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Mar.23.17 | About: Chipotle Mexican (CMG) Get Alerts

Jonathan Abenaim
Long only, growth at reasonable price

Summary

Investors should avoid having a short term outlook.

Chipotles long term growth prospects are intact based on its industry
trends and overall business quality.

Investors must remain patient as Chipotle transitions from stabilization to


growth.

As a wise investor once said, "The best thing that happens to us is when a
great company gets into temporary troubleWe want to buy them when
they're on the operating table."- Warren Buffet.

Chipotle (NYSE:CMG) is the quintessential example of buying a solid business


in temporary trouble, and will lead to solid investor returns in the long run.
Based on growth prospects, industry trends, as well as the potential to unlock
shareholder value through potential deregulation and unique initiatives,
Chipotle has many avenues it can cross to create long term returns for its
shareholders.

A look at what went wrong

From its IPO in 2006, Chipotle has seen many ups and downs, however,
investors ultimately witnessed a 1500% share price appreciation in a 9-year
period. Steve Ells' concept was able to continue its robust growth from its IPO
and through its time as a public company with revenues growing from $860
million to $4.5 billion in that 9-year period.

Chipotle's fall from grace began in 2015 with its first food crisis outbreak
causing what was later to become a 60% decline in its share price. It seemed
like every week, major news outlets were announcing bacteria such as
Salmonella and E-coli had infested yet another Chipotle store. Ultimately, this
resulted in a major loss of confidence by its clients. What was previously a jam
packed, high-quality quick service concept, became a deserted burrito chain.

(Source: Bloomberg)

As seen on the chart above, Chipotle's same-store-sales (SSS) witnessed an


immediate -30% decline in months following the outbreaks. In simplistic terms,
this means that there was on average a 30% decline in store sales compared
to the year prior. At this point, investors started to lose confidence in this Wall
Street Darling and the share price declined from over $740 a share to $360 a
share in a matter of 18 months.

It is important to note that more severe outbreaks at other restaurant chains


were quickly brushed off and ultimately forgotten by the consumer. One
example is Jack in the Box (NASDAQ:JACK) which was responsible for the death
of 4 children due to its E-coli outbreak. Remember, there were NO deaths from
Chipotles outbreaks. Over time, after Jack in the Box's 50% decline in share
price during the crisis, shares have risen over 12 fold since then.

A look at its business model and industry trends

Let's first take a look at Chipotle's unique business model and then at the
industry trends, signaling whether the consumer is switching to a fast casual
service or sticking to a different style of eatery.

Chipotle's rise to fame all began when a young professionally trained chef
named Steve Ells created a Mexican fast-casual concept in which customers
can eat quality food, prepared fast with local organic ingredients, at a low
price. What made Chipotle a unique eatery was that its food was prepared in
front of the customer with an open style kitchen, something never done before
in the quick service restaurant industry.

Since its inception in 1993, Chipotle has risen its store count from 1 to over
2000 stores today. An extremely important factor to be taken into account is
that all these stores are corporately owned and have no franchises. Chipotle
was able to cycle cash and continue to grow its store base without the use of
debt, showing management's excellent ability to deploy capital. ROIC has been
the highest in the industry for years. Excluding MCD and others who conduct a
franchise model, Chipotle had the most impressive economics to its business.
With a $2.5 million average revenue for mature stores and $2 million for new
stores openings, Chipotle has remarkable store revenues compared to its
peers. Moreover, it costs the burrito chain a mere ~$800,000 to open these
new stores.

It is evident that with such impressive economics, if Chipotle is able to continue


to scale these stores across the country, shareholders will make a massive
profit.

It is important to have a look at the trends in the restaurant industry to see if


growth in the fast-casual space is a thing of the past or whether growth will
continue to be robust.

(Source: Euromonitor)

As seen in the graph above, it is clear that since the beginning of the 2000's,
there has been a major shift away from the fast food space as consumers are
leaning towards a healthier fast-casual experience. I believe that based on
significant growth seen at Panera (NASDAQ:PNRA) and other publicly traded
fast-casual eateries, this trend will continue its rise.

