Description

“The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.” – Warren Buffett

Chipotle Mexican Grill, Inc. (“Chipotle”) is a great company facing a temporary problem. The company’s well-publicized E. coli and norovirus outbreaks in October and November have decimated customer traffic, such that fourth-quarter same-store sales were down 14.6%. December and January same-store sales were down 30% and 36%, respectively. Restaurant-level and company operating margins are certain to fall significantly this year due to fixed cost deleveraging, one-time costs, higher food safety expenses, and higher marketing expenses. The company’s once beloved stock has collapsed from a recent high of $759 per share to $445 per share—a 41% drop. I believe the stock is now a very compelling investment.

This is an opportunity to buy a piece of a great business at a cheap price. Chipotle has a proven model with incredible unit economics, a rabid fan base, and an opportunity to more than double its restaurant count in the U.S. over time. Additionally, the company is planting seeds in Canada and Europe, and has two emerging “Chipotle-like” concepts in ShopHouse Southeast Asian Kitchen and Pizzeria Locale.

I believe the company’s stock is currently worth at least $650 per share and that value will grow meaningfully as the company opens over 200 new restaurants per year. Paying $445 per share for the stock is likely to provide an attractive return over time as the value of the business grows and the discount at which the stock is trading eventually closes.

The stock is mispriced primarily due to the uncertainty around near-term business results and market participants’ tendency to extrapolate present circumstances indefinitely into the future. Recent sales results have been dismal and sales and margins are certain to be weak this year, but few seem willing to look beyond 2016. Much of the sell-side commentary remains overly negative, often suggesting investors wait until a recovery is underway before buying the stock.

Importantly, other restaurant chains have gone through their own food safety issues—some more serious than Chipotle’s—and ultimately recovered as the negative headlines faded. I am confident that Chipotle will recover and its 2015 food safety issues will seem like an unfortunate but distant memory within a few years. Sentiment should improve as same-store sales improve sequentially during 2016 and margins begin to recover in 2017. By 2018, I expect average restaurant sales and margins to have recovered to pre-incident levels.

The best part of this investment is that Chipotle is not slowing down its unit growth. The company is opening 220-235 new locations this year and will probably open similar numbers during the next several years, so the company’s underlying earnings power is growing meaningfully below the surface. By 2018, I expect a full recovery in restaurant economics and roughly 33% more restaurants than exist today.

Company Background

Steve Ells graduated from The Culinary Institute of America in 1990. After working as a sous chef at Stars restaurant in San Francisco, Mr. Ells moved to Denver with the goal of opening a restaurant. With a loan from his father, he opened the first Chipotle Mexican Grill in 1993. After opening another 15 locations, the company accepted an investment from McDonald’s, which was diversifying by buying other restaurant chains at the time. McDonald’s helped accelerate Chipotle’s growth in a mostly hands-off manner, and ultimately sold its stake during and shortly after Chipotle had its IPO in 2006.

At the end of 2015, Chipotle had 2,010 restaurants with about 98% of them in the U.S. The company owned 23 locations between Canada and Europe, and another 16 of two growing concepts: ShopHouse Southeast Asian Kitchen and Pizzeria Locale. The company expects to open 220-235 new locations this year and sees room for at least 4,000 locations in the U.S. over time. The ultimate potential number of locations has grown larger over the years as the company has gained widespread acceptance and average restaurant sales have continued to increase, reaching over $2.5 million during 2015.

Restaurant Economic Model

Chipotle’s economics are among the very best in the restaurant industry. Return on invested capital has continuously improved over the years as average restaurant sales and margins have drifted higher.

Average restaurant sales peaked at over $2.5 million during the third quarter of 2015—just prior to the food safety issues—and have increased year after year as the company improved its customer throughput potential and consumers flocked to the stores. The ultimate potential for average restaurant sales could be meaningfully higher than $2.5 million. Chipotle’s focus on increasing throughput allows them to serve a tremendous number of customers, yet long lines were still the norm before the food safety issues. To alleviate the long lines, the company is working on growing online or mobile orders, catering orders, and delivery orders (via its third party delivery partners). Those orders are made on a second line, which avoids disruption to the main customer line and increases overall throughput, average restaurant sales, and unit economics.

