Value Investors Club / Chipotle Mexican Grill (CMG-B)

Description

With 795 company-owned locations, Chipotle Mexican Grill Inc is less than halfway through its self-funding domestic rollout. It has a net $195MM on its balance sheet, three quarters of which is probably excess cash. Its stores have low (possibly negative) working capital requirements and are operated at high efficiency, resulting in 35-40% cash-on-cash returns and ~2.5-3.0 year paybacks periods on new restaurants.

The company’s decade-long run of posting double-digit comps – achieved despite modest marketing expenditure, infrequent price increases and a near refusal to introduce new menu items (CMG doesn’t even serve breakfast) – is over though, and investors are of course focused on the company’s dimmed prospects in a recessionary environment.

This presents patient investors with a potential time arbitrage: accept the fact that the store base will likely comp at levels below the ~5% SSS that maintaining the current contribution margin requires and enjoy the longer term benefit of ~20% growth from unit rollout over the next several years.

BRIEF HISTORY/NOTE ON CLASS B SHARES

CEO/CHB Steve Ells, a Culinary Institute of America (CIA) graduate, founded Chipotle in 1993, using it as a vehicle to apply his CIA training to casual dining and to promote his ‘Food With Integrity’ philosophy. In 1998 McDonald’s acquired a majority equity stake, providing growth capital and important tutelage (site selection, cannibalization modeling, etc). CMG came public in a 1/06 IPO in which MCD sold a portion of its shares – it disposed of the remainder in a 10/06 tax-free exchange of shares.

The class B shares that I AM recommending participate equally in dividends with the company’s A shares, and carry 10x the voting power. They have traded at an average 10% discount since 10/06 according to Yahoo’s weekly closing prices, though the current discount is greater. Given the tax-free nature of the exchange, CMG was prevented for a period of two years (until 10/08) from pursuing a collapse of share classes or a buyback to address the valuation disparity. The 10-K has some verbiage about not pursuing such actions for a period of three years unless certain unspecified conditions (presumably relating to legal opinions or IRS rulings) are met. In light of this, it seems the A-B discount will persist for at least another year.

DIFFERENTIATION

CMG offers a comparatively few number of menu items, each drawing on the same set of high-quality ingredients. This leads to tremendous customer throughput (crew familiarity with the offerings), low inventory requirements and low spoilage (both from rapid inventory turnover). The company’s Food With Integrity (FWI) effort aims at using free-range and hormone/antibiotic free foods where possible. The introduction of FWI compliant ingredients is often accompanied by price increases. Interestingly, price increases absent ingredient introductions seem to be infrequent in several markets, suggesting untapped pricing power may exist. The FWI roll-out has been slowed as pre-existing supply chains for such products apparently did not exist. CMG seems to be relatively advantaged after having created such chains for itself.

The company is similarly focused when it comes to its restaurant-level managers, instituting various schemes to increase managerial recruitment from within, retain managers of all stripes, and to encourage career-tracking and indeed entrepreneurial behavior among its managers with its Restaurateur program. The latter program is particularly important. It provides top-tier managers (each interviewed personally by the C suite) the chance to earn ~$10K bonuses for each crew member they successfully groom for management as well as a 10% of gross sales above company-specified bogeys if the manager is able to boost a particular store’s top line. This accelerating initiative should aid the company’s restaurant sales and reduce G&A.

ROUGH HACK AT UNIT ECONOMICS

Management estimates it costs $900K to open a restaurant. With cash pre-opening costs and leases capitalized at 10x, the figure is perhaps $2MM. A restaurant does 85% the sales of a mature location in its first year – maybe $1.49MM ramping up with contribution margins until the third year. At that point, contribution margins are in the low 20s, and cash-on-cash returns are ~40%. Pre-tax ROIC is above 20% accounting for capitalized leases.

With self-funding growth this accretive, the question then is how many units can CMG build? The company has unfortunately never answered this question directly, so far as I can tell. In the 3Q07 conference call, Ells said “We still have thousands of restaurants that we can build in the United States,” and I have seen published reports where analysts have estimated saturation at 2,500 units. (More optimistic estimates can be arrived at by using the store count by state table in the 10-K.) If the 2,500 is indeed correct, CMG has six further years of 20% unit growth ahead. Things like international growth and addition of breakfast menu or any new menu item are free options, as is possible further leverage of indirect expenses (particularly G&A) and lower build and rent costs as the company moves further away from standalones and toward smaller inlines and end-caps.

