Chipotle Short: Estimates are still entirely too high. 26% Restaurant operating margins are a thing of the past. Price Target $300
Chipotle (NYSE:CMG) has been a very controversial name over the past 18 months, since the well-known e.coli/noro-virus debacle. On the one hand, you have a seemingly growing concept expanding its store base at a low-double-digit (LDD) rate. Consumer analysts and PM's were falling over themselves to own this fast growing, highly profitable concept (opening units at a mid-teen % rate in 2012). The company boasted a pristine balance sheet and they offered stellar returns on invested capital, averaging around 34% in the five years prior to the outbreak. Many looked at the decline in comps as only a speed bump in the long term picture. There were several bull/bear lunches late in 2015 discussed the topic and drew comparison to the Jack In the Box (NASDAQ:JACK) outbreak in 1993, and now it was possible to own a concept that can easily double its store base with fantastic returns at half the valuation.
At first glance, it seemed like a terrific buying opportunity. To the long-term investor, a short term sales blip is insignificant in the bigger picture as long as the AUV got back to that $2.5mm run rate and the Restaurant level operating margin got back to the ~26% trend and ROIC's return to that mid 30% rate. PM's would plug in Starbucks-like growth and operating margin expansion for 15+ years into their DCF models and be happy buying the dip of this uber-growth concept.
But what if this wasn't a blip? What if operating margins could never recover and CMG was over-earning all along? What if CMG was underinvesting and the ROIC and margin metrics were never really sustainable? What will the future look like if the targeted market saturated more quickly than expected? The way the comp and margin recovery acted throughout 2016 this seems like the more likely scenario.
Even prior to the outbreak, new stores started to yield lower productivity rates. In FY13, FY14 and FY15 new store productivity trended roughly 81%, 79% then 77% respectively and reached 71% of the drastically lower comp store AUV in FY16. Perhaps CMG now lives in a world where a higher advertising spend needs to accompany its aggressive store roll out.
Chipotle was good at making one thing and they made it great. They were the first fast casual Tex-Mex/burrito concept to come to the mass market and they had an almost cult like following. People LOVED the Chipotle food and ordering experience alike. But now, when you walk down the streets of any major city, you can see this model repeated over and over, whether it be Dos Toros, Just Salad, Chop't or any of a myriad of concepts that line the streets. While CMG comped (when they were one of the only games in town), unit growth slowed significantly from 16% in 2012 to ~12.3% in FY16. My point being that people are inherently creatures of habit and Chipotle no longer offered them the exclusive "we're the best fast casual Mexican food" it once presented for their daily lunch breaks.
While CMG still offers a great business model with improving margins, I'm hard pressed to believe that a real business outlook warrants its current rich valuation. At $405, CMG trades at 49x and 34x consensus 2017 and 2018 EPS, respectively. Street numbers likely are facing further revisions, and in my view shares are trading at 60x and 40x more realistic 2017 and 2018 EPS numbers. My price target range of $290-$311 implies a 23-27% reduction in share price. This target is based off of a realistic 14-15x FY18 EBITDA level which assumes a HSD, and MSD comp FY17 and FY18 respectively, and a ~18% operating margin level in FY18. In my view, this is a base case outlook, and still awards CMG a premium valuation. Variations in comps and operating margins would warrant a similar change in target price.
Outlook and Margin Analysis
For 3Q:16, management released initial guidance for 2017 of high-single digit (HSD) comps and a 20% operating margin that would equate to roughly $10 in earnings. Basically no one believed them and they've since back-pedaled, now referring to these as "stretch goals, but still achievable". It's my opinion that the HSD comp outcome is achievable (especially given the down 20% comp from 2016), but in my opinion a HSD comp in conjunction with a 20% restaurant operating margin just isn't realistic. Specifically, I'm skeptical of savings relating to the labor and Advertising/Promo line items.
Same Store Sales (Comps)
Management guided to a high-single digit comp, and this is a part of their guidance which I actually believe. Given that we know January comped +24% on top of a -36% in Jan of 2016, the two year comp trajectory carried through the year would imply an 8% comp for the year. There are several puts and takes throughout the quarters, but the two year trajectory when projecting the year will smooth out the anniversary of the change in promotional activity. An 8.5% comp for the year is reasonable and should result in roughly a ~$1.95mm AUV. A mid-single digit comp in FY18 will equate to ~$1.99mm in AUV.
