Description

Well Chipotle finally reached a price of $311 a share. Given the quality of the business and its prospects I think that is attractive.

CMG was doing very well until 2015. It kept opening more restaurants, while the comparable store sales continued to increase at a fast clip which allowed for restaurant and operating margins to improve at a fast clip. Basically it was a virtuous cycle for the company that resulted in excellent ROICs. Here are some numbers through 2014.

Then CMG was hit with not one, but six food safety events in the period from July 2015 through November 2015. Three E.Coli outbreaks, one Salmonella outbreak and two Norovirus outbreaks. Then in July 2017 we had another Norovirus outbreak. While it is hard to have 100% food safety it was clear that there was a problem. So during the 2015 and 2016 period CMG made significant efforts to improve it food safety. Despite the latest Norovirus outbreak I feel confident that they largely fixed the problem. Norovirus is hard to protect oneself against 100% as a restaurant. One customer or employee can bring it in, which is what happened in each of the instances of Norovirus at CMG.

This all had a significant impact on the business as the numbers for 2015 and 2016 show. Things went from great to horrendous as average restaurant sales went from a high of $2.472 million in 2014 to $1.868 million in 2016. At the same time CMG had significant expenses in fixing the food safety issues and spending on marketing to drive more traffic to the stores.

But things have been improving during Q1 and Q2 2017 as shown below. Average restaurant sales have increased again to $1.957 million. We are not yet back to where we want to be but it is an encouraging trends to see average restaurant sales increase by close to $100K over the last two quarters versus Q4 2016

What is also interesting is how CMG management has continued to open new restaurants. In 2016 the number of restaurants opened actually accelerated to 243. In the first two quarters of 2017 they added another 107 restaurants. CMG spends about $900K to open a restaurant. What this means is that if you look at the capex it is fairly easy to figure out that maintenance capex for CMG is low. Therefore I think the best way to value CMG is using adjusted maintenance free cash flow.

I believe that it is highly likely that CMG will be able to return to some form of its previous performance. Clearly the mix of social media and these repeated food safety issues was toxic, but CMG is pro-actively addressing them. Many new procedures were put in place and the same as happened with other food safety alarms for other companies, CMG seems to have fixed the problem. The main worry I have is that the Norovirus makes another return. The problem is that the Norovirus is highly contagious and just an employee that decides to come to work sick can start it.

If the food safety issue is truly behind us, then I do not see why revenues per store should not return to its old growth path. The reason being that Chipotle is just a great offering for the customer. You get an excellent quality meal for the price you pay. I am an avid Chipotle eater and early 2016 I even back off as the news was seemed so bad, but soon I ended up finding my way back. What else should I get for lunch? KFC, MCD, Subway? Even the nutritional value of a Panera meal does not come close to what is on offer at Chipotle. (Yes, I know it is high in sodium.) If it was not for the food safety issues, I would guess that revenues per restaurant by now would have been higher than the $2.472 million in 2014.

Here is the way I get to my valuation:

If I take the average of the adjusted free cash flow per store for the years 2011 through 2015, I get $340K in adjusted free cash flow. Multiply that by the amount of stores we had at the end of Q2 2017 and divide that number by the amount of shares outstanding at the end of Q2 and we get $28.61 in adjusted free cash flow per share on a normalized basis. That is about a 9.2% free cash flow yield once the business normalizes.

Then we also have the potential continued growth. The number management keeps throwing out is a minimum of 4,000 restaurants.

If we add 1,600 restaurants using the same $340K in average adjusted maintenance free cash flow per restaurant. Then we get additional adjusted free cash flow of $19.07 per share. Now that will also cost an additional 1.44 billion in growth capex.

So let us add the $19.07 to $28.61 and we get $47.68 in adjusted maintenance free cash flow with 4,000 restaurants which gives us a 15.3% yield. Now it will take some time to get to 4,000 restaurants. At the current pace they should get there in about 8 years. If we assume that the company should then trade at a 15 multiple $715.2 per share or a market cap of $20.4 billion. Deduct the $1.44 billion in growth capex and I get a market cap of $18.95 billion or $664 per share.

Now I do believe we will not have to wait too long before we actually get a higher price for our CMG shares. As the whole food safety issue abates over time, demand for the stock should increase. A good way to think about stocks I feel is that “you will always make way more money when things go from truly awful to merely bad, than when they go from good to better”. Well to me it seems the CMG stock is trading at a price as if things are still pretty awful, while the company has already made significant progress and we are already at the merely bad phase on the way to good.

