Chipotle Mexican Grill In-Depth IPO Analysis (CMG)

Includes: CMG, MCD
by: Bill Simpson

Chipotle Mexican Grill, Inc. (CMG)plans on offering 9 million shares, 3 million from majority shareholder McDonald's Corporation (MCD), at a range of $15 1/2 - $17 1/2. Among a myriad of underwriters, Morgan Stanley and SG Cowen are lead underwriting the deal. Post-offering CMG will have 32 1/2 million shares outstanding for a market cap mid-range of $536 million. IPO proceeds are going to repay $4 million of debt to McDonalds, with remainder to be used by CMG for expansion and general corporate purposes. CMG is a spin-off from McDonalds but unlike most spin-offs, CMG is keeping all but $4 million of the IPO proceeds. This is unusual as quite often the parent company uses a spin-off as a payday for themselves. Not the case here, this offering is actually structured to benefit post-offering CMG shareholders.

Post-offering McDonalds will own 65% of outstanding stock and 85% voting control. At any time after the 180 day lock-up expiry McDonalds can and may distribute remaining stake to shareholders in the form of a tax free distribution. My assessment is that McDonalds has no plans to distribute remainder of shares anytime soon. If they did plan on doing so I believe they would have structured the IPO to benefit McDonalds shareholders much more so than the new Chipotle shareholders. That's not the case here, a clue that McDonalds plans on retaining majority control of CMG mid-term.

Chipotle is a burrito/ taco 'non fast food' restaurant. Founded in 1993 in Denver with one location by current Chairman/ CEO Steve Ells, Chipotle was an immediate hit and expanded throughout Colorado. In 1998 McDonalds acquired an initial stake than later a controlling interest. Since 1998 utilizing McDonalds decades of restaurant expansion expertise, Chipotle has expanded nationally. As of December 31, 2005 Chipotle had 489 locations in 24 states, 189 of which have been opened since January 1, 2004. Chipotle opened 71 stores in '03, 103 in '04 and 80 in '05. California leads the way with 67 locations, Ohio 60, Texas 60 and 55 in Colorado. Chipotle actually experiences higher per store revenue in Ohio than in founding state Colorado (quite possibly this is due to this analyst moving out of Colorado in 2002). Nearly all locations are company owned, Chipotle has thus far resisted franchise expansion.

What sets Chipotle apart from the myriad of fast food taco/ burrito places across the United States? Menu items are relatively simple with a choice of taco, burrito or bol filled with either chicken, steak, carnitas, barbacoa or veggies. Other various fillers include rice, black beans, pinto beans, guacamole and 4 different salsas. What differentiates Chipotle from the competition is that Chipotle uses high quality ingredients from selected suppliers and prepares all menu items daily on premise. Chipotle equates their restaurant experience to a "Whole Foods, fast food experience." A few ad slogans reiterate this point: "The gourmet restaurant where you eat with your hands", and "Fresh as the day it was made, which would be today". They accomplish this goal as I've been eating at Chipotle since they opened their original location in Denver in 1993, and I've always believed it is the best 'fast food' I've ever experienced. Wahoos fish tacos come close, but the national mexican chains don't come close to competing with Chipotle on taste. I was quite concerned when McDonalds took a controlling stake as I assumed it would result in lower quality food. That has not happened fortunately, possibly since the founder Mr. Ells has remained on board as CEO since inception.

Unlike most competitors CMG does not discount nor offer any 'meal deals' etc... the food critics at both Food and Wine and The New York Times' have featured favorable articles on Chipotle, quite unusual for a 'fast casual' restaurant chain.

Chipotles growth has not only been swift, it has been impressive. Chipotle has experienced double digit same store sales growth each year for the past 8 years. This annual 10%+ same store sales growth hasn't been fueled by new product offerings as Chipotles menu really hasn't changed in 13 years. It has been fueled in large part by strong word of mouth. Chipotle has utilized limited print/ radio/ television campaigns instead relying on the quality of food to keep customers coming back and telling others. Note that same store growth down each of past 2 years from an unsustainable blowout 24% in 2003 to 13% in 2004 to 10% in 2005. Big reason for same store sales slowing a bit is overall sales volume increases per store have made it difficult to sustain 15- 24% annual growth. Trend may be slowing here, but 10% same store sales growth in '05 coming on the heels of 24% and 15% prior 2 years is impressive. Should note that CMG is forecasting only low to mid single digit same store sales in 2006. CMG same store sales for 4th quarter of '05 came in at 14-15%, quite possibly CMG is forecasting conservatively.