So what will this post-apocalyptic margin structure look like in CMG's future? In my opinion, this is the main question, not the speed of comp recovery.
At the end of 2Q:16, management bridged what was expected to be the normalized 15.5% operating margin to the 26% seen in 2011 the last time the AUV was sub $2mm.
(source: 2Q:16 CMG earnings call; charted by Jared Orr)
Since then, margins only did not inflect from that 15.5%, but they got sequentially worse. 3Q:16 had a 14.1% margin and 4Q:16 a 13.5%. Some of this was from a slower than expected comp recovery, but this was also from a continued marketing and promo expense increase, which is likely the new norm. Labor costs also continued to weigh heavily on the margin.
Breaking down the cost buckets specifically for 2017 we have food costs, labor, occupancy, Promo and Ad expense and 'other operating costs'. Management gave guidance to Food costs and occupancy. Labor, promo and other were left relatively vague (although management gave some discussion to labor, which we'll look at below).
Food costs increased ~157bps to 35% of sales in 2016 primarily due to increase in avocado prices and food prep. Management guided food costs in the low 34% range in 2017 (assuming no new food inflation) which includes successful cost savings from supplier negotiations and food ordering optimization. I am slightly skeptical of all of these sudden savings, but will give them the benefit of the doubt on this line item. For modeling purposes a 34.4% food cost is appropriate.
Management guided occupancy cost leveraging to just over 7% of sales. That is completely reasonable just assuming HSD comp and flat occupancy $/store y/y.
Labor costs have de-levered ~630bps over the last 2 years to 28.3% of sales with 510bps of the de-leverage coming in FY16. With the sharp declines in comps, work schedules were adjusted due to lighter traffic. Labor $/store decreased ~6.5% throughout the year. Comps now are inflecting positively off of last year's precipitous drop in traffic yet wage inflation will continue to pressure the industry for the foreseeable future. On the 4Q:16 conference call, management stated an expectation of 4-5% of wage inflation in 2017, which will be partially offset by further schedule optimization. Management's labor optimization plans are to adjust the number of staff so there are less employees working during slower times and be fully staffed during the lunch and dinner rush.
Assuming no cost saving initiatives, one would assume that labor $'s per store would have to increase ~7-8% this year, consisting of ~3.2% of replacing half of the labor cost/store that was taken out of last year plus the 4-5% wage inflation expected in 2017. The variable for modeling purposes then becomes how much labor efficiency can CMG realize without noticeably effecting service? Let's give management the benefit of the doubt and assume that prior to the outbreak, CMG's labor schedules were drastically inefficient, and the 6.5% per store decrease is sustainable going forward. This still leaves 4-5% of wage inflation to offset with optimization. Management is adding one person per store during peak times to facilitate digital order pickups (and subsequently guided 1Q:17 labor cost as a % of sales to be higher than 4Q:16). Labor efficiencies then will have 2-3 quarters to take place to provide sufficient offsets. Taking all of this into account, a 2-3% labor per store growth rate in 2017 is more than fair and giving management a significant amount of credit in its cost saving ability. This will all equate to 100bps of company-wide labor expense leverage to 27.3% from FY16's 28.3%.
This is actually right in line with managements' previously stated outline saying 100-150bps labor inefficiencies that they will eventually get back. Assuming 2% per store growth in 2018, they will get that extra 50bps back yielding 26.8% labor costs in FY18 (assuming a MSD FY18 comp rate).
Advertising and Promotional Costs (A&P)
Advertising and promotional costs were inflated this year due to the "free burrito", "free chips" and "Chiptopia" promotions throughout the year to regain traffic. Prior to FY16, Ad and promotion costs were slim, a mere 1-2% of sales. In FY16 this line item accounted for ~5% of sales, including 6.6% in 1Q during the free burrito promotion, lowering to 4.3% in 2Q settling out to ~4.7% in the 2H of the year. On a $ basis, this is a ~184% increase to $196mm from $69mm in 2015. At the end of 2Q:16 management highlighted ~200bps of A&P as "non-recurring" costs that will eventually be taken out of the cost structure, but then stepped UP the spend sequentially throughout the back half of the year. Thus far it seems that the level of A&P determines the comp recovery trajectory. This means that not only will it not return to the anemic levels of the pre-outbreak era, but may not be leverage-able at all below that low 4% level, as many of the promotions includes free giveaways as opposed to increased advertising. A&P expenses may need to remain elevated as well if new store productivity continues to under-perform.
