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Investment Conclusion
Chipotle Mexican Grill (NYSE:CMG) delivered outstanding F2Q2022 financial results. The outperformance was driven by double digit growth in system sales and same-store sales derived from substantial expansion in dine-in transactions and sustained off-premise orders. Accordingly, supported by a decrease in delivery transactions (which generate relatively low margins), and revenue leverage from the sharply higher retail sales, as fixed cost/dollar of sales declined, restaurant level margins advanced considerably, inching closer to peak levels, experienced prior to the food contamination incidences that plagued the company during CY2015. That margins expanded despite cost inflation related to commodities and hourly wages, was encouraging. Moreover, annual average unit volumes reached $2.8 million (best stores are generating between $6 million and $7 million), extending significantly towards the $3 million target. CMG added 42 new stores (of which 32 feature Chipotlanes) to its restaurant footprint ending the quarter with 3,052 outlets.
Over the next couple of quarters, we expect the strong momentum in sales to continue, fueled by the persistent uptrend in dine-in sales, sustained digital sales, and the launch of a new menu item, the garlic guajillo steak. In addition, we don’t view a potential economic downturn as a gating factor for sales (although the frequency of visits associated with the lower-income group is clearly declining), as CMG’s customers belong to the higher income bracket, for the most part. Further, despite some decrease in sales related to college towns as kids return home for the Summer, overall, we expect seasonality to support sales, during the third quarter.
Moreover, we anticipate sequential improvement in margins at the restaurant level, driven by some easing in commodity cost inflation, stabilizing federal wage growth, improved labor productivity due to the deployment of a digital scheduling tool, a planned price increase, and the impact of operating initiatives being rolled-out. Similarly, we expect leverage at the company level, due to decrease in SG&A spending, and economies of scale related to lower marginal costs associated with corporate infrastructure, marketing, and technology. Therefore, buoyed by solid upside in revenues and margins, earnings and free cash flows are likely to surge considerably, during FY2022, in our opinion.
For the year, CMG plans on launching between 235 and 250 new restaurants, of which ~80% are expected to include a Chipotlane. In addition, the firm has guided to F3Q2022 same-store sales in a range of mid-to-high single digits. During July, CMG’s same-store sales were trending at around mid-single digits.
Longer-term, CMG’s planned growth in footprint to 7,000 restaurants within ~10 years, from the current ~3,000 will drive the majority of its growth. Given that the massive expansion in the number of restaurants is likely to be focused on under penetrated regions, we do not expect cannibalization in sales or declines in average unit volumes, as new units are established. Additional growth will be derived from an increase in same-store sales attributed to: Chipotlanes, menu innovation, the loyalty program, some conversion of dine-in orders to digital, and the continued growth of off-premise sales. Given the potential significant expansion in sales, margins are likely to increase as marginal fixed costs decrease substantially and economies of scale related to corporate spending, advertising, and the digital platform are secured. As a flow-through of higher sales and improved margins, we expect substantial growth in earnings and free cash flows over an elongated time horizon.
Considering that F2Q2022 financial results have further established our strong long-term view on CMG, we are confident that the firm will handily meet and exceed our normalized 10-year revenue growth rate of 17%, which incorporates a 10-year store count of 7,000 and average unit volumes of over $3 million. Therefore, we are maintaining our 1-year Price Target of $2,020/share for CMG. Reiterate Buy Rating.
(Please go through our initiation report “Chipotle Mexican Grill: Turnaround Story With Substantial Growth Potential” and related notes for our long term opinion on the stock).
Key Takeaways From The Second Quarter
F2Q2022 Results Summary. For the quarter, CMG reported revenues of ~$2.21 billion (+17% compared to F2Q2021) missing analyst expectations of ~$2.25 billion, and earnings per share of $9.25 (+40.2% on a year over year basis) was above consensus estimates of $9.04. Excluding extraordinary items, earnings per share would have been $9.30, representing an increase of 24.7% from F2Q2021. In addition, compared to the same quarter last year, same-store sales increased by 10.1% over the second quarter. Net income for the period was ~$260 million reflecting an expansion of 38.2% on a year-over-year basis. Restaurant margins of 25.2% increased by 70 bps compared to the prior year’s same quarter.
