Chipotle: Growth In The Fast Food Industry Is Too Expensive (NYSE:CMG)

Company description:

Chipotle Mexican Grill (NYSE:CMG) owns and operates Chipotle Mexican Grill restaurants. As of September 30, 2022, it had approximately 3,100 restaurants in the United States, Canada, the United Kingdom, France, Germany, and rest of Europe.

Unlike many of their competitors who use a franchise model, Chipotle owns and runs their restaurants. This gives them greater reward, earning the franchise’s cut, while taking on greater risk and responsibility. For this reason, their operating profile is different, being asset heavy and placing greater importance on their supply chain.

Chipotle operates in several countries but is primarily a US business, with the vast majority of its earnings derived from this country.

Chipotle’s stock has been on a tear in the last 5-years, gaining over 350%. The primarily contributing factor has been sustained growth and improvement in the profile of the business.

As the graph shows, from Q3’21 to present the stock has experienced stagnation, with a c.20% fall from its all-time high. It is not a coincidence that market conditions had begun to weaken around this time, but that does not necessarily mean CMG’s fundamentals have changed. With an extended period of time having elapsed, now is a great time to consider if CMG is now undervalued.

In order to assess this, we will consider current market conditions and developments in the fast-casual restaurant industry, as well as considerations of CMG’s financial performance. We will then conclude with a relative performance assessment to peers and a valuation exercise.

Macro-economic conditions:

Inflationary pressure is a primary contributing factor to the weakening market conditions observed from late 2021 to present. In order to combat this, central bankers have increased interest rates as a means of cooling demand. Inflationary conditions stem from many factors, including wage inflation and energy prices (Due in part to the Russian invasion of Ukraine). These factors have been relatively sticky, making it difficult for interest rates to have an immediate effect. Inflation in Dec22 was in excess of 3% across most western nations, meaning interest rates will likely increase into 2023. The FED are currently projecting levels in the region of 5-5.25%.

With other countries following suit, it is likely that a recession will be triggered in many weaker economies, and potentially the US too. What likely follows this is the classic recessionary indicators, rising unemployment, reduced consumption etc.

On paper, this is not a good thing for CMG. CMG is considered fast-casual, which is a hybrid between fast-food and casual restaurant dining. The problem with this is that consumers generally assign discretionary spending to such consumption. Should their discretionary income continue to be squeezed with high inflation and interest rates, we could see demand fall. The Oracle Corporation (ORCL) offers a contrarian view, highlighting that although history suggests the restaurant industry experiences a slowdown during a downturn, evidence suggests that trends have changed. They believe consumers will continue to allocate some level of income to such activities, although potentially far less. This could contribute to a “soft-landing” where demand remains relatively flat Y/Y or dips slightly, as opposed to a material pull back.

Marketing:

One of the ways Chipotle has been able grow is through effective marketing. Chipotle is very focused on retaining customers and developing a longstanding relationship. As an example, Chipotle offer a rewards loyalty program, allowing customers to earn points for purchases. This is something that some, but not all of their competitors do. The benefit of this is several folds, including being able to track purchase history in order to understand trends and attract repeat customers through rewards. In Jan23, Chipotle launched a new reward that gives customers the chance to win free food for a year, a great marketing move with a relatively low cost.

Further, Chipotle have also done the following in recent months alone:

• Created an augmented reality experience on Snapchat (SNAP) to inspire customers to maintain their new year’s resolutions
• Partnered with Farmlink project and a Tik Tok chef in order to fight food insecurity
• Halloween-themed event which encourages customers to come to their stores.

Supply chain / direct cost issues:

Many in the food / restaurant industry have been struggling with supply chain issues due to a shortage of key ingredients and a general increase in food costs. Further, we have seen wage inflation and an employee shortage across much of the industry, as inflation encourages people to seek higher paying jobs. The combination of these both have been tightening margins across the industries, with many unable to pass on costs due to heavy competition.

What is impressive about CMG is that they do not seem to have been impacted by this financially. The business has seen both GPM and NIM increase consistently across the last few years with no interruption. Management attribute this to their ability to successfully increase menu prices, while maintaining demand. This suggests an impressive level of stickiness in demand.

Delivery:

The fast-food / restaurant industry has been disrupted by the rise of e-commerce delivery businesses. The reason for this is that they have been able to gain a large number of users very quickly, thus impacting consumers purchasing habits. Many consumers now look to make food decisions based on the choices available on their favorite app, fundamentally changing the industry. For this reason, it has become a necessity for these chains to partner with a delivery platform. The problem with these platforms is that these businesses want to take a cut, thus tightening the restaurants margins. Further, it creates greater competition on a playing field that the restaurants cannot wholly control. We have detailed the economics of this and how they are likely unsustainable for restaurants as part of our DoorDash (DASH) write-up linked here.