Now here is why I really like CMG … and it is called Pizzeria Locale. CMG management has talked in the past about implementing the same processes of serving food used by Chipotle restaurants for other foods. I think CMG management is on the right track there. They started up Shophouse, but recently closed it down, because management was not seeing the financial restaurant level results it was hoping for. A good sign of disciplined management I believe. I believe Ells personally spent a lot of developing the concept, but when it did not meet the necessary hurdle they killed it. Then they also just opened Tasty Made, a hamburger concept, and opened one restaurant. I have no idea if this will be a successful concept, but it is a good try. Because in the end for CMG stock to have the potential to become one of those stocks that goes up many more times in value, we need one of these concepts to work. If CMG can do another concept like Chipotle and open another 4,000 restaurants over the next few decades, the numbers will become crazy. And once investors believe there is another concept that is successful CMG stock should sell for significantly more. And I think that new concept is Pizzeria Locale. Pizzeria Locale is a new pizza concept following the Chipotle principles. It is a joint venture with Denver based entrepreneurs that currently have a majority stake, but the agreement with CMG is that once Pizzeria Locale is large enough CMG has an option to buy a majority stake. I am not sure how much that majority stake will be, but honestly, I would guess that the moment CMG thinks it is ready to put a lot of money behind the Pizzeria Locale concept, they will just buyout the current owners. So why do I like Pizzeria Locale so much? Well the first Pizzeria Locale was opened 4 blocks from my house a number of years ago. Since I had moved to my current place that same location had had in short order 2 other pizza places in the same location and both were busts. Actually when they were building this Pizzeria Locale I thought “another idiot trying to do pizza where two others failed”. And I was wrong. I eat at this place often and each time it is busy. I can already hear you say “it’s just another pizza place”. But I believe it is not. And so do many other patrons think because every time I pass by there, there is a nice crowd in there. It is more of a dinner crowd than lunch, but even at lunch I often see a decent crowd in there. It is very similar to Chipotle, in that you line up, order your pizza. They make it there right in front of you, then they drop it into this proprietary oven burning at 1,000 degrees that turns and two minutes later, when your pizza has gone around one turn, your pizza comes out ready to eat. It is low cost as you do not need anyone to really pay attention to the pizza, except to make sure they take it out after the first lap. While you wait you get to order your salad, meatballs, Prosciutto, dessert, soda or alcohol. You pay and take your food to a table. It takes a little longer than going through a Chipotle line, but not much. All the items are of great quality and it ranks with the best pizza I have eaten. I remember telling a friend what a great concept it was when it opened and I have come to appreciate it more over time. Sitting at my table I have looked at every aspect of what is going on and I feel the economics must be very much in line with Chipotle restaurants. Basically the pizza is an 11 inch dough with cheese, marinara sauce and some toppings. The next item on the menu are the Prosciutto and the meatballs which should have a decent margin and then there are the salads, soda, alcohol and the one dessert they sell. Many at night also order alcohol which is high margin. I just don’t see how Pizzeria Locale doesn’t have at least similar margins as Chipotle. And then there is the revenue number. At $2.5 million in revenue a Pizzeria Locale would have to generate about $6,850 per day. I believe they hit that number. Especially on weekends the place is packed all day it seems. I assume an average check size of $10, but I believe that to be conservative as I see many people ordering multiple items and alcohol with their meal. If/When Pizzeria Locale does become a CMG business I think it will reenergize the market cap of the company. Imagine if you the Chipotle concept had a runway of 8,000 more restaurants rather than the 1,600 I assumed. If I am right, I think Pizzeria Locale could be bigger than the Chipotle concept. It is hard to transfer the Chipotle concept outside of the US. Mexican like food is just not as accepted in many overseas areas. But Pizza is. I think this concept would do just as well internationally as it would do in the US. Anyway, I know this sounds like an enormously bullish story, but I have now eaten at that place for a number of years on a weekly basis and it is just a great quality product. Some will say “It is just pizza, everyone can do it”. Well everyone can make Burritos too. Also from what I learned the oven is a differentiator. The oven was developed internally with the help of CMG where CMG brought an engineering team together to design it. From what I learned they are on their 7^th iteration of the oven. So yes, other companies could do the same. But you will need money to develop the oven. Lastly if one compares the capex needed to open a Pizzeria Locale I have a hard time seeing how the average new Pizzeria Locale would cost more than a new Chipotle restaurant, for Pizzeria Locale does not need the same size kitchen as Chipotle does. So ROIC should be similar. The one downside argument against Pizzeria Locale is that the pizza is mostly useless carbs, where at Chipotle they serve more nutritious food. Lastly one might question why CMG hasn’t put more money behind Pizzeria Locale. I think for now CMG management has its hands full fixing the Chipotle restaurants and do not have the bandwidth to take on Pizzeria Locale. Also I think it might make sense to allow Pizzeria Locale to work out the concept completely before blowing it out. Anyway, even if I am wrong and Pizzeria Locale does not become a CMG concept I think we are still covered well with just the Chipotle restaurants at a valuation around $311 per share.

Risks:

More food safety issues will likely impact the price of CMG stock negatively. I am not too worried about the Norovirus issue. Each time it has turned out that it was caused by a sick employee that was made to work by a manager. CMG has implemented many new food safety rules, like all employees need to wash their hands every 30 minutes. If we get more E.Coli and Salmonella incidences then I would start worrying.

Catalyst

Continued improvement of restaurant metrics.

CMG putting its muscle behind Pizzeria Locale.