Chipotle Mexican Grill CMG-B
October 20, 2008 - 2:16am EST by
fatman174
2008 2009
Price: 36.46 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 1,202 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

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Description

With 795 company-owned locations, Chipotle Mexican Grill Inc is less than halfway through its self-funding domestic rollout. It has a net $195MM on its balance sheet, three quarters of which is probably excess cash. Its stores have low (possibly negative) working capital requirements and are operated at high efficiency, resulting in 35-40% cash-on-cash returns and ~2.5-3.0 year paybacks periods on new restaurants.
The company’s decade-long run of posting double-digit comps – achieved despite modest marketing expenditure, infrequent price increases and a near refusal to introduce new menu items (CMG doesn’t even serve breakfast) – is over though, and investors are of course focused on the company’s dimmed prospects in a recessionary environment.
 
This presents patient investors with a potential time arbitrage: accept the fact that the store base will likely comp at levels below the ~5% SSS that maintaining the current contribution margin requires and enjoy the longer term benefit of ~20% growth from unit rollout over the next several years.
 
 
BRIEF HISTORY/NOTE ON CLASS B SHARES
 
CEO/CHB Steve Ells, a Culinary Institute of America (CIA) graduate, founded Chipotle in 1993, using it as a vehicle to apply his CIA training to casual dining and to promote his ‘Food With Integrity’ philosophy. In 1998 McDonald’s acquired a majority equity stake, providing growth capital and important tutelage (site selection, cannibalization modeling, etc). CMG came public in a 1/06 IPO in which MCD sold a portion of its shares – it disposed of the remainder in a 10/06 tax-free exchange of shares.
 
The class B shares that I AM recommending participate equally in dividends with the company’s A shares, and carry 10x the voting power. They have traded at an average 10% discount since 10/06 according to Yahoo’s weekly closing prices, though the current discount is greater. Given the tax-free nature of the exchange, CMG was prevented for a period of two years (until 10/08) from pursuing a collapse of share classes or a buyback to address the valuation disparity. The 10-K has some verbiage about not pursuing such actions for a period of three years unless certain unspecified conditions (presumably relating to legal opinions or IRS rulings) are met. In light of this, it seems the A-B discount will persist for at least another year.
 
 
DIFFERENTIATION
 
CMG offers a comparatively few number of menu items, each drawing on the same set of high-quality ingredients. This leads to tremendous customer throughput (crew familiarity with the offerings), low inventory requirements and low spoilage (both from rapid inventory turnover). The company’s Food With Integrity (FWI) effort aims at using free-range and hormone/antibiotic free foods where possible. The introduction of FWI compliant ingredients is often accompanied by price increases. Interestingly, price increases absent ingredient introductions seem to be infrequent in several markets, suggesting untapped pricing power may exist. The FWI roll-out has been slowed as pre-existing supply chains for such products apparently did not exist. CMG seems to be relatively advantaged after having created such chains for itself.
 
The company is similarly focused when it comes to its restaurant-level managers, instituting various schemes to increase managerial recruitment from within, retain managers of all stripes, and to encourage career-tracking and indeed entrepreneurial behavior among its managers with its Restaurateur program. The latter program is particularly important. It provides top-tier managers (each interviewed personally by the C suite) the chance to earn ~$10K bonuses for each crew member they successfully groom for management as well as a 10% of gross sales above company-specified bogeys if the manager is able to boost a particular store’s top line. This accelerating initiative should aid the company’s restaurant sales and reduce G&A.    
 
 
ROUGH HACK AT UNIT ECONOMICS
 
Management estimates it costs $900K to open a restaurant. With cash pre-opening costs and leases capitalized at 10x, the figure is perhaps $2MM. A restaurant does 85% the sales of a mature location in its first year – maybe $1.49MM ramping up with contribution margins until the third year. At that point, contribution margins are in the low 20s, and cash-on-cash returns are ~40%. Pre-tax ROIC is above 20% accounting for capitalized leases.
 
