CHIPOTLE MEXICAN GRILL

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Company Overview   (2016 10-K)

Chipotle Mexican Grill, Inc. is the owner and operator of a 2,339 unit fast casual chain of with a narrowly focused menu of burritos, tacos and salads generating $4.3B in sales in TTM through 17Q2. The company has long been a top performer in the industry but in 2015 its progress was interrupted by outbreaks of food-related illnesses in its stores. It has been in turnaround mode ever since.  While the worst of the crisis seems over, the company experienced a norovirus incident in a Virginia store in mid-July 2017. The incident was an unwelcome reminder the company hasn’t fully put the past behind it, and its challenge is to sustain the recovery and re-attain the industry-leading store productivity profitability it generated previously.

Menu  The vision of founder and CEO, Steve Ells, is “food served fast but not fast food.”  It aims to be distinct from typical fast food in being prepared from fresh, high-quality ingredients using classic cooking methods, or “Food With Integrity” (FWI).   The FWI objective includes serving meats from humanely raised animals, without non-therapeutic antibiotics or added hormones.  FWI extends to sourcing a portion of its produce that is locally and organically grown when in season, among other related aims.

The menu is simplicity itself. The several burritos, tacos and salad items are assembled to order from 4 proteins (beef, chicken, pork, tofu) prepared with just 47 other ingredients. Sides are masa corn chips with guacamole or salsa. Beverages consist of soft drinks, fruit juices and (in some locations) beer and margaritas. The company is testing 2 desserts and queso cheese sides, which, if they make it to the menu, should boost the ingredient count slightly above 51.

Operational Model & Unit Level Economics The average cash outlay for the 2016 class stores (size 2,550 sq.ft. seating about 58) was $865 (per 10-K + est. preopening expense).  For this cash outlay we estimate cash-on-cash returns of 33.9% assuming TTM AUV of $1,931K & store-level EBITDA margin of 15.2%. We should point out that new stores have been disclosed to generate $1.4-$1.5M in the first year, presumably with a lower EBITDA than the company average. If the first year EBITDA is 12%, for example, on $1.5M, that would generate $180k of EBITDA which would represent a first year cash on cash return of 20.8%, so we could consider that the 33.9% described above is a “target” return in year three. Of course, the Company expects sales to continue to recover and EBITDA to improve substantially from the 33.9% of ’16. Presumably, first year cash-on-cash returns would ratchet upward as well.

Company Strategy In 1998, with only 14 units, the company was bought by McDonald’s (NYSE: MCD) which spun it off in 2006 to the public by which time it had grown to 500 locations. For the next 10 years CMG had an extraordinary run on the strength of its FWI brand promise.  The store count quadrupled (including establishing small beachheads in Canada and Europe).  Comps were consistently positive, averaging 8.4%, and Store AUV’s increased from $1.63M to $2.53M, driving 20% revenues CAGR.  Below the top line EBIT margin expanded over 1,000 bps to 18.8% , net income grew at a 29.8% annual pace and returns on invested capital hovered in the low to mid 20% range.

But in 2015, the rapid growth outstripped the company’s ability to manage the quality of a widely disbursed supply chain consisting largely of small producers.  Early in the year, a pork supplier had to be eliminated due to quality issues, so pork products were not available in the stores for nine months.  Later in 2015 and in early 2016 outbreaks of food-borne, e-coli related illnesses among its guests were widely reported.  The reports triggered criminal and SEC investigations, and an investigation by the Centers for Disease Control and Prevention (CDC).  While the CDC investigation ended in June 2016, remnants of the other legal issues, including class action lawsuits are still pending.

In the wake of these developments customers fled, voting with their feet their belief the FWI brand promise had been broken.  Needless to say, comps fell abruptly, dropping as low as negative 29.7% in 16Q1after which they recovered quarter by quarter, finally returning to positive territory, posting +17.8% in 17Q1 against the bottom in the prior year’s quarter (8.1% in 17Q2).   AUV’s followed suit, dropping steadily in 2016 before rebounding to $1.957K in 17Q2 in sync with the bounce back in comps. Quarterly operating margins continued rising to 19.3% in 15Q3, before plunging to -5.6% in 16Q1, after which they recovered somewhat steadily to 9.1% in 17Q2. The plunge was caused by deleverage and the expense of initiatives to recover public trust.  The chart below tells the same story in terms of AUV’s, comps and restaurant-level EBITDA margins.