In 2015, Chipotle spent about $879,000 to open a new location between leasehold improvements, equipment, and pre-opening costs. According to management, new units open at an initial sales run-rate of $1.8–$1.9 million per year; however, according to the 2014 proxy statement, new units opened in 2014 averaged a $2.0 million annual run-rate during the year. New restaurants typically ramp up their sales to the $2.5 million company average within roughly 24 months. At that productivity level, restaurant-level margin reaches about 27-28%, amounting to about $690,000 of restaurant profit per year. That is a pre-tax cash-on-cash return in the 70%–80% range. Certainly, unit economics will be weaker during 2016 but should rebound to these figures with time. The ability to roll out new restaurants and generate returns in that ballpark for a very long time will create a tremendous amount of value.

Market Potential

Chipotle ended 2015 with 2,010 restaurants with about 98% of them Chipotle restaurants in the U.S. Management believes the U.S. market potential for Chipotle is over 4,000 restaurants. Management’s view of the ultimate market potential has increased over time as the brand’s popularity has grown and average restaurant sales have surged higher. The company is now able to open new restaurants in locations it never would have expected just a few years ago.

“At the time of the IPO, we had calculated that if we just penetrated the top 75 DMAs, we could build about 3,000 restaurants in Chipotle. Let's go to the next group of about 150 to 200 DMAs and then had densities similar to our most dense market at that time that was years ago, that would get you up to 4,000. Well, our densities in those dense markets are greater today than they were back then and we've entered different opportunities today. In the last several years of that, we didn't have that then. For example malls, we are starting to enter malls. We've got a couple dozen malls that are doing exceptionally well, like food court malls where it's very, very small space, a thousand square feet or so. And we're doing phenomenally well. The financials are terrific. We've entered small towns, which we had not entered eight years ago. So we don't think about the pace of how fast we will get there. We know that our potential is at least that 4,000, but it's likely greater. And we know if we're very discerning about the sites that we pick, we pick only great real estate, that we have great managers ready to run those restaurants, we know that the potential whatever that number is, it's going to continue to grow and then the pace of growth is less important than making sure that we have that ultimate tremendous potential.” — Jack Hartung, CFO, on April 29, 2014

Exhibit 1 shows the largest restaurant chains in the U.S. and their average unit volumes. Many less popular chains with inferior food quality and inferior unit economics have far more U.S. locations than Chipotle.

Additionally, restaurants with higher quality food like Chipotle have a tailwind at their backs. Consumers are increasingly shifting towards chains with higher quality ingredients and away from the highly-processed foods of traditional fast food restaurants. Chipotle’s “Food with Integrity” mission is a meaningful differentiator, highlighting the company’s “Responsibly Raised” meats, which come from free-range animals that have not been treated with hormones or antibiotics, its organically grown produce, and cheese and sour cream from pasture-raised cows. Between Chipotle’s “on trend” message and food quality, its $2.5 million and growing average restaurant sales, and its very high returns on new restaurants, I believe the brand’s upside is likely higher than 4,000 locations in the U.S. over the long term. Additional locations for Chipotle in Canada and Europe and for the two emerging concepts in the U.S. should add to that potential.

Food Safety

I am confident Chipotle will recover from its recent food safety issues because it has implemented what appear to be very rigorous food handling and screening protocols, both at the supplier level and the company level.

In addition, Chipotle is not the first restaurant chain to have food safety incidents.

In 1993, Jack in the Box had its own outbreak that resulted in over 700 cases of E. coli. The outbreak originated from undercooked beef at 73 restaurants in Washington, Idaho, California, and Nevada. 171 people, including 45 children, were hospitalized. 41 victims developed hemolytic uremic syndrome (HUS), a disease that destroys red blood cells and can lead to kidney failure. Tragically, four children died.

Jack in the Box same-store sales declined 22% in its fiscal second quarter of 1993, including a 40% decline during the first week of February. After three quarters of 9% same-store sales declines, same-store sales rebounded 23% in its fiscal second quarter in 1994. The brand posted solid same-store sales gains in the next few years. Since 1993, Jack in the Box has expanded from about 1,200 total company-operated and franchise-owned restaurants to over 2,200 locations today.