Labor Management Tool Represents Key Growth Driver. CMG’s is currently rolling-out technology which is designed to optimally schedule employees based on labor requirements on the front make-line as well as the digital make-line. In addition, strategies are being implemented to orient the newer staff, particularly that hired on during and after the pandemic, including front-line workers and General Managers, on the mechanics of the firm’s peak throughput that was achieved during 2013 and 2014.
Based on management commentary, a five entrée increase every 15 minutes during regular hours, could potentially translate to 1% of same-store sales growth for that day. Considering that the current throughput is 25 entrees/every 15 minutes compared to the peak throughput of between 30 to 33 entrées/every 15 minutes evidenced during the 2013/2014 time frame, there appears significant opportunity for same-store sales growth, as the initiatives being rolled out to ignite throughput begin to gain traction.
International Opportunity Gathering Momentum. CMG’s business outside the U.S, continued to shine with Canadian restaurants generating annual average unit volumes consistent with those associated with domestic restaurants. In addition, same-store sales continued to advance substantially in the region. Given the recent addition of the loyalty program to the Canadian business, we expect sales momentum to continue, as transactions associated with rewards platforms are considered as digital sales, which are associated with superior margins and incremental sales, as customers that transact online, order more frequently and with higher check values.
Beyond North America, CMG’s business in Europe continues to develop, with improving unit economics, the roll-out of digital platforms, and opening of smaller footprint store formats. In addition, additional territories in the region are being tested under CMG’s stage-gate process. In that regard, supported by the launch of five new restaurants over the past 18 months and the roll-out of the digital ecosystem, CMG’s U.K. business has been outperforming, as per management. In addition, the digital platform associated with the company’s French business is expected to be introduced shortly.
Plant Protein As Center-Of-Plate Item On Cards. CMG typically introduces two to three new menu items every year, comprised mainly of limited time offerings. During FY2022, the firm has launched Pollo Asado and Chorizo, and a new menu item, the garlic guajillo steak is nearing debut, having already passed the stage-gate process.
Given the increasing attention that plant-based foods are gathering, CMG is actively expending efforts to identify a substantive plant based menu item that would be consistent with the company’s food with integrity ethos and also delicious from a culinary standpoint. To support the objective, CMG has invested in an early stage plant food company called Meati, that is focused on developing mushroom based meat alternatives. Recall that CMG has actively supported the plant food trend, launching the tofu based Sofrita in 2014, which remains on the menu as a permanent item, and introducing the pea based Chorizo as a limited time offer, earlier this year.
Balance Sheet Remains Solid. At the end of F2Q2022, the company had a cash and cash equivalents balance of ~$521 million and no long-term debt on its balance sheet. CMG can borrow an additional $500 million to fund operations under a credit facility, it has available. During the period, the firm bought back ~$261 million worth of shares at an average price of $1,350. Given its funding position, we believe that CMG will handily maintain sufficient capital to fund operations and execute on the new unit development program.
Bottom Line
The sole element that could derail CMG’s progress is widespread food contamination at its restaurants. We hope, for investor’s sakes, that management continues to pay close attention to the issue. With standards falling in numerous areas across the U.S., a food safety outbreak could easily resurface with a vengeance.
Besides that, CMG is on cruise control. The food and large portion sizes are the key drivers of CMG’s customer demand (once a Chipotle customer, always a Chipotle customer). As these are unlikely to change, and the footprint is positioned to double over the decade, sales growth is ensured. Unit economics driven by price elasticity have proven to be strong, even under cost inflation. As a flow-through, earnings and free cash flows are invariably positioned for expansion over an elongated time horizon.
In addition, with much hankering for a presence across the pond, the European opportunity is solid. It’s only a matter of pulling the trigger, in a timely fashion. Considering that the company only has a handful of restaurants outside North America, the white space is significant.
Given business dynamics, we fail to see how CMG could falter. Investors should take advantage of the disconnect between the stock’s intrinsic value and its market price and accumulate shares.
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