Chipotle is an enormously profitable business. So profitable that it’s able to fund its own rapid expansion with cash from operations and zero debt. Many investors have recently discounted the stock because comparable sales growth has slowed, and the company will certainly feel near-term pain from the E. coli outbreak, but comps will still grow over the long-term and so will the number of restaurants and the potential for the company’s newer brands. We believe these profitable growth opportunities, combined with its current market valuation, give Chipotle’s stock more upside than risk.
Comparable Sales Growth: Less Strong, But Still Strong
Comps Growth: Chipotle’s comparable restaurant sales growth is slowing, but it’s still strong. For example, for the nine months ended September 30, 2015, comparable restaurant sales grew 5.5% versus the same period a year earlier. However, when Chipotle reported this same figure a year earlier, comparable sales had grown at a rate of 17.0%. And while more growth is better for the bottom line than less growth, positive growth is still far better than negative growth. And according to Chipotle’s Chief Financial Officer, John Hartung “For the full year , we continue to expect our overall comp will be in a low to mid-single-digits, and as we look to 2016, we expect the comps will remain in the low single digits.” And while Mr. Hartung’s comments are positive, they were made before the recent E. coli outbreak.
E. Coli Outbreak: Forty-three Chipotle restaurants were closed for approximately one-week at the beginning of November due to an E. coli outbreak, and at least 43 additional cases of Chipotle-related E. coli were reported by the Center for Disease Control and Prevention on November 20th. We believe this will put significant downward pressure on comparative restaurant sales during the fourth quarter and into next year. It will also cause the restaurant to miss short-term revenue and earnings goals. However, we believe it will have little impact on Chipotle's long-term success. Health related food issues are not unique to Chipotle, and we believe the company will come out unscathed in the long-term.
Online Orders: Another potential impact to Chipotle’s comparative restaurant sales growth is the company’s increasing online order placement abilities. According to Chipotle’s Chief Creative and Development Officer, Mark Crumpacker: “Our mobile and online sales continued to grow for the seventh consecutive quarter and currently represent more than 5% of topline sales, up more than 40% over last year.” Online sales represents a powerful growth opportunity. And Chipotle recently hired a new Chief Technology Officer that will likely focus on improving online sales. According to Chief Financial Officer, John Hartung:
“Two-thirds of our business is eaten outside of a restaurant, but only 7% of our business is ordered outside of a restaurant. And so, there's a big gap between our customers who choose to or end up eating somewhere else other than a restaurant… I think we can enhance their overall experience so that 7% can continue to grow over time.”
More Chipotle Restaurants: A Powerful Driver of Growth
Chipotle recently increased its target for new restaurant openings in 2015 and beyond. For example, as part of the company’s third quarter earnings announcement, Chipotle increased its “guidance to 215-225 new restaurant openings [for 2015], up from the previously announced range of 190-205.” And for 2016, Chipotle expects even more new restaurant openings of 220-235. This amount of new restaurants is significant considering the company currently has only around 2,000 restaurants total. We expect Chipotle can increase its number of restaurants by 230 per year from 2016-2020, and we have included this powerful driver of growth in our valuation later in this report.
New Brands: More Long-Term Opportunity
In addition to improving comparable sales and opening new restaurants, Chipotle can grow in the long-term via its new brands including Pizzeria Locale and ShopHouse. With regards to these new brands, John Hartung recently said:
“They're still in the nurturing phase, it's still in the brand building phase. When we open up a new restaurant, it behaves a lot like Chipotle 12 years, 15 years ago, when we went into a new market where it's an unfamiliar brand, it takes a while for customers to figure out what ShopHouse is. Pizzeria Locale, while it's pizza, it's pizza that may be unfamiliar to customers that are used to traditional pizza.”
It is encouraging to know that Chipotle is nurturing its new brands rather than forcing growth that the market may not yet be ready for. There are currently only 14 ShopHouse locations and only three Pizzeria Locales. And for reference, ShopHouse is basically “the food culture of Thailand, Vietnam, Malaysia, and Singapore… with a focus on fresh, expertly prepared, and affordable fare that can be eaten every day.”
Pizzeria Locale is pizza “inspired by the traditional pizzerias of Naples, Italy.” And considering the success Chipotle management is having with its Chipotle brand, either one of these newer brands could eventually lead to dramatic revenue growth if/when expansion ramps up.
Valuation: Chipotle’s Growth is Attractively Priced
Chipotle generates an enormous amount of free cash flow (FCF), for example $406.7 million in the first nine months of 2015. We believe the company can increase this amount dramatically through 2020 based on moderate comparable sales growth and aggressive new restaurant openings. For example, if Chipotle adds 220-240 new restaurants in each of the next five years then it’s not unreasonable to believe it can increase its total annual FCF to around $1.3 billion by 2020 (we’re assuming no new restaurant openings thereafter which would significantly reduce capital expenditures and increase FCF). If we assume an 8.9% weighted average cost of capital and a 3% growth rate thereafter, Chipotle would be worth around $706 per share.