In comparison, Chipotle’s impact on human health in 2015 was far less severe. Chipotle sickened 60 people with E. coli in October and November. Two separate norovirus outbreaks linked not to food, but sick employees, sickened 386 people. Salmonella sickened another 60 people in two states. No one developed HUS and no one died. However, the widespread reach of today’s media, including social media, significantly amplified the news. The negativity culminated with a Bloomberg BusinessWeek cover story highlighting Chipotle’s food safety woes.

Chipotle’s same-store sales fell 14.6% in the fourth quarter, including declines of 16% in November and 30% in December. January’s same-store sales fell 36% as the media reporting continued for an extended period of time and the CDC’s investigation into the cause of the outbreak continued. Chipotle management decided to wait until the CDC’s investigation was concluded before trying to actively bring customers back in to the stores with a marketing campaign.

The CDC finally concluded its investigation on February 1, 2015. The long time period between the first negative headlines in October and the CDC’s “all-clear” lengthened and deepened the same-store sale weakness, in my opinion.

Chipotle is set to begin the largest marketing campaign in its history this week and closed each of its stores for four hours yesterday to host a companywide food safety meeting. It is highly probable that the worst of the company’s same-store sales declines are over.

Valuation

I primarily use a discounted cash flow model to value Chipotle. The key assumptions are:

• A weak 2016 with average restaurant sales down 11% and a depressed 8.5% operating margin

• Average restaurant sales recover to pre-incident levels in 2018.

• Restaurant-level and company operating margins roughly equal 2014 levels in 2019.

• 2.0% same-store sales growth in 2019 and beyond

• 225 new restaurant openings per year until 4,000 units are reached in 2024

• New restaurants cost $805,000 to build between leasehold improvements and equipment.

• 8.0% discount rate

• 5.0% TTM NOPAT yield for the terminal value

These assumptions result in about $19.0 billion of enterprise value, to which I add $1.3 billion of cash and investments, cash for options assumed exercised, and deduct $478 million for imminent share repurchases. The result is an equity value of $20.5 billion or $657 per share.

If the long-term market potential is 5,000 restaurants instead of 4,000 restaurants, that would create roughly $3 billion of additional present value or roughly $100 per share, making the equity worth about $757 per share.

What does the current stock price of $445 per share imply? I believe it implies the company recovers to normal economics in a few years, but only opens another 400–500 more restaurants from today’s number. Those numbers represent roughly two more years of growth before the brand permanently halts its expansion. That is wildly unrealistic, in my opinion.

A second DCF that isolates the new restaurant growth opportunity suggests the NPV of that growth is about $8 billion. I use the same new restaurant growth assumptions as outlined above.

Method 2: 2018 Earnings

My numbers are above consensus, but I can apply a 35x TTM multiple to 2018 consensus earnings and reach a $678 share price at the end of 2018. At that point, the company would have something around $1.7 billion of cash on the balance sheet, assuming no additional repurchases, which would be worth another $55 per share. A year-end 2018 stock price of $733 per share suggests a 65% return in three years, or 18% annualized.

A good question is whether Chipotle will deserve a 35x trailing multiple at the end of 2018. I believe it will.

• The stock’s average TTM multiple between 2006 and just prior to the food safety issues was 44x. Certainly, the average multiple at which a stock has traded is not necessarily the “right” multiple; however, it is impossible to argue that the average multiple was too high considering the stock appreciated 14-fold over that period. With the benefit of hindsight, the multiple was clearly too low for most of those ten years.

• The average TTM multiple in the three years leading up to the food safety issues was 46x, indicating the 10-year average multiple was not skewed by meaningfully higher multiples in the earlier years.

• Considering my expectation that the business recovers to its normalized best-in-class economics, and will still have a long growth runway ahead of it, it seems unlikely the market would apply a multiple below 35x.

To be clear, Chipotle deserves such a high multiple because the return it generates on new restaurants is off-the-charts and it has an opportunity to open at least 2,000 more in the U.S. alone. Chipotle is a proven concept with a loyal fan base and a demonstrated track record of creating value through new restaurant openings.

Why Is the Stock Mispriced?

• It is psychologically difficult for most people to buy in the face of negative headlines and sparsely crowded restaurants. Many cannot help but extrapolate current circumstances indefinitely into the future. A common view is currently, “Let’s wait to see traffic come back before buying the stock,” or “Let’s see how effective the marketing campaign is first.” Those expressing these views seem not to appreciate that by the time a recovery is apparent, the stock price is likely to be much higher than it is today.