Once again, CMG seem to have navigated this perfectly. The business operates a 2-system delivery model, with all deliveries fulfilled by third-party providers. Firstly, they offer delivery through their website, for which they receive delivery income. Secondly, deliveries can be initiated through apps, for which the delivery fee is not earned by CMG. CMG’s partnership with DoorDash has yielded great benefits, with 11% of Chipotle’s sales derived from this platform and digital sales now comprising 37.2% of sales (Source: Q3 results). This is quite impressive for a sit-down establishment. The margins from this source may not be superior to a traditional in-store transactions but fundamental trends are changing, the restaurants cannot control this. Therefore, they must lean into it and if they can do that without an overall net impact to margins, like in the case of CMG, you have to say it is successful.

Geographical footprint:

The vast majority of Chipotle’s footprint is in the US, with limited global expansion, at least compared to many of their peers. The reason for this is partially due to resources and market understanding required to do this. We highlight this point as it is a greater area for growth, especially if things do slow in the US.

Financial analysis:

We have touched on aspects of CMG’s financials above but as presented; they are quite impressive. Revenue has only dipped in one period, with a CAGR of 13%. The driving force of this is very healthy. New stores are of course a material factor, but also average restaurant sales have increased period-on-period. This is very important to see as this statistic will be a reflection of the brand as a whole, and its marketing efforts.

As we have mentioned, cost controls have been incredibly good and where required, menu prices can be increased. The impact of this is a general uptrend in margins, with economies of scale allowing this to flow down to NI.

Other operating expenses have increased as a % of revenue, which includes performance and stock related compensation for employees.

From a balance sheet perspective, we see an impressive degree of prudence. Debt to equity has increased as a result of the change in accounting standards, as opposed to an increase in loans. Net debt as a ratio of EBITDA is only 1.63x, which is a very conservative level for an asset-heavy business. This contributes to an impressive RoE of 35% in the LTM period.

Outlook:

Analysts are very bullish on CMG, expecting growth of 14.4% in the coming 4-years. They are expecting FY22 to come in at 15.2% up on the prior year, which is an incredible follow up to over 20% growth. The driving factor for this will likely be the investment in new stores, with 7.7% stores opened in FY21 and a further 5% in 9M Sept22. With market conditions weakening, we are more comfortable with CMG being able to perform well (even if average store sales fall) when we know the store count is up to the degree it is.

Many others in this industry have seen slowing growth in the LTM period. As an example, Cheesecake Factory (CAKE) is up 9%, Domino’s Pizza (DPZ) is up 3%, McDonald’s (MCD) is up <1%, all significantly below their prior year.

Peer comparison:

Above we have presented several restaurant businesses, some of which operate on a franchise model and some own outright.

From a profitability perspective, CMG is relatively middle-of-the-park, GPM and EBITDA margins are below average, but FCF yield is on par. The franchise model is highly profitable due to the relative lack of personnel and depreciation expenses and so it would be difficult for CMG to reach such a level. If we compare them to Starbucks (SBUX) and Darden (DRI), who both mostly own their locations, CMG does well.

The attractiveness of CMG is clearly in the growth section, where they are double the peer average. Given the marginal difference in FCF, having superior growth is far more valuable. Although attempting to forecast the future can be folly, the lack of leverage allows for more growth through locations.

Valuation:

The majority of this paper has been very complementary of CMG and so it is probably not surprising to see that the business is very expensive. Only Wingstop (WING) is trading at a larger multiple. Valuations seem to be primarily driven by growth, which makes sense given the relative uniformity of profitability (being very high). Further, the industry can be shaken up by trends and so opportunity in this industry comes from identifying what’s on the uptrend.

Based on the peer group average, CMG is overvalued by 33%. This is likely not its fair value, as we’ve established that growth is very important. Instead, we believe CMG’s current fair value is closer to 31x EBITDA. This is very high, but we see good foundations which should allow for sustained growth.

This does mean at 35x EBITDA CMG is overvalued. The issue many investors could face is getting this stock at a relatively attractive valuation, given its track record of delivering strong results. Since their ATH in late 2021, CMG is up 25% from its “bottom”, which gives prospective investors some hope for a cheaper price.

Conclusion:

Chipotle is a great business. It is growing very fast for a restaurant chain, in both like-for-like sales and new stores. Management have maintained strong controls over costs and are able to increase menu costs as required (so far). We think macro-conditions will impact the business but not to a level where growth is in doubt medium-term. In exchange for this, investors must pay a premium, and a steep one at that. With economic uncertainty, bearish market sentiment and growth likely slowing partially, it is not a good time to be buying an overvalued stock. Given the quality of the business however, we consider a hold rating a fair rating.