buy Chipotle (those who did have seen their investment return over 30% as of this writing, nearly double that of the S&P 500 since that time), the biggest criticism of that article was levied at our comparison of Chipotle to Apple. Critics fumed at our suggestion that a simple burrito company could ever be anything like Apple, a company in a class of its own; that doing so is an insult to the iPhone and iPad maker. And it seems that such a claim cannot be made even by an investor whose largest single holding is Apple.
In that article (as well as this one), our intent was not to say that Chipotle and Apple are on the same level. Rather, our comparison refers to one specific aspect that the two companies share, as evidenced by their financial results. Both Apple and Chipotle have been criticized as poor investments in the past for their exposure to consumer spending. Fears of an economic slowdown have been used as arguments to avoid shares of both companies.
Results at both Apple and Chipotle have shown that they are resilient to economic stress. Apple is set to grow European revenues by over 32% in this quarter, despite all of Europe's economic problems. And in Chipotle's latest quarter, revenues grew by 25.76% to $640.603 million. Apple is doing just fine in Europe, and Chipotle is not seeing any signs of consumer weakness in the United States. How can this be? The answer lies in the target customers of these 2 companies.
Both Apple and Chipotle have a core target customer: young, urban, and affluent professionals. These consumers are far less exposed to economic pressures than the average American (or European customer). If you can afford to buy each of Apple's newest products, or eat regularly at Chipotle, it is highly likely that the macroeconomic situation in your home country means little to you. A look at the states where Chipotle is concentrated shows that over a quarter of Chipotle's stores are located in the 10 states with the highest median incomes (that data was used in an article recommending that investors wait for a pullback in Chipotle stock before buying it; at the time, Chipotle was trading above the consensus price target, it has now returned to trading below it as analysts raised price targets and earnings estimates to reflect continued growth at the company).
We are not comparing the products or profitability of Apple and Chipotle. Rather, we are trying to emphasize the point that Chipotle, like Apple, does not need a strong economy to grow. Its target customer is resilient and insulated from economic stress. In this regard, Chipotle is similar to Apple, and we believe that it is one of the aspects that has made, and will continue to make Chipotle a good long-term investment. We turn now to Cantina Bell and Chipotle's position in the Mexican dining market.
Chipotle: Luxury in Mexican Dining
We believe that Chipotle should not be looked as simply a restaurant chain. Rather, it should be seen as a luxury retailer. An examination of what the company does and how it is viewed by consumers shows this to be true, in our opinion.
For critics of Chipotle, one of Cantina Bell's main selling points is its price. Given that Taco Bell will be providing meals similar to those at Chipotle, but for lower prices, critics assume that this will lead to Chipotle losing its place as the market leader. We, however, do not see it that way. Chipotle is about more than selling Mexican food, as we explain below.
Luxury retail is not about selling a specific product. It is about the experience that the product in question allows consumers to have. That is why luxury retailers survive. We offer Nordstrom (JWN) and Whole Foods (WFM) as examples of this fact. Nordstrom is one of this country's most upscale department stores. Among the products it sells are cashmere sweaters. A search for "cashmere" at Nordstrom's website returns many items, with prices regularly surpassing $500. A consumer could go to Costco (COST) and find cashmere sweaters there for under $100. And the price discrepancy does not stop there. Every type of product that Nordstrom sells can be found elsewhere for less. If price was the only consideration shoppers had when buying clothing, or jewelry, Nordstrom would have gone bankrupt years ago. People buy products from Nordstrom for the experience, the brands, and the ability to say that they bought something at Nordstrom. The department store has cachet, and great customer loyalty. Nordstrom's customers shop there because it is Nordstrom. The fact that they are buying something from Nordstrom outweighs the fact that they could get an equivalent product for far less at Costco, or any other clothing store. Whole Foods provides another example of this within the grocery space. The company's growth and margins are the envy of the industry. Whole Foods has built a successful business by convincing people to pay premium prices for its grocery products, even though customers can find equivalent products at Kroger (KR), Safeway (SWY), or SUPERVALU (SVU) stores for much less. Like Nordstrom, or Chipotle, Whole Foods is a luxury retailer, not just a grocer. People shop at Whole Foods because of the experience it offers them, the feeling that they are doing the right (and cool) thing by buying organic and sustainable food. The fact that they are paying premium prices is irrelevant.
