Chipotle: TACOS THAT ROCKOS

You could try out for the Olympics
Or just watch it on TV
You could hide that new tattoo
Or let everybody see

You can choose to eat the chicken
You can choose to eat no meat
At Chipotle you can choose
Exactly what you want to eat

— Chipotles Radio Ad

I don’t get excited about new IPOs because usually they are priced for perfection and if you don’t get shares in the offer (that is, if you’re name isn’t Fidelity), then you don’t have much chance of making money.  But after reviewing the Chipotle IPO, I did get excited mainly because of the high quality of the company and the relatively low offering price.   

However, the stock priced last night at $22, up from an initial price of $16.50 when the prospectus was submitted a month ago.  In the past week, Prudential published a 20 page research report on the stock and CNBC has mentioned it several times as the "Hottest IPO of 2006!!!!".  So a great opportunity to own a high growth business at a low growth multiple has been priced away.  Thanks Prudential!  Thanks CNBC!  "Efficient market" academics everywhere should be thanking you today.

Nevertheless, I’ll post my analysis, just in case the stock doesn’t strat trading over $25 right away.  I will pass on the burrito if the price is any higher than that.   

Overview

If you’ve been to a McDonald’s lately, you’ll notice that the company is trying to increase the quality of its food.  Same for Hardee’s, Burger King, and TacoBell.  Unfortunately, these companies have the "genetics" of a fast-food restaurant.  It’s very difficult for them to increase the quality of their food because people that go there are used to paying 99 cents for a burger or fries.  And it’s difficult to make anything of quality for 99c…and still make money. 

That’s why a new premium category of "fast-food" restaurants have cropped up, termed "fast casual."  The most prominent company in this industry is Boston Market.  But because of a weak corporate structure and a desire to grow rather than be profitable, the company crashed and burned.  It’s still around (ironically, also owned by McDonald’s) but it’s a shell of its former self.

Now the second round of fast casual restaurants are reaching the critical mass and coming public.  Panera Bread is still running strong despite some minor missteps.  Red-Robin Gourmet was a very successful IPO but the company has run into the typical growing pains experienced by companies after they are public. 

One of my favorites fast casual restaurants is Chipotle Mexican Grill.  The company is currently owned by McDonald’s but will be spun out today (Thursday Jan 26th). 

Investment Thesis

Chipotle seems to be in the "sweet spot" for a restaurants life cycle growth.  It has enough experience in opening stores that you can have confidence in management’s ability not to screw up.  But it doesn’t own so many restaurants that there’s no more opportunity for quality expansion.  The company has 466 stores currently, up from 177 in the beginning of 2002.   The company plans on opening about 75 stores a year.  I estimate that the company won’t run out of good locations until it hits about 1,200 – 1,500 restaurants, so the company should have several years of 25-30% growth ahead of it. 

The company’s stores are also becoming more profitable as the number of transactions has increased.  As the company becomes more well know, it’s actually easier for it make money more quickly at newly opened locations.  Average sales for a new store in the first 90 days increased 29.4% to $303,390, up from $234,450 two years ago.  This translates into higher margins as all the fixed costs such as rent and administrative expense are a smaller percent of revenues.

The company should be able to earn better returns on its capital than traditional fast food restaurants because it has several advantages.  First, the Chipotle ticket size ranges from $7 to $10 per customer, higher than the average $5 ticket of fast food restaurants.  While it takes the same number of employees to run both a fast-food and a Chipotle restaurant, the leverage should be higher for the casual-food chain because of the higher average ticket.  That should directly translate into higher operating margins and a higher return on capital.  Second, Chipotle serves alcohol in many of its locations which carries a higher margin.  Third, the company’s stores are still all relatively new and should continue to experience high same store comparable sales.  Typically high same store sales lead to higher margins and higher returns on capital.

The Numbers

Chipotle is a growth AND a margin expansion story.  You can’t ask any better of a stock than having those two traits.   Here’s a quick run down of the company’s finances…

Income Statement

The company’s top line growth has been nothing short of spectacular.  In the first nine month of 2005, the company posted 32% revenue growth.  That was actually down from 46% the year before.  I’m expecting the company to continue growing between 25% and 30% for several more years.

   

Some other notable highlights from the income statement…

Increases in same store sales were 10.2% in 2005, 13.3% in 2004, 24.4% in 2003.  Chipotles’ same store sales growth for fiscal 2006 as a percentage should be be in the low- to mid-single digits.  The company is showing lower comps because new stores start out at a higher level of sales since Chipotle concept is now better known.   Comp store sales also increased when the company introduce modest price increases in each of 2002, 2003 and 2004 and there was no price increase in 2005.  So I think the one knock against the company can be explained away pretty easily. 

