Contradictory tales of two restaurant chains – Chipotle Mexican Grill, Inc. (NYSE:CMG) vs. McDonald’s Corporation (NYSE:MCD)
Before I put down my thoughts in detail, I must confess that I have been bullish about Chipotle Mexican Grill since year 2008. Part of the reason to my bullishness is my stay in Texas (where Mexican food is predominant) and my frequent visits to Chipotle during the office lunch hours. No matter how many times a week I go to Chipotle for dining, I have always enjoyed the food and the overall experience. Having said that, it doesn’t justify one to invest the money in the company, however, it certainly deserves an inspection. Hence, part of my investment thesis will certainly have upward biasness towards Chipotle given my fondness for its chicken burrito bowl and tacos.
McDonald’s has been one of the very few companies from the last century that has provided incredible returns to its shareholders. However, it has been on a declining trend in last 5 years (as seen in figure 1). The wide moat that the company has created over the years in terms of its economies of scales, strong brand value, and cohesive franchisee system has been weakening as never before. Last week, McDonald’s reports its third quarter earnings for FY’14. It had its worst same stores sales performance in a decade. Its earnings dropped by 30% over same period last year.
Figure 1: McDonald’s stock’s cumulative five year total returns in comparison to S&P 500
Source: McDonald’s Annual Report 2013
On the contrary, Chipotle which was formerly owned by McDonald until 1999, reported stellar Q3’14 earnings results. EPS growth was 56% YoY, same-store sales was up 19.8% despite 6.3% increase in prices. Restaurant margin was 28.8%. Company expects to add 180 to 195 restaurants for FY’14, while it will further strengthen its position by opening up 190 to 205 new restaurants in 2015. Chipotle has been the best growth story in the restaurant space and will continue to be so.
Figure 2: Chipotle’s cumulative 5 year total return against S&P 500 and S&P Restaurants index
Source: Chipotle’s Annual Report 2013
One significant reason for such contrasting stories of McDonald and Chipotle in last five years and ten years period has been – Millennials turning away from the traditional fast food in favor of healthy food with an enjoyable experience overall. They are also more concerned with how the food is raised and prepared than the older generation was. Research shows that this change in trend has been driving customers from tradition fast food chains such as McDonald’s to fast casual restaurants such as Chipotle over the last decade. This changing trend forms the foundation of my positive outlook towards Chipotle’s business while negative outlook towards McDonald’s.
PAST GROWTH COMPARISON: As Warren Buffett once quipped “If past history was all there was to the game, the richest people would be librarians”. However, a closer look at past performance certainly gives a sense of where the company is positioned and how effectively management has driven the performance. A closer look at their key financial metrics (Revenue growth, EBITDA growth, and Free-Cash Flow growth) of CMG and MCD for last 5 and 10 years (as seen in figure 3) clearly reveals the CMG has been by far a better performer than MCD.
Figure 3: Key financial metrics of MCD and CMG over different time periods.
So does the continual decline in the business of McDonald and continual ascent of Chipotle’s business justify investing in the Chipotle at the current prices? This needs further examination of business from qualitative and quantitative perspective.
ECONOMIC MOAT FOR CHIPOTLE: The idea behind the economic moat is how likely a company is going to keep its competitors at bay. Company will be able to do so and generate superior investment returns on a longer run only if it has got strong and sustainable competitive advantages over its competitors.
a. Changing Consumer Behavior – According to NPD’s foodservice market research, the restaurant industry has been negatively impacted by changing dining habits in the US. Quick Service Restaurants (QSRs) such as McDonald and Burger King as a result of changing consumer behavior have been experiencing sluggish growths in last few years. This trend will continue going forward because of increasing awareness and concerns among consumers about what they eat and how it is prepared in fast-casual segment. As it can be evidenced from figure 4, the biggest beneficiary of the ongoing consumer trend has been Chipotle. Being in a growing industry segment and benefiting from the changing industry trend qualifies Chipotle for my first check for a potential investment.
Figure 4: Change in usage (2005 vs 2013)
Source: Morgan Stanley Research
b. Pricing Power – Company differentiates itself based on its “Food with Integrity” principal and strives to change the way people think about and eat food. Chipotle serves locally grown produce in its 1700+ restaurants. Many of these products are sourced from small to midsize suppliers–often local ranchers and farmers. It is safe to assume that Chipotle generally commands favorable pricing terms with its suppliers. Additionally, because of usage of higher-quality ingredients, I believe that the Chipotle brand possesses more pricing power than other restaurant peers. Average check (per transaction spending by customers) per transaction has been more than that for the Quick Service Restaurants QSRs average. Company has been able to maintain its gross margins of around 37% over last 5 years. Chipotle displayed its pricing prowess when it increased its prices by 6.3% in Q3’2014 and yet comparable store sales increased by 19.8%. Chipotle’s ability to increase the sales and maintain or push the margins year over year qualifies it for my second check for a potential investment.
c. Operational efficiency – Chipotle has a basic menu structure offering majorly burritos, burrito bowl, tacos, and salads. Within these items it offers four different meat – braised carnitas or barbacoa, adobo-marinated and grilled chicken or steak. Such basic menu structure minimizes employee’s training cost. One area in particular where company has strived to improve is in the area of our throughput. During the quarter, throughput got stronger with an increase of six transactions during the peak lunch hour and six transaction during the peak dinner hour compared to the same time last year.
It will be difficult to achieve such extraordinary same store sales increases without these continued improvements in throughput during the busiest hours. Fastest of Chipotle’s restaurants operates at around 350 transactions per hour during peak hours. Thus, higher operational efficiency has helped company to average 8% comp sales growth in past three year.
The fast-casual restaurant industry will continue to grow given that it resonates with the thinking of Millennials. Chipotle will be one of the biggest beneficiaries of this growth. Chipotle has been able to maintain its unit growth in last 10 years despite the challenging environment. I expect the firm to continue doing so for another 10 years before it reaches saturation point. Though, Chipotle might not have the wide economic moat that companies like McDonald or Coke offered till few years back, it certainly has compelling value proposition for customers, simplicity of menus, fast service, and excellent unit economics (lower labor cost and real estate than casual dining). These things will add substantial value to Chipotle’s long term shareholders.
Chipotle has strong business economics – unit growth in lower double digits, low-to-mid digit growth in comp sales, higher pricing power, strong customer loyalty and increasing brand awareness. Company will benefit further from its expansion in the ShopHouse Southeast kitchen restaurants and Pizzeria Locale. Management has provided guidance that there will be some pressure on COGS going forward for FY’15. However, on a longer run it will not have meaningful impact on the bottomline. I performed back of the envelope calculation taking the conservative estimate from the forward guidance provided by the management. Based on the forecasted EPS of $18.95 for FY’16 and applying P/E multiple of 37.5 (using three year average) share price should be roughly valued at $710 i.e. an upside potential of 15% from the current stock price of $615. There is not sufficient margin of safety at this price level. Given that the business economics for Chipotle are solid, long term shareholder should not feel uncomfortable by paying closer to $1 for a $1 business.
Appendix 1: EPS forecast of Chipotle