When evaluating individual companies, the wisdom of Warren Buffett of Berkshire Hathaway (BRK.A) fame advises us to be mindful of three key issues prior to making a decision to either own or decline to own part of a company via shares purchased in the open markets. The first of these is the management team in place charged with guiding the company's future successes or lack thereof. Second, one should evaluate the economic prospects available to the business (i.e. areas of potential growth or expansion that would be beneficial to the company's bottom line profits). Finally, and perhaps the most important in my humble opinion, is we must assess the price we must pay to own our portion of said company. This is perhaps the most challenging part of the decision making process. Many can identify companies with fabulous management teams and large potential earnings growth potential. The challenge is having the patience to find an entry point that is fairly priced, or the Holy Grail, significantly underpriced. Even great companies sometimes have price tags that investors should not be eager to pay.
So with this good common sense approach to guide us, courtesy of Omaha's Oracle, I'd like to take a look at Chipotle Mexican Grill (CMG) and how they stack up on each of the above criteria.
Some information and quoted material following is from company website materials found here.
Chipotle Mexican Grill was founded in Colorado in 1993 by a gentleman named Steve Ells. In his own words he says he never intended to open more than one restaurant, but simply wished to "build a place where you could eat delicious food made of the finest ingredients quickly and affordably." He goes on to say this was an idea people got behind, and in my opinion this seems to still hold true today. There are now approximately 1,300 CMG stores nationwide. Beginning around the turn of the century, Mr. Ells began formulating his 'Food with Integrity' plan, and throughout the next decade-plus the company has made huge strides in this area. For example, the company serves 100% naturally raised chicken, pork, and beef in their restaurants. They now serve sour cream that is 100% from pasture-raised cattle (rather than those from terribly confined quarters, etc.) and are well on their way to accomplishing a similar feat with various other dairy products. They have rolled out a local produce program, and project utilizing 10 million pounds from local farms this season. They utilize sunflower oil in over 200 restaurants currently as it is healthier, containing zero trans fats, and tastes better, and they intend to roll out sunflower oil in each and every one of their restaurants in the not-too-distant future. The company does an excellent job of cultivating managers for new and current stores through their "Restaurateur" program, and now has 98% of managers coming from within the ranks of CMG's crews.
This may all seem like extraneous information for the business minded, number crunching, analysts of the financial world. But I believe it bears noting, and I include it for the following reasons: The 'Food with Integrity' program is no mere façade, rather it is a philosophy by which Chipotle is run and one that customers seem eager to embrace. This commitment is a clear sign of an unwavering management team that is dedicated to their business quality and to their customers, which is often a recipe for continued success.
Now, from a more numerical standpoint, the management team has performed phenomenally as well. One may start by acknowledging this fact; since the company opened its first store in 1993, approximately 1,300 stores have been added to the lineup, and the company has managed this with absolutely no debt currently on the balance sheet as of the most recent quarterly filings, compared with $700 million cash and equivalents.
Chipotle also demonstrates more than competent management in the way in which new stores are rolled out efficiently and in a manner to immediately be productive and accretive to bottom line profits. The most recent comments on stores opened in 2012 thus far (87 as of reporting date) are that they are performing well. More specifically, they are operating at or above the high end of guided $1.5-1.6 million sales range. I could ramble for several pages about various attributes that have made me a believer in Chipotle's management philosophy and team, but suffice it to say I am just that; a believer.
Economic Prospects Available to the Business:
Let's lay some groundwork very quickly before attempting to delve into the future here. Some important statistics loom large to me when glancing at Chipotle's most recent quarterly earnings report and earnings call transcript. One of which is the sales leverage the company is able to achieve. Here are the big numbers at a glance:
-Sales for quarter ended June 30, 2012 of $690.9 million, an increase of 21% year over year.
-Earnings per diluted share of $2.56, an increase of 61%.
One does not need to be a particularly gifted mathematician to understand that increasing earnings by 61% on sales increase of 21% is a good thing.
As of Q2 report, 87 new stores had been opened this year, out of a guided 155-165 for full year 2012, indicating that before January 1, 2013, as many as 78 more will be opened. We have already briefly touched on the fact that these new stores are opening up at high revenue levels, and that the company is able to translate these revenues into even higher profit increases, so I have faith the EPS figure will continue to grow at a nice clip.