With self-funding growth this accretive, the question then is how many units can CMG build? The company has unfortunately never answered this question directly, so far as I can tell. In the 3Q07 conference call, Ells said “We still have thousands of restaurants that we can build in the United States,” and I have seen published reports where analysts have estimated saturation at 2,500 units. (More optimistic estimates can be arrived at by using the store count by state table in the 10-K.) If the 2,500 is indeed correct, CMG has six further years of 20% unit growth ahead. Things like international growth and addition of breakfast menu or any new menu item are free options, as is possible further leverage of indirect expenses (particularly G&A) and lower build and rent costs as the company moves further away from standalones and toward smaller inlines and end-caps.
 
 
SUMMARY TTM NUMBERS
 
Here are some relevant numbers from recent income statements and balance sheets, taking some liberties on restaurant-level numbers (they are not normalized to account for the relatively high portion of immature locations).
 
 
2Q08
1Q08
4Q07
3Q07
2Q07
Restaurant Sales
 $ 340,754
 $ 305,327
 $ 288,910
 $ 286,431
 $ 274,222
Food, beverage and packaging
109,697
98,894
92,184
92,075
87,463
Labor
88,278
81,410
77,452
75,395
71,116
Occupancy
23,404
21,833
20,536
19,745
18,322
Other operating costs
42,897
38,373
34,849
33,240
33,665
Direct costs
264,276
240,510
225,021
220,455
210,566
G&A
20,684
21,560
20,641
19,279
18,109
D&A
12,707
12,170
11,688
11,167
10,576
Pre-opening costs
3,403
2,831
2,855
2,350
2,570
Indirect costs (normalized)
36,794
36,561
35,184
32,796
31,255
Loss on disposal of assets
1,370
1,463
1,249
1,784
1,843
Total costs
302,440
278,534
261,454
255,035
243,664
EBIT
38,314
26,793
27,456
31,396
30,558
Interest income
925
1,343
1,498
1,597
1,530
Interest expense
             (75)
             (74)
               73
             (74)
             (74)
Income before income taxes
39,164
28,062
29,027
32,919
32,014
Provision for income taxes
     (14,696)
     (10,778)
     (11,343)
     (12,315)
     (12,157)
Net income
24,468
17,284
17,684
20,604
19,857
 
 
 
 
 
 
# of stores - beginning of period
730
704
668
640
605
# of stores - end of period
778
730
704
668
640
 
 
 
 
 
 
Direct gross margins
22.44%
21.23%
22.11%
23.03%
23.21%
Indirect margins
10.80%
11.97%
12.18%
11.45%
11.40%
SG&A margins
6.07%
7.06%
7.14%
6.73%
6.60%
EBIT margins
11.24%
8.78%
9.50%
10.96%
11.14%
 
 
 
 
 
 
A/R
 $      5,374
 $      3,879
 $      5,373
 $      5,869
 $      6,270
Inventory
5,151
4,583
4,332
4,404
4,418
Prepaid expenses
11,423
11,180
8,997
8,633
7,947
PP&E
539,340
515,247
494,930
469,295
444,259
A/P
25,565
25,682
19,880
24,958
19,923
Accrued payroll and benefits
19,977
24,873
26,210
25,618
16,116
Accrued liabilities
24,307
25,301
27,135
19,605
20,753
 
 
 
 
 
 
Average annualized sales/store
 $      1,808
 $      1,703
 $      1,685
 $      1,752
 $      1,762
Average annualized contribution/store
406
362
373
404
409
Invested capital/store
632
629
626
626
635
Store contribution/invested capital
64.23%
57.51%
59.55%
64.48%
64.46%
 
 
VALUATION
 
The company has said it views $40-50MM of its $195MM cash as required, so the ~$4.50/share balance is excess. Using annualized six month EBIT (assuming seasonality washes with growth), the EV/EBIT implied by the B shares is ~8.11x. TTM EV/EBIT is a bit higher at ~8.5x. EPS numbers are skewed by both the company’s cash balance and its expensing non-cash pre-opening rent and future lease escalations, though the income and cash flow statements will converge at maturity.
 
