Chipotle Mexican Grill Inc (CMG) has retreated close to 10% recently after ITG analyst Steve West warned of slowing comparable sales growth of its existing restaurants. (Read: Chipotle falls as analyst suggests slower growth.) Comp sales growth are expected to be around 8%, down from 12.7% in the first quarter. Note that since the company gives the guidance for the number of restaurants to be added each year, the total sales forecast is largely dependent on the comp sales growth. So based on the forecasts for the comparable sales growth, the stock price can fluctuate to a great extent.
All of Chipotle’s restaurants are company-operated, which means it doesn’t have any restaurants which are franchised. Here we look at how this could shape up for the restaurant chain and how likely it is to rebound or test new lows. A couple of things working in favor of the company are:
1. Advantageous Supply Chain Dynamics
Okay, we know Chipotle touts the quality of ingredients it uses. But from a business point of view, that translates to nothing if the customers don’t value it or the company doesn’t receive any tax breaks or incentives. But with the FDA getting more stringent on how the animals have to be raised, this is something which will benefit Chipotle in the long run.
The recently passed FDA regulation requires farmers to obtain prescriptions from a veterinarian if they need to use antibiotics in animal feed, a move aimed to curb the rampant use of antibiotics. And although the FDA’s current proposal will not alter the current supply chain of most major restaurant chains substantially, it certainly provides guidance as to where things are headed in the future. Moreover, its not just the lawmakers but the consumers, too, who want to reduce the usage of antibiotics. According to one survey, as much as 75% of Americans want legislation passed to restrict the use of antibiotics at animal farms.
2. Healthy Balance Sheet
Chipotle has almost zero debt ($3.6 million to be precise, which is nothing compared to its $18 billion market cap). Moreover, it had cash reserves of $370 million as of March 31, 2012. Companies in their initial phase often have huge debt loads in the belief that the additional value created would be greater than the interest expenses to be incurred. However, when things don’t go as per expectations, the debt undertaken to fuel growth actually starts acting as a burden, and is often the reason why further growth stagnates.
Chipotle expects to incur capital expenditures of about $160-$170 million in 2012, of which $138 million relates to the construction of new restaurants (in the region of 155 to 165) and the remainder primarily relates to restaurant investments. With Chipotle’s balance sheet in a healthy condition, we believe the company is in a position to add restaurants on a timely basis and even accelerate the store openings if the need arises.
It’s quite natural for the comp sales to slow down to 8% as the number of restaurants increase. Comp sales growth of more than 10% are often unsustainable on a bigger base. Thus, we are assuming a 6-8% comp sales growth in the long run (which can be broken down into 4-5% growth in the average spend per visit and 2-3% growth in the average number of footfalls per restaurant). Chipotle has been technological developments such as facilitating the usage of fax, internet and iPhones to accept food orders, so that customers don’t have to stand in lines, thereby improving the overall customer experience.
Coming to margins, Chipotle has benefited from lower occupancy costs, labor costs and other fixed costs, although the cost of raw materials has crept up in recent times (all figures as a percentage of revenues). A good comparable sales growth ensures the percentage of fixed costs gets lower. Thus, occasional price hikes combined with a healthy comp sales growth should ensure the restaurant chain is able to maintain its margins in the long run.
Using these assumptions along with a discount rate of 9%, we get a price estimate of $417, which is about 10% more than the current market price. Thus, we believe there is no need to panic because of the recent declines. The company’s long-term fundamentals look solid.