Growth Company Shopping List For A Declining Market: Part 2- Chipotle Mexican Grill

Oct.30.12 | About: Chipotle Mexican (CMG)

As markets have lost some momentum in recent weeks, I have begun organizing my watch list and prioritizing growth companies in an effort to be prepared should better entry points present themselves.

There are many looming factors that may weigh on the broad markets in coming days. While I do not feel capable of, nor have the interest to even attempt to predict where the broader markets are headed short- term, I do feel it is important to have a game plan in order, should good companies get hit by broad market swoons.

As a relatively young investor, I am particularly interested in finding intriguing entry points to growth companies, and will be presenting those most compelling to me in coming days. As an additional caveat to this idea, I am particularly interested in finding well-managed, strong growth companies with the vast majority of their revenues generated in the United States (a kind of domestic security play, as Jim Cramer is fond of saying, but with a growth twist rather than dividend emphasis).

In my first installment of this growth-company wish list chat I briefly highlighted the success Under Armour (NYSE:UA) has had in growing their business, the prospects it has before them, and the recent decline in their stock price despite delivering a good quarter and fairly good guidance for 2013. It is a company I like that is also primarily a U.S. story (limited European exposure risk currently).

This second installment centers on Chipotle Mexican Grill (NYSE:CMG). If one were to read my previous piece highlighting CMG, they would know I have great confidence in the business model, greater confidence in the management team and strategy, and belief in the room for growth, particularly domestically, at present. However, readers of the previous article are also aware that I was too early into the stock. I began building my own position with a tiny purchase at $312, and have subsequently added to the position at $249. I am carrying a loss currently, but my belief in the business prospects have not changed, so I will highlight my thesis and strategy going forward.

To avoid redundancy, I will refer readers to my previous thoughts on the Food with Integrity mission, Management team, etc and resume the conversation where it picks up with recent events and the recent earnings report and conference call.

First let's take a look at financial results for the third quarter of 2012.

  • Revenues increased 18.4% year over year to $700.5 million, with first three quarters of 2012 revenues totaling over $2 billion, which is up 21.5% year over year.
  • Diluted EPS of $2.27 in Q3, up 19.5% year over year
  • Will meet or exceed 165 new stores opened by 2012's end
  • 1,350 company wide stores opened at Q3's end, including 4 stores in Toronto, 5 in London, and 1 in Paris, and 1 Shophouse store in D.C.
  • Comparable store sales of 4.8%

Now let's look at guidance for 2013

  • Plan to open 165-180 new restaurants in 2013, with 70% of these expected to be opened in "proven markets"
  • Plans to open a second Shophouse store in D.C. where the first has already performed well.
  • Will open a 3rd Shophouse store in Los Angeles in the first half of 2013. Management believes the L.A. store will be a success and help build the reputation as L.A. is a 'tremendous food city' with a variety of international influences.
  • Comparable store sales projections to be flat to low single-digit growth

Before we dive into what I feel are the positives for the company it is important to note the Bear thesis to be aware of potential pitfalls. Anyone who has followed this company for a year or more is aware of the near halving of the stock price in the past year. This has been capped off quite publicly by negative commentary by David Einhorn of Greenlight Capital, whose notoriety has helped lead to having 13.4% of the outstanding shares being shorted as of October 15, 2012. The following is a brief synopsis of the concerns raised by Einhorn and other Chipotle doubters.

1. Potential loss of market share to Yum! Brand's (NYSE:YUM) Taco Bell

2. Declining comparable store sales

3. High stock valuations

4. Slow pace of overseas expansion

5. Hesitancy to accelerate the Shophouse stores growth pace, if it is successful at all

6. Lack of pricing power going forward

While these are all valid concerns, I believe they may pose less risk in the out years than one may surmise in the near term.

For instance, I believe management has demonstrated that they are maintaining their market share in the face of increased competition from the new Taco Bell menu initiatives. Take a look at this quote from the recent conference call:

There's a lot of noise during the quarter about somebody taking market share away from us. They did a lot of very, very heavy advertising. A lot of the advertising was intended to attract our customers, for obvious reasons. But our transaction trends in the second quarter when none of that advertising happened were identical to the third quarter when there was very, very heavy advertising in the quarter. So we're not seeing any kind of loss whatsoever in our transactions moving from us to any other competitor.

Chipotle management seems confident they are maintaining their market share position, and I tend to believe them as they are able to cite stable transaction trends in the face of heavy advertising by competitors. Management also notes that transaction trends have remained stable throughout the early days of October, so I see no signs that they will lose share in this quarter.