Given the fact that Chipotle's meals run around $10 when everything is factored in, it is obvious that people do not go to Chipotle for just the food. If that were the case, Cantina Bell would be the final nail in Chipotle's coffin, with prior nails provided by Qdoba, or any other number of private competitors. Chipotle has spent almost 2 decades (the company was founded in 1993) building a brand that customers adore, a brand that they will pay premium prices to experience and be a part of. Chipotle's latest press release serves as proof of this. On June 18, the company announced that 100% of the sour cream in its restaurants is made from dairy that comes from pasture-raised cattle. It is moves like this that have won Chipotle the respect and business of its customers. Chipotle does not source its ingredients in a sustainable fashion to save money. On the contrary, the company would save millions by simply buying ingredients in the same manner as Taco Bell. But a commitment to natural and quality ingredients is the core of what has made Chipotle the leader in its market. The company, like Nordstrom or Whole Foods, does not sell a product. It sells an experience, and customers are ready and willing to pay premium prices to be a part of that experience. We think that Chipotle's critics underestimate the power of the company's brand and the loyalty of its customers. People have come to see Chipotle as a different kind of food company, one that cares about where its ingredients come from and that the food it sells is of the highest quality. Such a focus is what sets Chipotle apart from its competitors. We believe that there is another aspect of Chipotle's business that both further highlights its status as a luxury retailer, and serves to show that Cantina Bell will not dethrone Chipotle. That aspect is advertising.
Most luxury retailers spend little, if anything on advertising. Both Nordstrom and Whole Foods have little presence in the advertising markets, even as lower-end peers, such as Macy's or Ralphs and Vons spend millions to advertise their products. Companies like Nordstrom and Whole Foods do not need to spend money to promote their brands. Their customers do it for them. A lack of advertising is a tell-tale sign of a luxury brand. When a brand has enough cachet, it effectively promotes itself. Chipotle reflects this fact, as evidenced by its advertising and marketing spending. In 2011, the company spent just $31.902 million on advertising and marketing, and the majority of those costs were due to announcing the opening of new restaurants. Once those restaurants are open, however, there is little need to spend more on promoting them. The quality of Chipotle's product and its customers speak for themselves.
Taco Bell, however, does not have the same cachet as Chipotle (items such as Dorito tacos serve to highlight that fact). Yum! Brands spent a total of $593 million in 2011 on advertising and marketing (splitting that amount evenly across the company's 3 brands implies that Taco Bell spend $197.667 million on advertising and marketing, more than 6 times what Chipotle spent). Taco Bell advertisements appear constantly across the country, in various mediums. And when Cantina Bell launches, it will be no different. Taco Bell is spending $20 million to promote the nationwide launch of Cantina Bell, and the company is certain to increase that amount in the months ahead. If Cantina Bell were on par with Chipotle in terms of quality and cachet, there would be no need for that amount of advertising The product and customer evangelism would be all the advertising
Chipotle and Taco Bell: 2 Successful Companies, 2 Different Markets
Taco Bell has built a successful and profitable business selling mass-market fast food across the nation, and the stock of its parent, Yum! Brands, has reflected that success (Chipotle, however, has risen even more since its IPO).
While Taco Bell may have built a good business, it and Chipotle cater to different markets. Taco Bell's brand has come to be seen with inexpensive, late-night food, while Chipotle has come to be seen as a purveyor of high-quality Mexican food (not that it matters to Yum! Brands, as Taco Bell is still a profitable business).