This for me is a buy-and-hold that will hopefully deliver ~20% annual gains from unit volume growth alone. As such, I do not have a price target.
 
 
RISKS
 
One obvious risk is an extreme fall-off in discretionary spend crushing restaurant sales. I don’t really have a counter to this, but I will note that as of the last conference call the company reported not seeing much of an impact in the troubled Florida and California markets. They had noted some weakness in Arizona previously, but then were able to put a 10% price increase through in 4Q07 that did not lead to additional fall-off.
 
Both the QSR and ‘Mexican’ food categories are competitive. Continued weakness in the franchisee lending space may well help CMG relatively given its self-funding corporate-owned expansion plans and large cash balance. JBX’s Qdoba Mexican Grill, for instance, is ~75% franchised.
 
Minimum wage hikes are not the concern here they are with other fast food operators as less than 1% of company employees make minimum wage. A hike would obviously lead to inflationary wage pressures in non-minimum wage earners, but CMG’s margin structure is not dependent on paying workers as little as possible.

.

Catalyst

Continued roll out of stores at favirable returns. Possible fixed cost leverage. Eventual collapse of A/B share structure.
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    Description

    With 795 company-owned locations, Chipotle Mexican Grill Inc is less than halfway through its self-funding domestic rollout. It has a net $195MM on its balance sheet, three quarters of which is probably excess cash. Its stores have low (possibly negative) working capital requirements and are operated at high efficiency, resulting in 35-40% cash-on-cash returns and ~2.5-3.0 year paybacks periods on new restaurants.
    The company’s decade-long run of posting double-digit comps – achieved despite modest marketing expenditure, infrequent price increases and a near refusal to introduce new menu items (CMG doesn’t even serve breakfast) – is over though, and investors are of course focused on the company’s dimmed prospects in a recessionary environment.
     
    This presents patient investors with a potential time arbitrage: accept the fact that the store base will likely comp at levels below the ~5% SSS that maintaining the current contribution margin requires and enjoy the longer term benefit of ~20% growth from unit rollout over the next several years.
     
     
    BRIEF HISTORY/NOTE ON CLASS B SHARES
     
    CEO/CHB Steve Ells, a Culinary Institute of America (CIA) graduate, founded Chipotle in 1993, using it as a vehicle to apply his CIA training to casual dining and to promote his ‘Food With Integrity’ philosophy. In 1998 McDonald’s acquired a majority equity stake, providing growth capital and important tutelage (site selection, cannibalization modeling, etc). CMG came public in a 1/06 IPO in which MCD sold a portion of its shares – it disposed of the remainder in a 10/06 tax-free exchange of shares.
     
    The class B shares that I AM recommending participate equally in dividends with the company’s A shares, and carry 10x the voting power. They have traded at an average 10% discount since 10/06 according to Yahoo’s weekly closing prices, though the current discount is greater. Given the tax-free nature of the exchange, CMG was prevented for a period of two years (until 10/08) from pursuing a collapse of share classes or a buyback to address the valuation disparity. The 10-K has some verbiage about not pursuing such actions for a period of three years unless certain unspecified conditions (presumably relating to legal opinions or IRS rulings) are met. In light of this, it seems the A-B discount will persist for at least another year.
     
     
    DIFFERENTIATION
     
    CMG offers a comparatively few number of menu items, each drawing on the same set of high-quality ingredients. This leads to tremendous customer throughput (crew familiarity with the offerings), low inventory requirements and low spoilage (both from rapid inventory turnover). The company’s Food With Integrity (FWI) effort aims at using free-range and hormone/antibiotic free foods where possible. The introduction of FWI compliant ingredients is often accompanied by price increases. Interestingly, price increases absent ingredient introductions seem to be infrequent in several markets, suggesting untapped pricing power may exist. The FWI roll-out has been slowed as pre-existing supply chains for such products apparently did not exist. CMG seems to be relatively advantaged after having created such chains for itself.
     
    The company is similarly focused when it comes to its restaurant-level managers, instituting various schemes to increase managerial recruitment from within, retain managers of all stripes, and to encourage career-tracking and indeed entrepreneurial behavior among its managers with its Restaurateur program. The latter program is particularly important. It provides top-tier managers (each interviewed personally by the C suite) the chance to earn ~$10K bonuses for each crew member they successfully groom for management as well as a 10% of gross sales above company-specified bogeys if the manager is able to boost a particular store’s top line. This accelerating initiative should aid the company’s restaurant sales and reduce G&A.    
     
     
    ROUGH HACK AT UNIT ECONOMICS
     
    Management estimates it costs $900K to open a restaurant. With cash pre-opening costs and leases capitalized at 10x, the figure is perhaps $2MM. A restaurant does 85% the sales of a mature location in its first year – maybe $1.49MM ramping up with contribution margins until the third year. At that point, contribution margins are in the low 20s, and cash-on-cash returns are ~40%. Pre-tax ROIC is above 20% accounting for capitalized leases.
     
    With self-funding growth this accretive, the question then is how many units can CMG build? The company has unfortunately never answered this question directly, so far as I can tell. In the 3Q07 conference call, Ells said “We still have thousands of restaurants that we can build in the United States,” and I have seen published reports where analysts have estimated saturation at 2,500 units. (More optimistic estimates can be arrived at by using the store count by state table in the 10-K.) If the 2,500 is indeed correct, CMG has six further years of 20% unit growth ahead. Things like international growth and addition of breakfast menu or any new menu item are free options, as is possible further leverage of indirect expenses (particularly G&A) and lower build and rent costs as the company moves further away from standalones and toward smaller inlines and end-caps.
     
     
    SUMMARY TTM NUMBERS
     
    Here are some relevant numbers from recent income statements and balance sheets, taking some liberties on restaurant-level numbers (they are not normalized to account for the relatively high portion of immature locations).
     
     
    2Q08
    1Q08
    4Q07
    3Q07
    2Q07
    Restaurant Sales
     $ 340,754
     $ 305,327
     $ 288,910
     $ 286,431
     $ 274,222
    Food, beverage and packaging
    109,697
    98,894
    92,184
    92,075
    87,463
    Labor
    88,278
    81,410
    77,452
    75,395
    71,116
    Occupancy
    23,404
    21,833
    20,536
    19,745
    18,322
    Other operating costs
    42,897
    38,373
    34,849
    33,240
    33,665
    Direct costs
    264,276
    240,510
    225,021
    220,455
    210,566
    G&A
    20,684
    21,560
    20,641
    19,279
    18,109
    D&A
    12,707
    12,170
    11,688
    11,167
    10,576
    Pre-opening costs
    3,403
    2,831
    2,855
    2,350
    2,570
    Indirect costs (normalized)
    36,794
    36,561
    35,184
    32,796
    31,255
    Loss on disposal of assets
    1,370
    1,463
    1,249
    1,784
    1,843
    Total costs
    302,440
    278,534
    261,454
    255,035
    243,664
    EBIT
    38,314
    26,793
    27,456
    31,396
    30,558
    Interest income
    925
    1,343
    1,498
    1,597
    1,530
    Interest expense
                 (75)
                 (74)
                   73
                 (74)
                 (74)
    Income before income taxes
    39,164
    28,062
    29,027
    32,919
    32,014
    Provision for income taxes
         (14,696)
         (10,778)
         (11,343)
         (12,315)
         (12,157)
    Net income
    24,468
    17,284
    17,684
    20,604
    19,857
     
     
     
     
     
     
    # of stores - beginning of period
    730
    704
    668
    640
    605
    # of stores - end of period
    778
    730
    704
    668
    640
     
     
     
     
     