While the decline in comps is certainly undesirable, it is important to remember a few key points affecting the comp numbers. First of all, Chipotle has been growing this number at such a huge rate for so long, the comparisons were inevitably going to be hard to maintain. In fact, management has warned us in the past that this day would come. Additionally, we must remember that the recent decline in comp sales figures (comparative decline in that it is slower growth) is due partially to the rolling off of recent pricing initiatives. This decrease in comparable store sales growth may also not be company-specific. Chipotle's management notes that many customers have begun opting not to purchase drinks with their meals, which had a negative effect, and suggests that consumer confidence or spending may be in decline. In light of so many revenue misses this earnings season from a multitude of company types, I am led to speculate it may be more of a macro-caused slow down CMG is facing. Additionally, I am encouraged by the above quote in this way; if transaction trends were to blame for the declining comps, I would run for the door in this stock. However, as it appears there is just as much traffic in Chipotle restaurants as before, I will remain inside as well.

I understand the impatience investors are experiencing regarding overseas expansion and the spread of the Shophouse name. Many investors holding losses would love for these to be the opportunities to see re-accelerated growth to allow them to recoup losses. However, as one looking for a good entry point into a well-run company, I am pleased with the way the management team has handled these issues.

I am in no hurry for the Chipotle team to push things to the limit in Europe. Europe is in a mess, unemployment rates are sky high, and I doubt their consumers have the spending power our own consumers do at present. I think the management team is doing the right thing in slowly building the brand name in Europe in these uncertain times, while currently focusing on expansion of a proven strong business in the U.S. Why do I say a strong business? Well, new Chipotle restaurants have continued to perform very well, at or above managements target range of $1.5-1.6 million sales in their first year. Remember as well, that 70% of the 165+ stores opening in 2013 are in proven markets. I am happy to see cash spent growing this business before growing at an overly-accelerated pace in uncertain European markets. I would rather see a slow build-up in the cash position while only investing in proven high-return businesses, than see an increased cash burn rate while investing simultaneously in lower return businesses overseas. This strategy fits right in line with my growth spin on the domestic security thought.

I take the same approach with the Shophouse brand. Though the company notes that the original restaurant in Washington D.C. has performed well, I think they are doing the right thing in easing into the growth phase of this segment in strong markets with only two new stores next year. There will be a time for accelerating this chain if it continues to do well, and I think the CMG team will be ready when that time comes.

In the meantime, the company is still taking an active approach with cash on hand. As already discussed, they are opening slightly more stores next year than this, investing in proven business. They will also reportedly be more aggressive with their newly approved $100 million repurchase program at current levels, shrinking the share count more than would have been previously possible. They have demonstrated a good feel for repurchases in the past, having spent $388 million in the last four years on repurchases at an average share price of $117.

Look, here's my basic positive line. I think this is a fantastically managed company with plenty of room for domestic growth for the next several years. They are gaining traction (albeit slowly) with Shophouse, and eventually will begin to grow this segment at an accelerated rate if it continues to be successful. There are overseas opportunities when the clouds clear 'over there', and they are building the brand in important cities in the meantime. It is important to note also that this company has $574 million in cash, compared to only $3.5 million in debt which should allow readiness to pursue these growth opportunities when the time comes.

I am encouraged that this thesis is an accurate one when I read the following quote by management, also found in the recent conference call:

While we continue to generate more cash from operations than we invest in the Chipotle business today, we're confident that the growth options we're seeding today, including ShopHouse and Chipotle outside the U.S., will provide attractive value-enhancing growth investments in the future. In the meantime, we'll continue to invest in our high-returning domestic restaurants and we'll continue to opportunistically repurchase our stock to enhance shareholder value.

As a word of caution in light of guidance for flat to low-single digit comps into next year, I must admit there may be more multiple compression in front of this stock in coming months as it currently trades at a premium to its peers, with a P/E approaching 30 and seems to have lost all Mojo and momentum currently. The forward P/E of 24 according to yahoo! finance looks somewhat better.

I've been too early into the name already, and will be cautious adding to my position to average down cost. This is probably not a name to own for immediate gains, but this paper is geared more towards long time-horizon investors, as I think there will be a re-acceleration of growth in the years to come and there is a ton of value to be unlocked in the out years. Investors that got ahead of themselves with this stock have undoubtedly been hammered, but the company has continued to be well-managed, and I like its prospects.

I will give no specific advice as to a great entry price for this company, as that has proven to be difficult and presumptuous. I would simply suggest that if you are looking to add growth to your portfolio with a long timeframe to invest, buying into CMG with wide scales with declines to average down cost may be a very viable strategy going forward, especially should multiple compression or broad market worries bring the valuation more in line with competitors, as I still feel this is primed to be a best-of-breed restaurant company with phenomenal growth prospects in years to come.

As always, I encourage all to do their own homework before making an investment decision, and wish all happy investing.

Disclosure: I am long CMG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am also looking to initiate a long position in Under Armour, though I hold no position as of the time of this submission.