The company scrambled to recover with massive (and expensive) quality control initiatives in its supply chain and the stores.  It also undertook extensive food promotions and massive public relations campaign to communicate the initiatives. Among these initiatives (aside from investigation and inspection of the entire operation) were: a $10M commitment to training and support of its specialized network of farms and ranches, including product barcoding to trace all food supplies to its sources; sophisticated ongoing supervision regimens; and overhaul of store food handling procedures.  To entice customers back in the stores the company offered free entrees in early 2016 followed by its “Summertime Chiptopia” BOGO type program.  The company broadcast its initiatives with extensive advertising.

As indicated by the numbers, the worst is probably over and the company is shifting from damage control to sustaining a turnaround.  To this end the company is simplifying its operations. Despite the vision of simplicity for the model, management concedes operational procedures had accrued unnecessary complexity over the years, particularly in hiring and developing employees. The company has also overhauled its digital platform, making it more user-friendly, aiming to halve order fulfillment time. It is introducing new second make-lines for on-line sales in many of its stores after testing demonstrated they could produce as many as 130 additional entrees in a typical 3 hour peak without additional labor.  It has hired 2 new advertising firms and recently launched a broadly based brand building campaign. And it is also expanding its catering business and exploring delivery.

The company believes these initiatives will propel it back to $2.5M AUV’s, 20%+ store level EBITDA margins and EPS of $10 in the near term.  It has not provided a timetable for reaching these targets, acknowledging progress will be uneven, but indicates they are the first milestones on its path to growth at its former pace.

Operating Metrics  CMG has no debt but after accounting for debt implied by operating leases, the company’s ratio of lease adjusted debt to EBITDAR, at 3.3X, is only slightly above the 3.1X average of its peers (PNRA, SHAK, SBUX, CHUY and ZOES).  Prior to the food/trust crisis, the company’s level of profitability ensured it compared much more favorably by this measure.  However, the company’s still ample cash flows and reserves provide the capacity to engage on multiple fronts simultaneously without resort to debt.  TTM free cash flow through 17Q2 was $167.3M (CFO $413.21M, CapEx $248.8M) or a FCF margin of 3.9%. Still, this was down from FCF of $458.6M or FCF margin of 10.3% in 15Q2, just before the crisis. Importantly, the company has not slowed its annual capex spend (about $250M) due the crisis, though it is allocating slightly more for food safety infrastructure, digital initiatives and slightly less to store growth (in 2013-2016 average new store investment was about 210 per year, and in 2017 management is guiding to 195-205 new stores. Another sign of the concentration of management focus was the announcement of the closure of all 15 of its ShopHouse chain (although management remains committed to its embryonic Tasty Made burger concept and majority investment in Pizzeria Locale).

Shareholder Returns  In the last 10 years CMG has appreciated 323.7% or 15.5% annually.  Its high of $749 was reached in July 2015 at the onset of its food-borne illness crisis.  It had begun to recover in the last 2 quarters, but the stock had been drifting down following 17Q1, with all the recent gains lost following the July 2017 norovirus incident.  As the chart below indicates the stock has always been richly valued with the forward P/E trading pre-crisis in a range between 25X and 55X.  Post crisis, the market is clearly discounting a successful turnaround. Even so, as of this writing (2 weeks after the Virginia store norovirus incident and 2 days after the 17Q2 earnings release) the forward multiple hasn’t slipped below its current level of 38X.  The company does not pay a dividend, but has long made modest repurchases of its stock.  However, since the crisis it has materially stepped up repurchases, spending some $1.26B since 15Q2 to repurchase some 2.7M shares at an average price of $472. The repurchases were financed by drawing down cash balances and with the proceeds from sales and maturities of longer term investments in U.S. treasuries.