However, Chipotle has the ability to grow even more dramatically by opening more restaurants (in the US and overseas), growing ShopHouse and/or Pizzeria Locale, or expanding comparable sales. For example, if Chipotle grows comparable restaurant sales by 10% per year from 2016-2020 then it could easily generate $15.6 billion in FCF making it worth around $939 per share. Or if Chipotle were to more aggressively open new restaurants (Chipotle, ShopHouse or Pizzeria Locale) then it could just as easily achieve a similarly high valuation. Depending on the level of success Chipotle achieves in growing its business will determine how much higher its valuation goes, but the attractive aspect of Chipotle is that it still does have a lot of room to grow.
As another check on valuation, if Chipotle does expand FCF to $1.3 billion by 2020 then it’s currently trading at only 12.8 times that amount ($16.7 billion market cap /$1.3 billion free cash flow). For comparison, if McDonald’s grows its FCF ($4.146 billion in 2014) by 8% per year through 2020 (which it likely won’t because it’s already a very mature company with a hefty dividend) then it trades at 15.5 times that amount. Chipotle is “on sale” compared to McDonalds. And if Chipotle achieves an even higher level of growth (which it has the potential to do) then it is even more on sale. Granted McDonald’s cash flow is safer and less volatile than Chipotle’s, but more volatility is the price you often pay for more growth over the long-term. And make no mistake, increasing growth by only 1-2% per year is worth a lot more than 1-2% over the long-term because of the amazing power of compound growth.
Chipotle’s Free Cash Flow: It’s Impressive
The amount of free cash flow Chipotle currently generates is impressive. It is impressive because the company generates enough cash from operations to fund its own growth (i.e. hundreds of new restaurants per year) with zero debt and lots of extra cash left over. This is exceptional considering many other growing companies require significant debt to generate growth and they are often not profitable until after the growth period ends. The question for Chipotle is what should they do with the cash that is left over after they have funded new restaurants?
Recently, Chipotle has been using its extra cash to repurchase shares instead of paying a dividend. For example, Chipotle repurchased $30 million of its own shares during the most recent third quarter, and still has $155 million remaining in its approved share repurchase program. However, the amount of cash the company generates far exceeds the amount needed for growth or used on share repurchases. Chipotle either needs to start paying a healthy dividend, or else admit they have other big plans for all that cash. According to CFO John Hartung:
“we continue to believe that the best use of cash is to invest in opening our high-returning Chipotle restaurants in the U.S. and we'll continue to nurture our growth seed, including ShopHouse, Pizzeria Locale, and our international Chipotle restaurants so they will become a compelling use of capital in the future. In the meantime, we'll continue to repurchase shares of our stock opportunistically to enhance shareholder value.”
This quote seems to suggest that the share repurchases are only a temporary activity, and instead the company his big future growth plans including more rapidly expanding the number of US restaurants, opening more non-US restaurants, and ramping up new brands like ShopHouse and Pizzeria Locale. This bodes well for shareholders because if management didn’t believe in these big profitable growth opportunities then they’d likely be talking about initiating dividend payments.
Executive Compensation: It’s Aligned with Shareholders
Worth noting, the majority of Chipotle’s executive-level compensation is tied to the value of the stock. As noted on page 49 of Chipotle’s 2014 Annual Report “The fundamental aim of our executive compensation program is to reward our executive officers for the creation of shareholder value.” This helps align the interests of management and shareholders. Executives are awarded additional shares based largely on four specific performance measures: operating income, new restaurant average daily sales, comparable restaurant sales increase, and new weeks of operations (2014 Annual Report, p.60). We believe these performance measures are appropriate, and they are less likely to incent perverse or short-term management behavior when compared to the performance measures of some other companies. The combination of these factors seems to create prudent incentive for management to create long-term value for shareholders.
Sources of Risk:
It almost goes without saying that Chipotle faces a variety of risks as it continues to grow. In the near-term, the E. coli outbreak will impact sales results, and it could damage the brand. In the long-term, Chipotle may not be able to grow as significantly or as profitably as it hopes. Also, new brands may never achieve enough customer interest for them to grow substantially. Additionally, Chipotle’s high quality food standards may make large scale growth unrealistic simply because they won’t be able to source enough ingredients. For example, we’ve already seen Chipotle temporarily remove carnitas (pork) from its menu because they were not able to obtain pork in a way that met their own animal welfare standards. It is these types of unknowns that make the stock risky and prevent it from achieving a higher valuation sooner. However, it is also these types of unknowns that give Chipotle its attractive long-term return potential for investors willing to own the stock.
Chipotle’s cash generation is impressive. It makes the company’s growth initiatives more achievable. And it makes the stock more attractive, especially given its current valuation. Further, the fact that management is not yet willing to use its piles of extra free cash flow to initiate a dividend suggests they believe in big opportunities ahead.
There are significant risks to Chipotle’s initiatives to improve comparable sales, open more restaurants and grow new brands. However, it is these risks that create big long-term profit opportunities. If you were only allowed to own one stock for the rest of your life, Chipotle would probably not be it (plus you’d be a fool to put all your eggs in one basket anyway). However, when included within a diversified portfolio of individual stocks, Chipotle is very attractive.