• Some believe Chipotle is destined to have lower margins over the long term as a result of higher food safety expenses. While this is clearly true in 2016 and perhaps 2017 due to 200 bps of higher food safety related expenses, this is unlikely in the long run. Management has stated it expects the company’s margins to fully recover as the company grows average restaurant sales, leverages fixed costs, and eventually implements a modest price increase in 2017 or 2018.

• Some believe certain changes in food preparation are going to negatively impact the taste of Chipotle’s food and impair customer traffic in a meaningful way. Certainly, tomatoes, lettuce, and cilantro will be chopped and prepared in central kitchens and other items like jalapenos and avocados will be quickly blanched to kill any potential microbes. However, I would challenge anyone to eat at Chipotle and honestly conclude the food tastes any different than it did six months ago. I do not notice a difference.

Even that is missing the point though. Not only would customers have to notice, but the difference in taste would have to be drastic enough to cause them to eat elsewhere. I find that unlikely. I believe Chipotle’s customers would still find a hypothetical Chipotle burrito that tastes 98% as good as it did six months ago to still be more appealing than most alternatives.

• I have also heard, “Sure the stock has fallen 40%, but it is still trading at 50x forward earnings.” This argument ignores two important points. First, 2016 earnings are enormously depressed and should not be used to value the company. Second, it can be misleading to simply slap a multiple on a business without understanding the long-term assumptions baked into that valuation. Every business is different and has different growth profiles and return characteristics, so comparing Chipotle’s multiple to that of lower quality restaurant companies is not very useful, in my opinion. I prefer to value Chipotle by discounting the cash flows the old-fashioned way, so that I can be more certain about the assumptions my valuation implies. I believe Chipotle is worth a substantial premium to its current market price because of its highly productive existing restaurants and its opportunity to open many more at very high returns on capital.

Catalysts

Last week, the CDC concluded their investigation into E. coli at Chipotle, effectively signaling the “all-clear.” The company will begin its largest ever marketing campaign this week in an effort to bring customers back into the restaurants. I expect investor sentiment to improve as same-store sales declines become less and less negative during 2016 before ultimately turning positive perhaps in late 2016 or early 2017. Market participants will gradually recognize that the business is not permanently impaired and is likely to fully recover with time.

Risks

• Traffic does not come back and Chipotle’s business model is permanently impaired.

• Higher food safety costs prevent the business from returning to its historical margins and returns.

• The grand jury investigation into Chipotle’s handling of its food safety incidents results in massive fines or mandates additional changes to the company’s business practices, which negatively impact margin potential permanently.

• The company’s potential restaurant count is far lower than 4,000. That said, I believe the current stock price is pricing in only 400–500 new restaurants.

Conclusion

Chipotle is a great business with fantastic unit economics and a large growth opportunity. The food safety issues of 2015 are unfortunate for the business, but are only a temporary problem. The company’s stock is cheap because most investors are unable or unwilling to buy in the face of a weak and uncertain 2016. As long as the brand eventually recovers and continues to grow—which is highly probable, in my opinion—paying $445 per share in early 2016 is likely to be a good decision. Most importantly, I believe the long-term assumptions necessary to appraise the stock at or below its current price are completely unrealistic. In other words, I believe losing money permanently with this investment should be highly unlikely.

As a side benefit, I expect an investment in CMG to be somewhat uncorrelated with the overall stock market. The stock’s future trajectory will be much more dependent on the company-specific recovery than on overall changes in consumer spending, the general whims of the stock market, or things of that nature.

“If you wait for the robins, spring will be over.” — Warren Buffett

Disclosure: The author’s fund is long CMG. This is not a recommendation to buy or sell any security. All the information in this write-up may be completely wrong. Do your own research.

Catalyst

Last week, the CDC concluded their investigation into E. coli at Chipotle, effectively signaling the “all-clear.” The company will begin its largest ever marketing campaign this week in an effort to bring customers back into the restaurants. I expect investor sentiment to improve as same-store sales declines become less and less negative during 2016 before ultimately turning positive perhaps in late 2016 or early 2017. Market participants will gradually recognize that the business is not permanently impaired and is likely to fully recover with time.