Recent Developments

The norovirus incident ten days ago, so widely reported in the press, which loves a bad story, has modestly affected the 18 month recovery in sales that had already plateaued over the last several months, down about 17% on a two year basis after being down as much as 37% during Q1’16. Management indicated that most recent sales seem to have been affected by 5-5.5 points from the previous trend, which matches our own personal anecdotal observations of modest declines. The Company obviously hopes that there will be no further incidents of this kind, and minimal further news coverage, and the recovery in sales that has taken place over the last year or so can resume. We have no doubt that operational executives are “all over it” in terms of doubling down on store level (and supply chain) policies to prevent another disastrous situation.

Q2’17 Results

While the recent norovirus incident dominates everyone’s thinking, earnings per share in Q2’17 were $2.32 per share, up sharply from the depressed $0.87 a year earlier and $1.60 in the previous quarter. Food costs increased 30 bp to 34.1% due to higher avocado prices, which have started to improve. Guidance is for food costs to improve by 40 bp in Q3 and move to the low 33% in Q4. Labor costs were 26.2% of sales, better than ’16 by 160 bp in spite of wage inflation of about 4%. Other operating costs were 14%, down from 15.2% in Q2’16, out of which Marketing and Promo was down 70 bp to 3.7%. In the second half of ’17, M&P are expected to be about 3.1%. G&A was 6% of sales, down from 7.1% a year earlier, helped by lower legal expenses, but increased by bonus accruals and stock comp expenses. Stock repurchases have continued, $77 million spent at an average of $423/share, and $167 million remains within the authorization. Though the Company has spent a cool $940 million buying back stock over the last eighteen months, there is still $569M of cash on the balance sheet and no debt. At least they haven’t (yet) gone into debt, as so many other companies do, while buying back all that stock at an average price of $458. You could say that buying back stock even at 20x EBITDA provides a 5% cash on cash yield, on presumably depressed EBITDA, and 5% is a lot more than treasury securities. The cash was available, and the share reduction did not affect expansion plans which have been maintained, to the consternation of some critics. Relative to the expansion plan and other issues, my role here is not to be a critic or presumed strategist. I leave that up to Steve Ells & Co., for better or worse, and I don’t mind pointing out that some observers feel that the Company has outgrown his capability. On the other hand, there aren’t any other restaurant executives that have built a company operated store system as rapidly and successfully as he.

There are lots of operational initiatives that could improve store level, and corporate, economics, some of which I will discuss below, but in Q2’17 the store level EBITDA margin was 18.9%, up from 15.5% in Q2’16 and, sequentially, 17.7% in Q1’17. Though down from about 28% a couple of years ago, a store level EBITDA margin that is approaching the 20% near term corporate objective is not shabby relative to other restaurant concepts, and generates a more than acceptable 30% cash on cash return.

Ongoing programs, and initiatives, that provide a high probability of contributing to improved results include: price increases for the first time in several years, continued emphasis of the increasingly successful mobile order and pay app, new products, more effective marketing including TV, a new loyalty program, further emphasis on operational training, improved existing products, rollout and advertising of a delivery capability, further reduction of unit development costs. Each of these programs can contribute in a materially positive way, so it seems to us that the sum of these initiatives could be very substantial. The second “make line” that is now part of the operational approach provides the attractive attribute of not affecting in-store ordering and dining, and building new businesses on existing real estate.

Conclusion

Putting it all together, barring a great deal of further poor publicity from customer illness, legal problems, or other corporate issues, the worst should be behind Chipotle. We suspect that the most recent setback will not be as large, or long lasting, as the E-Coli problems from eighteen months ago. It seems that there is a lot more that can go right than wrong at this point, and the $10.00 per share earnings level is achievable within the next 12-18 months. Building on that base, from new locations as well as steady same store sales gains, even without eye-catching increases, could establish an earnings trajectory of 15-20% annual gains and a reasonable P/E of 25-30x forward earnings. CMG at $343 (at 34.3 times the $10.00/share that is still a “reach”) is no bargain yet, but a long term investor is more likely to be rewarded than badly hurt. “Headline Risk” is the biggest danger, out of everyone’s control, but most of the operational mistakes should be behind us.

 

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