Critics of Chipotle believe that Cantina Bell will be able to capture meaningful share from Chipotle, because it is cheaper than Chipotle. We do not think that will happen. For Chipotle's customers to experience Cantina Bell, they will have to go to a Taco Bell, and that is something that few Chipotle customers are likely to do. Most Chipotle customers, at least those that fit into the company's core demographic of young, urban, and affluent consumers, are not likely to have a desire to visit a Taco Bell, and an advertising blitz is unlikely to change that. And it will take more than millions in advertising to change that. Taco Bell makes a good deal of profit selling product to its customers. So does Walmart (WMT). But simply introducing something similar to what Chipotle sells, even at a lower price will not draw customers away from Chipotle. Walmart, if it chose to, could sell all the cashmere it wants at "everyday low prices," but Nordstrom's customers would still go to Nordstrom to buy it, because those who shop at Nordstrom do so for the experience and the brand, not the price. Chipotle critics who believe that Cantina Bell will capture Chipotle's customers seem to be forgetting this important fact.
An Ironic Twist in the World of Analysts
This section of our article will attempt to address another criticism that has been levied at Chipotle: that it is the subject of a massive pump and dump scheme that is designed to enrich analysts and institutions at the expense of unsuspecting retail investors. We do not believe that this is the case. 49.42% of Chipotle is owned by mutual fund companies such as Fidelity (the company's largest investor), T-Rowe Price, or Vanguard. Nearly half the company is owned by institutional investors that own it on behalf of retail investors. Critics of Chipotle also charge that analysts are inflating their estimates even as their firms scheme to dump their shares (this is unlikely because no brokerage firms show up in a list of Chipotle's top institutional investors). But let us suppose for a moment that this sort of scheme is in fact true. Let us suppose that the consensus estimate of $8.89 in 2012 EPS and $11.09 in 2013 EPS is a sham.
If that is the case with Chipotle, we argue that estimates for Yum! Brands (Taco Bell's parent) are also suspect. Why? Because at most brokerage firms, both companies are tracked by a single analyst team. We have access to the research of 5 firms: Argus, Credit Suisse, Morningstar, S&P, and Merrill Lynch. And at each of those 5 firms, the same analysts cover both Chipotle and Yum! Brands. And we see no reason why it would be any different at other firms. After all, both companies are in the same industry, and with Cantina Bell, it would appear that they are now competitors. And if the analysts covering Chipotle are engaged in a pump and dump scheme, is it really that much of a stretch to assume that Yum! Brands is subject to the same treatment. If one argues that estimates and price targets for Chipotle cannot be trusted, can estimates and price targets for Yum! Brands be trusted, if the same analysts rate both and follow both companies?
The data above show that Chipotle is expected to grow EPS by 30.543% in 2012, and 24.747% in 2013. Yum! Brands is expected to grow EPS by 15.331% in 2012, and 14.502% in 2013.
Investors should formulate their own opinions about what place, if any, Chipotle should have in their portfolio. For us, having Chipotle in our portfolio has been a very successful move, and we believe that in the long run, that success will continue. That being said, we are using options to protect ourselves against an earnings surprise.
There are both pros and cons to investing in Chipotle, as with any company. The purpose of this article was to show that Cantina Bell should not be seen as a reason to avoid Chipotle. We do not believe that Cantina Bell will be able to take share from Chipotle, or supplant the almost 20-year old company as the leader in this market. While Cantina Bell can be a successful addition to Taco Bell's lineup, it will lead to, if anything, incremental revenue growth at Taco Bell, not revenue declines at Chipotle. Chipotle's brand and customer loyalty are, in our view, too strong to be impacted by Cantina Bell. Investors should see Chipotle as a luxury retailer, not just a restaurant, for it has all the attributes of a luxury retailer. Rightly or wrongly, Chipotle is the leader in the Mexican dining space, and we see no indication that its position is threatened.