SUMMARY TTM NUMBERS

Here are some relevant numbers from recent income statements and balance sheets, taking some liberties on restaurant-level numbers (they are not normalized to account for the relatively high portion of immature locations).

	2Q08	1Q08	4Q07	3Q07	2Q07
Restaurant Sales	$ 340,754	$ 305,327	$ 288,910	$ 286,431	$ 274,222
Food, beverage and packaging	109,697	98,894	92,184	92,075	87,463
Labor	88,278	81,410	77,452	75,395	71,116
Occupancy	23,404	21,833	20,536	19,745	18,322
Other operating costs	42,897	38,373	34,849	33,240	33,665
Direct costs	264,276	240,510	225,021	220,455	210,566
G&A	20,684	21,560	20,641	19,279	18,109
D&A	12,707	12,170	11,688	11,167	10,576
Pre-opening costs	3,403	2,831	2,855	2,350	2,570
Indirect costs (normalized)	36,794	36,561	35,184	32,796	31,255
Loss on disposal of assets	1,370	1,463	1,249	1,784	1,843
Total costs	302,440	278,534	261,454	255,035	243,664
EBIT	38,314	26,793	27,456	31,396	30,558
Interest income	925	1,343	1,498	1,597	1,530
Interest expense	(75)	(74)	73	(74)	(74)
Income before income taxes	39,164	28,062	29,027	32,919	32,014
Provision for income taxes	(14,696)	(10,778)	(11,343)	(12,315)	(12,157)
Net income	24,468	17,284	17,684	20,604	19,857

# of stores - beginning of period	730	704	668	640	605
# of stores - end of period	778	730	704	668	640

Direct gross margins	22.44%	21.23%	22.11%	23.03%	23.21%
Indirect margins	10.80%	11.97%	12.18%	11.45%	11.40%
SG&A margins	6.07%	7.06%	7.14%	6.73%	6.60%
EBIT margins	11.24%	8.78%	9.50%	10.96%	11.14%

A/R	$ 5,374	$ 3,879	$ 5,373	$ 5,869	$ 6,270
Inventory	5,151	4,583	4,332	4,404	4,418
Prepaid expenses	11,423	11,180	8,997	8,633	7,947
PP&E	539,340	515,247	494,930	469,295	444,259
A/P	25,565	25,682	19,880	24,958	19,923
Accrued payroll and benefits	19,977	24,873	26,210	25,618	16,116
Accrued liabilities	24,307	25,301	27,135	19,605	20,753

Average annualized sales/store	$ 1,808	$ 1,703	$ 1,685	$ 1,752	$ 1,762
Average annualized contribution/store	406	362	373	404	409
Invested capital/store	632	629	626	626	635
Store contribution/invested capital	64.23%	57.51%	59.55%	64.48%	64.46%

VALUATION

The company has said it views $40-50MM of its $195MM cash as required, so the ~$4.50/share balance is excess. Using annualized six month EBIT (assuming seasonality washes with growth), the EV/EBIT implied by the B shares is ~8.11x. TTM EV/EBIT is a bit higher at ~8.5x. EPS numbers are skewed by both the company’s cash balance and its expensing non-cash pre-opening rent and future lease escalations, though the income and cash flow statements will converge at maturity.

This for me is a buy-and-hold that will hopefully deliver ~20% annual gains from unit volume growth alone. As such, I do not have a price target.

RISKS

One obvious risk is an extreme fall-off in discretionary spend crushing restaurant sales. I don’t really have a counter to this, but I will note that as of the last conference call the company reported not seeing much of an impact in the troubled Florida and California markets. They had noted some weakness in Arizona previously, but then were able to put a 10% price increase through in 4Q07 that did not lead to additional fall-off.

Both the QSR and ‘Mexican’ food categories are competitive. Continued weakness in the franchisee lending space may well help CMG relatively given its self-funding corporate-owned expansion plans and large cash balance. JBX’s Qdoba Mexican Grill, for instance, is ~75% franchised.

Minimum wage hikes are not the concern here they are with other fast food operators as less than 1% of company employees make minimum wage. A hike would obviously lead to inflationary wage pressures in non-minimum wage earners, but CMG’s margin structure is not dependent on paying workers as little as possible.

Catalyst

Continued roll out of stores at favirable returns. Possible fixed cost leverage. Eventual collapse of A/B share structure.

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			2008	2009
Price:	36.46	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	1,202	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT