Service Innovations Power Chipotle’s Growth in the Long Term

Service Innovations Power Chipotle’s Growth in the Long Term

• Full year revenue totaled $4.1 billion, an increase of 27.8%, with a full year comp of 16.8%
• EPS of 14.13/share grew 35% YOY
• Earnings growth will come from restaurant efficiency
• Fast casual restaurant sector is not a fad, but rather a shift in consumer taste
• $700/share price target based on 2016 earnings

Sales & Analysis

Chipotle Mexican Grill’s (CMG) stock sold off almost 7% on February 4, 2015, after reporting quarterly numbers of a stellar 16.1% comp, revenue of $1.1 billion, and  EPS of 3.84, versus the street estimate of 3.80/share. Full year revenue totaled $4.1 billion, an increase of 27.8%, with a full year comp of 16.8% and EPS of 14.13.  EPS growth of 35% outpaced sales growth as the higher comps in food and the menu increase (in price) allowed CMG to leverage labor and occupancy lines at the restaurant level.  Guidance for 2015 is low to mid-single digits, mostly because comps in the latter half of the year will present a high hurdle, 13.4%, 17.3%, 19.8%, and 16.1% respectively for the 2014 quarters.  

Most people would say that CMG will need to go outside of the box in order to improve on its SSS going forward:

• Start serving breakfast
• Extend hours of operation
• Remodel the restaurants in order to add a second line
• Start building restaurants with drive-thru windows
• Add more selections to the menu

All of those ideas could move the needle, but the only things that need to happen are to maintain the food quality and increase the average number of transactions per location.  During peak hours, it is common to see a line of customers extending beyond the restaurant entrance, and that long line can be a deterrent for those who are in a hurry.  In such a scenario, people often look for alternatives with a shorter line.  One thing to keep in mind is that a customer who chose to select an alternative because of time constraints will return in the future in order to fill that Steak Fajita Burrito craving. 

In support of the opportunity to increase SSS in 2015, Monty Moran, the Co-CEO, said “[the] average restaurant in the country does… about one third of the transactions during lunch as the fastest restaurant in the country.”  Over that period of nine years, there have only been a couple opportunities to buy the stock at a discount, and this small pullback could be the impotence of the next opportunity.

Frankly, analyst have been questioning the growth of CMG since its IPO, in 2006.  In hindsight, those neutral and negative ratings have been wrong all along.  While listening to the earnings conference call, Karen Houlthouse, the senior analyst from Goldman Sachs, boldly pushed Jack Hartung to explain how CMG’s growth will continue beyond 2014, so Jack went on record with the following statement:

"For over 20 years we’ve been working very hard to improve every aspect of the customer experience… During all of those 20 years and particularly during the years since we’ve been public, we’ve been hearing a crescendo of people wondering why we don’t add additional menu items and change other aspects of what we do and yet we’ve had the highest comps I think in the history of the restaurant business during that… It may look like we’re staring down the pike at sort of flattening sales and no increase in comps, it looked that way 10 years ago and nine years ago and eight years ago and seven, six, five, four three, two, one years ago; I think even a year ago if you looked at what our guidance was for the year I believe at the very beginning of 2014 we said that there will be a low single digit comp.  I think [comps] are flat to low single digits and that looked like what it was going to be at the time."

In order to validate Jack’s statement, I pulled every Comparable Store Sales data point and annual guidance, from 2004 through 2014; in short, he was correct.  The typical annual comp guidance given by CMG’s executive team has been some variation of “flat” to “mid-single digits,” and these expectations were exceeded, if not blown away every year, outside of a recession-year.  

If you are not familiar with how this stock has traded over the years, you should be aware of a very interesting scenario that took place from July, 2012, through October, 2012.  After reporting revenue growth above 20% and the earnings growth was above 60% for that quarter (2Q12), the stock sold off by more than 20% the next day because guidance of “mid-single digit comparable restaurant sales growth for the full year” implied a slowdown that simply wouldn’t support a forward P/E of 50x.  There is a chance that a similar sell off could happen again, but I don't think the stock will be discounted nearly as much as what happened in 2012. 

If you are willing to withstand some downside pressure, start building a position in the stock over the next six months because the fast casual or quick service restaurant (QSR) sector is not a fad, but rather a shift in consumer taste.  Health concision teens and adults would prefer to eat healthy, high quality food, rather than the likes of McDonald’s.  Teens, millennials and generation x consumers are trading up for CMG.  Per the earnings conference call, Chipotle is one of the most popular restaurant chains among teens and has been growing in popularity among this demographic. This report from 2014 ranks Chipotle as the third most popular brand among teens up from number eight 2013. Generation X consumers were 33% more likely than average to consume Chipotle, and with millennials Chipotle was even more popular with customers in this group, 75% more likely… to choose Chipotle over other restaurants.

Price Target

My analysis is simple, I suspect the earnings will grow by 20% this year, and 18% next year, even though CMG is staring down the toughest comps in more than 10 years, but that doesn’t mean that we should punish the stock for the company’s success.  If my earnings growth plays out, the company would earn north of $20.00/share in 2016; apply a multiple of 35x, which is well below the current multiple of 47x and you have a stock trading at $700/share. If any of my conservative estimates are exceeded, the street will quickly raise its price targets based on EPS growth and multiple expansion, to reflect a much higher valuation. 

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