Other areas of growth for CMG include overseas expansion in years to come, where they have just seen the tip of the iceberg with three stores in London, and the first in Paris opened in the most recent quarter. The company does not seem in a huge hurry, but is emphasizing establishing the brand in new markets such that as new stores are opened they will be immediately accretive to earnings. I prefer this method vastly to an overly stretched thin, rapid expansion of a new name in a foreign place and applaud management for their comments and philosophy regarding overseas expansion.
I do acknowledge that no company can be perfectly managed. Recently, many have become quite worried about the comparable stores sales which declined to 8% for the quarter, from a normalized fairly steady 10% figure we have become spoiled by.
Management has also indicated that food costs may be higher than we would like to see in the near term, admitting that the already high costs of avocados and beef will be joined by increasing prices of dairy products and chicken. Not a rosy picture when one considers a huge portion of their menu items were just described as rising in cost.
While these are without question factors to be considered, earnings trends and my belief in a competent management team leads me to be inclined to afford them a pass and look towards out years more than tomorrow or next quarter alone. While I acknowledge that these are troublesome obstacles in the near term, I am going to believe this management's thesis that declining comp store sales were due to an overall macro decline in consumer spending and continue to have faith in the larger picture future of this company. Food costs will rise and fall, but a well-run business of this caliber will surely manage to ride the highs and hustle through the lows for an ultimately fine result in the end.
I clearly have stated my belief in the business model, the room for growth with success, and my faith in the management team. Now I am led to the primary area of concern with this company: Price.
Price-Fair or not?
We all know price matters. No matter how much one might love a particularly handsome new jacket, most have a price they would never pay, but would conversely jump at a chance to make the purchase in the event of a 25% sale, no? It is no different (or should be no different) with stocks.
Warren Buffett once provided the following maxim for investors: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." I agree to a large extent (though I would always prefer to buy a wonderful company at a bargain basement price!) Unfortunately, wonderful companies rarely sell for bargain basement prices, and I do not expect to see that for some time with the expansion of the QE3 business which I am neither capable of, nor inclined to attempt, understanding what its long-term effect will be.
So with all that buzzing in the back of my mind, I consider whether CMG is fairly priced. Even with the recent decline from annual highs of approximately 25% at current prices (lucky you if you're interested in initiating a position, and my condolences if you were already an owner), the stock still trades at 41 times trailing twelve months earnings. This is substantially lower than peer McDonald's (MCD) P/E of 17 without the protection of McDonald's 3% dividend. I realize that the two are vastly different companies in terms of maturity, but it is still a valid consideration. CMG still trades at a PEG ratio of around 1.7.
I do not personally feel that this valuation will preclude momentum investors from piling back into a well-known name once a good quarter or two has been posted, but one can certainly not call Chipotle cheap at these valuations, and there are sure to be those that would still consider it quite pricey. However, the year over year earnings growth of 61% makes me feel much better about the valuation each time it flashes through my mind.
I am aware that this is not a statistically dense essay, as I rarely get bogged down with the incremental effects commodity costs, etc., will have on the most imminent quarter, but rather tend to look many years out when evaluating a company.
In the end, one must consider their own risk appetite. The market provided a 25% discount or more after the most recent quarterly report. The company has much room for growth and is able to leverage increased revenues to vastly increased earnings with the best of them. Management is dedicated to a philosophy and plan that has worked well thus far, and I for one believe will continue to work. The company has no debt, and it is worth noting that it still has $75 million left on current share repurchasing abilities which may be more opportunistically employed at current prices.
My approach to these situations is always this: If you are a believer long term in the company, take advantage of the current 'sale' from the annual highs by taking a position you are comfortable with and that fits your portfolio goals. Then, if the market takes the stock up you have made at least something, and if the market takes shares down you can gladly increase the size of your position to average your cost down, while maintaining a disciplined percentage of your overall portfolio as your plan allows.
In full disclosure, I intend to be a buyer of CMG shares in the near future. I wish I had moved quickly enough to begin my purchases below $300 when we were afforded that opportunity recently, and I certainly will not miss the chance again should it present itself though I will candidly say I am comfortable nibbling away to build my position at current levels.
While I hope my comments spark thought and friendly debate, I always encourage others to do their own homework and make decisions based on their own investment goals and research. I welcome any and all collegial comments made for discussion regarding the pros or cons, or bull or bear case for the company in an effort to help all form a well-rounded decision as to CMG's prospects going forward.