Future Growth

One extremely important factor investors must assess is whether Chipotle has
effectively stabilized business and whether it will return to growth.

By having a look at recent SSS trends, investors can judge for themselves
whether management was effective in bringing customers back or not.
( Source: Company Fillings)

As seen in the chart above, December and January have both seen a major
uptick in traffic and same store sales for Chipotle. Moreover, according to a
private study conducted by M Science, March is looking to be an impressive
month of growth for Chipotle. In all, this signals to me that Chipotle is
effectively bringing the customer back to its burrito chain and a shift from
business stabilization to growth is underway.

An important note to take is that tax reform can be important to Chipotle's


bottom line in years to come. By being a predominantly domestic company,
Chipotle's tax rate is in the mid 30's, one of the highest tax rates in the world.
If President Trump's plan to reduce corporate taxes is put through,
shareholders will benefit tremendously.

Lastly, in terms of growth prospects, Chipotle would be able to monetize their


2000 store base by switching to a franchise model, collecting their royalty
payments and focusing more on the brand. While I am against this initiative,
this may be a possibility as activist investor Bill Ackman has taken a significant
stake in the company and recently received 2 board seats. Mr. Ackman has
tremendous experience in the restaurant industry. Having pushed McDonald's
(NYSE:MCD) and Burger King (NYSE:QSR) to switch to a franchisee model, the
notorious hedge fund investor racked massive profits as he led change at both
of these eateries. In my opinion, if Chipotle is able to maintain its current
business model, corporate stores are easier to manage and scale as there are
less management conflicts.

Risks

Just like any investment opportunity, there are risks associated with investing
in Chipotle. One of the biggest risks I see at the moment is Chipotle's ability to
continue on its growth path. A bet on the company today is a bet on
management's ability to continue to scale its stores while growing demand for
the brand.

Execution risk is second on my list of risks associated with investing in the


business. Due to Mr. Ackman's current influence on the business, he may push
for a franchise model, this in turn has execution risks associated. One must ask
themselves whether there could be hurdles along the way of this transition and
whether this will have a long term impact on the business.

The last risk I see on the share price is short term thinking. Investors must
avoid focusing on quarter to quarter results and instead concentrate on the
long term picture. The greatest business builders took time to execute their
strategy and same goes for Chipotle. If economics turn bad at Chipotle then it
may become a good reason to avoid the stock, however, these economics are
intact. Chipotle's business model is not broken.

Valuation

It is clear that Chipotle is an impressive business led by one of the restaurant


business' greatest. One of the most important factors in investing is buying at
the right price, this means valuing the company and assessing whether it
makes since to purchase shares at these levels.

One eye-popping statistic is Chipotle's current EPS of $0.77 compared to $15 in


2015. This in turn caused the P/E to be in the 400s due to the current $411
share price. Although a 400+ P/E may seem scary to investors, it is important
to note that the multiple will contract significantly in quarters to come. One
time charges such as changes in product ingredient costs, advertising costs
and safety implementation costs were all the main factor in EPS being less
than $1.

The most efficient approach to valuating this business to by conducting a DCF


analysis. In my model, I forecasted an average of 200 new store openings per
year during a 5-year period with cost of sales remaining the same and
operating margins decreasing minimally due to increased competition.
Moreover, a terminal growth rate of 2.5% and clean balance sheet yields a
target price of $760, over a 100% return.

Conclusion

Investors must remain focused on the long term rather than focusing on
quarter to quarter results. Chipotle is in the midst of transitioning from
stabilizing their business to returning to growth and investors must be patient.

In my opinion, the negative news around the stock and the recent attack by
short sellers sets the stage for a perfect investment opportunity with an
outstanding return potential.

As Chipotle focuses on returning to growth, I will continue to follow the


company in the process by releasing several articles along the way. As a way
to be up to date, click on the follow button next to my name to be noticed
when my next article will be available.

Disclosure: I am/we are long CMG.

I wrote this article myself, and it expresses my own opinions. I am not receiving
compensation for it (other than from Seeking Alpha). I have no business
relationship with any company whose stock is mentioned in this article.

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