Average annual store sales are $1.4 million, up from $1.35 million in 2004 and $1.2 million in 2003. CMG is growing locations and growing revenue from each existing location, something you like to see.

Plan going forward is to continue to expand locations with 80- 90 new locations on deck in 2006. Cash flow will be utilized to fuel growth, not debt.


$2.70 in cash post-offering, no real debt.

At mid-range CMG is coming public 1 1/2 X's book value and less than 1 X's trailing revenue. Parent MCD trades at 3 X's book and 2 X's revenue.

With the strong same store sales growth coupled with 70-100 new locations annually, CMG has been growing revenues swiftly. CMG booked a 50% top-line growth in 2003, another 50% in 2004, and forecast for another 32% top-line growth rate in 2005 to $620 million.

Gross margins have consistently remained in the 65- 70% range annually. Because CMG depends on high quality ingredients I wouldn't expect any gross margin increase going forward, even with increased buying power. Earnings power here will need to come from economies of scale lower operating expenses as a % of revenue.

Total expenses have remained in line through the swift growth, growing a bit slower overall to revenue growth. Total expenses grew 44% in 2004 and another expected 24% in 2005, 6- 8% points slower than revenue growth. This economy of scale expense slowing allowed CMG to shift into profitability in 2004. Net margins fully taxed in 2004 were less than 1% but following a blowout 4th quarter 2005, jumped to an expected 3 1/2% in 2005. Note that by being a subsidiary of McDonalds CMG has not been taxed and in fact has recorded tax benefits. To look at CMG operationally, I plugged normalized taxes back into the numbers. Fully taxed in 2005 CMG should earn 65- 70 cents a share or 24 X's '05 earnings at a mid-range pricing.

Going forward I think CMG can continue trends and expand net margin to the 4 1/2% - 5% ballpark in 2006.. I'd expect top-line in 2006 to come in at approximately $775 million an increase of 25%. At a 4 1/2% net margin (which may be conservative), CMG should earn $1.05 - $1.15 per share in 2006. Fully taxed CMG at mid-range will be trading at 15 X's 2006 earnings.

Like the trends here: Very strong top-line growth derived from both strong same store sales and aggressive but controlled smart new store openings resulting in expanding net margins. The trends and numbers here are quite strong. The big question is can CMG continue those trends going out the next 2-3 years. I don't know the answer, although I do think there is a very good chance CMG can continue these trends in 2006. If CMG is able to continue trends through 2006, into 2007 and beyond the offering range of $15 1/2 - $17 1/2 is simply too low.

As with many fast growing retail/restaurant chains, a large forward risk is growing too fast. While there have been many fast growing success stories over the years, there have also been instances like Boston Market and Krispy Kreme that took a very good brand and grew it into the ground. Recent IPO Caribou Coffee is currently facing many growth issues and trading well below IPO price. Thus far Chipotle has shown smart controlled growth, shying away from the swift franchise model. For a company that prepares everything fresh daily and prides itself on overall quality, I'd be concerned if CMG shifted to a faster growing franchise model.

Chipotle has also benefited greatly from it's relationship with McDonalds. From real estate selection, to distribution network, to negotiating with vendors, having McDonalds as a controlling owner has saved CMG a lot of operational expenses. As long as McDonalds remains a majority holder of CMG, those benefits will for the most part continue making any short term operating expense increases due to the IPO negligible.

This fast casual dining segment is an extremely competitive niche. CMG however has shown an ability to pick their spots quite well though having closed just 6 locations in their operating history. In other words, out of 500 restaurant openings, only 6 underperformed to the extent they needed to close.


Risks here are the potential overhang of McDonalds shares held coming to market, the usual fear of 'growing too fast' and CMGs ability to sustain trends. While those are very real risks here, this CMG IPO is the first great deal of 2006. In a tough niche CMG has been able to grow same store sales impressively while at the same time expand new locations smartly and profitably. Very good combination for a fast growing restaurant and this has put CMG right on the verge of an earnings breakout. CMG is coming public just as they're about to significantly grow the bottom line. This is a take all you can type deal on offering and any open 1-3 from pricing. I'm willing to pay up substantially for this offering, and am hoping that the threat of future McDonalds distribution overhang may mute a big opening print. If so, I'll have a pretty substantial position in CMG. I like this IPO a great deal.