     
    Direct gross margins
    22.44%
    21.23%
    22.11%
    23.03%
    23.21%
    Indirect margins
    10.80%
    11.97%
    12.18%
    11.45%
    11.40%
    SG&A margins
    6.07%
    7.06%
    7.14%
    6.73%
    6.60%
    EBIT margins
    11.24%
    8.78%
    9.50%
    10.96%
    11.14%
     
     
     
     
     
     
    A/R
     $      5,374
     $      3,879
     $      5,373
     $      5,869
     $      6,270
    Inventory
    5,151
    4,583
    4,332
    4,404
    4,418
    Prepaid expenses
    11,423
    11,180
    8,997
    8,633
    7,947
    PP&E
    539,340
    515,247
    494,930
    469,295
    444,259
    A/P
    25,565
    25,682
    19,880
    24,958
    19,923
    Accrued payroll and benefits
    19,977
    24,873
    26,210
    25,618
    16,116
    Accrued liabilities
    24,307
    25,301
    27,135
    19,605
    20,753
     
     
     
     
     
     
    Average annualized sales/store
     $      1,808
     $      1,703
     $      1,685
     $      1,752
     $      1,762
    Average annualized contribution/store
    406
    362
    373
    404
    409
    Invested capital/store
    632
    629
    626
    626
    635
    Store contribution/invested capital
    64.23%
    57.51%
    59.55%
    64.48%
    64.46%
     
     
    VALUATION
     
    The company has said it views $40-50MM of its $195MM cash as required, so the ~$4.50/share balance is excess. Using annualized six month EBIT (assuming seasonality washes with growth), the EV/EBIT implied by the B shares is ~8.11x. TTM EV/EBIT is a bit higher at ~8.5x. EPS numbers are skewed by both the company’s cash balance and its expensing non-cash pre-opening rent and future lease escalations, though the income and cash flow statements will converge at maturity.
     
    This for me is a buy-and-hold that will hopefully deliver ~20% annual gains from unit volume growth alone. As such, I do not have a price target.
     
     
    RISKS
     
    One obvious risk is an extreme fall-off in discretionary spend crushing restaurant sales. I don’t really have a counter to this, but I will note that as of the last conference call the company reported not seeing much of an impact in the troubled Florida and California markets. They had noted some weakness in Arizona previously, but then were able to put a 10% price increase through in 4Q07 that did not lead to additional fall-off.
     
    Both the QSR and ‘Mexican’ food categories are competitive. Continued weakness in the franchisee lending space may well help CMG relatively given its self-funding corporate-owned expansion plans and large cash balance. JBX’s Qdoba Mexican Grill, for instance, is ~75% franchised.
     
    Minimum wage hikes are not the concern here they are with other fast food operators as less than 1% of company employees make minimum wage. A hike would obviously lead to inflationary wage pressures in non-minimum wage earners, but CMG’s margin structure is not dependent on paying workers as little as possible.

    .

    Catalyst

    Continued roll out of stores at favirable returns. Possible fixed cost leverage. Eventual collapse of A/B share structure.

    Messages


    Subjectprices
    Entry10/23/2008 10:57 AM
    Memberedward965
    Notice you needed some pricing outside of NYC. In Texas, $5-$6. Minnesota, ~$6. Texas has a competitor called Freebirds that, while some say is a bit better, charges about the same. Drink prices are $1.25 and $1.5, in-line with competitors. And yes, I obviously go to Chipotle.

    Subjectmore pricing
    Entry10/23/2008 11:06 AM
    Memberfinn520
    Here are the NYC prices at the Chipotle's I patronzie: Mid-town Manhattan - Chicken burrito $7.75, Carnitas currito $8.25 Brooklyn - Both $7.04. Those are after tax of 8.375%, (pretax Chicken/Carnitas $6.50/$7.15 in Brooklyn and $7.15/$7.61 in Manhattan). An aside - www.menupages.com is the best designed website I have ever seen on any topic and is good for NYC restaurant stuff, not sure if other versions exist elsewhere - might help with pricing.
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