I believe the A&P spend will now be necessary to drive AUV growth. What is the level of required A&P spend to support CMG's comp recovery and new store growth? The short answer is that I have no idea, and as of now I don't think management does either. Judging from recent trends we can assume it will be >2% of sales yet < 5%. Given the sales rebound expected in FY17, a 4-4.2% of sales estimate I believe is fair. Granted I believe management will hit the gas in 2H if they see sales slipping in 1H, and conversely pull back on the spend if they start to see a pleasant surprise in sales recovery. As a base case, I believe 4-4.2% in FY17 and a 3.8% of sales in FY18. In $ terms this will equate to roughly a 5% reduction in FY17 and a 3.8% increase in FY18, a ~2% decrease in $s over that time despite an 18% increase in the store base over that two year period.
Other operating costs
This line item, when excluding the A&P portion, consists primarily of credit card fees and restaurant maintenance and utilities costs. In FY16 these costs decreased on a % basis ~11%/store, assuming primarily as a result of lower credit card fees associated with the -20% comp. For modeling purposes as a base case it seems fair to assume a LSD rate of growth /store in FY17 and flat per store $'s in FY18
So what does all of this mean?
Summarizing all of these assumptions yields 16% and 17.8% restaurant level operating margins for FY17 and FY18 respectively (vs. 12.8% in FY16 and 26% in FY15). Assuming managements' guidance of $300mm in G&A expenses in FY17, EBITDA under my assumptions would be about $406mm vs consensus of $537 in FY17 and $518 vs. $713 consensus in FY18. Applying a 39% tax rate (guidance of 39%-39.5%, although ultimately given any type of tax reform this will be reduced drastically) EPS will likely be $5.44 and $7.63 in FY17 and FY18 vs. $8.25 and $11.90 consensus. The streets consensus numbers have fallen considerably throughout the year (consensus went from $13.54 in March of 2016 to $8.25 currently) and I believe further downward revisions are still to come.
If we were to assume an anticipated lower tax rate of 20% in 2H:17 and FY18, this would yield $6.20 and $10.01 in FY17 and FY18, still below consensus but more accurately reflecting what is actually likely to occur. This $10 EPS number with a 17.8% restaurant level operating margin is a more accurate picture of the new normalized business in CMG's future. The ROIC metric will be back in the high 20's (28.5% under my assumptions).
Risks to a short position
Out-sized comp recovery could be the most immediate upward catalyst for the stock. If management would raise the HSD comp outlook to a low double digit, or low teens estimate, shares would increase.
The most significant near-term risk to a short position is that comps recover more dramatically than anticipated, and in conjunction with greater margin recovery. This will mean the efficient food purchasing initiatives working better than anticipated, labor efficiencies being realized and A&P spend subsiding. Thus far A&P expense has been directly correlated with comp recovery. If CMG can effectively take this crutch out from them and have comps recover unhinged, this could add ~>$2.00 to EPS and more than 200bps to operating margins. This is effectively reflected in the current street estimates and is needed for CMG to end up "in line" with sell-side expectations.
If CMG could simultaneously and successfully, recover 80% of the lost AUV, offset over 50% of upcoming labor wage inflation, reduce food costs another 80-100bps and still trade at a whopping 20x 2018 EBITDA level, shares could be valued at ~$500, a 23% increase from current levels.
The longer term bull thesis of continued store growth, at unscathed productivity and perceived outpaced international growth could maintain the high valuation.
Eventually monetizing a franchise model could keep the steep valuation in place, and provide upward support to shares.
Consensus numbers still have to come down considerably to a realistic level. Once numbers are reset, valuation will be a little easier to understand and grasp. CMG's stellar growth algorithm, balance sheet and ROIC metrics understandably warrant a premium valuation, but >20x an EBITDA number 2 years out is rich even for an eventual high 20% ROIC earner (yet $300 will still only yield 3.7% FY18 FCF). 14-15x a realistic 2018 $518 estimate would yield ~$290-$311, or a 23-27% reduction in current price.
(Note: All management commentary comes from CMG quarterly earnings calls. Consensus estimates were sourced from Bloomberg. Historical financial information was sourced from company financial statements and press releases)
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.