Despite using higher cost ingredients than most fast food restaurants, the company’s food costs as a percent of revenues range right in line with competitors at approximately 33%.  The most important factor affecting food, beverage and packaging costs is the price volatility of chicken, meat and vegetables.   The company could be affected by a bad case of Mad-Cow, Bird-Flu or Vegetable shortages. 

When financial analysts talk about operational leverage they typically mean the company is generating more earnings on the same asset base.  Chipotle is a good example of this trend.  The company’s occupancy costs represented 9.1% of total revenue in 2002, 8.1% in 2003, 7.7% in 2004 and 7.6% in the first nine months of 2005.  General and administrative expenses represented about 12.6% of total revenue in 2002, 10.8% in 2003, 9.5% in 2004 and 8.2% in the first nine months of 2005.  Both numbers should continue to trend downward.

The company has heretofore not accounted for tax expense because it was part of the McDonald’s parent company.  In addition, the company has $21.4 million of Net Operating Loss Carryforwards.  Therefore, the historical earnings as shown on the income statement are somewhat misleading. After the offering, Chipotles will recognize tax expense as a stand-alone entity without regard to the NOLs.  In my estimates, I assume the company will pay 34% tax rate.  The company incurred a one time gain on tax assets of $10.8 million which also makes the net income number look better than it is. 

Aside from paying taxes, the company will also have to alter the way it accounts for leases which will depress earnings in the future years.  Basically, most restaurant companies had a lease life mismatch problem – the rent expense for the property leased was calculated over a different time span than the depreciable life of the leasehold improvements on it.  This had the effect of increasing earnings.  In addition, the company capitalized rather than expensed new construction costs.  Like all publicly traded restaurant companies,  Chipotle has fixed the problem but this will lower earnings expectations. 

Balance Sheet

The company will have plenty of financial flexibility after the offering is complete with over $100  million in cash.  Long term leases will be the company’s main liability. 

   

Cash Flow

The company has burned through about $150 million of cash to reach its current size but should now be largely  able to fund its growth from cash from operations.  I don’t expect the company to need additional funds to continue growing.  This is an ideal situation for a growth stock investor as they don’t have to worry about being diluted by follow-on offerings.

Valuation

Like I stated in the opening, the initial offering price of $16.50 made the stock look very attractive.  But because of a good roadshow and strong publicity on CNBC, the offering was priced at $22.  I’ll be lucky if the stock ever trades at $25, which was the upper end of my valuation range.   

I have analyzed Chipotle earnings growth and margins vs. a handful of fast growing competitors.  In sum, the company is growing faster than competitors.  But margins are below competitors.  I actually like this situation because as margins rise, the company will be able to become more profitable than it looks today.   

At $22, Chipotles is valued at the average of several other fast growing restaurant chains.  I’ve assumed that Chipotles will earn about $0.75 per share fully taxed in 2006.  Remember, the numbers in the prospectus are based on a non-taxed basis so they are much higher than what the company will actually earn in the future.  Also, the company will incur several accounting changes for lease expense as well as several one time spin off costs.  I also assume 2006 EBITDA will be about $70 million and sales about $760 million. 

 

Despite the full IPO valuation, I think there could still be upside for the stock in the future if the company continues to execute as well as it has in the first years of its life.  That’s because CMG’s valuation could rival that of Panera Bread company, which saw a similar explosion of revenue growth and margin expansion. 

Over the past several years, Panera Bread has traded as high as 21.5x EBITDA with a median of 17.1x.  In addition, Panera traded as high as 54x Forward EPS with a median of 35.2x.  Finally, PNRA traded as high as 4.6x sales with a median of 3.4x. 

Chart courtesy Baseline

If my valuation thesis is correct and CMG trades at similar multiples to PNRA during its growth phase, Chipotle could trade much higher than the average growth restaurant stock.  At the median PNRA valuations, CMG could trade at $23 based on EBITDA, $26 based on forward EPS estimates and $60 based on sales.  The price to sales multiple is out of line because PNRA’s net income margins are 60% higher than those of CMG and therefore, it’s sales are worth more.  However, I believe CMG could approach similar margins which would make it’s sales as valuable as PNRA.   

Overall, I believe the stock should trade in the mid $20s after the IPO and, depending on management’s execution, could trade much higher over time. 

Management and Salaries

Current management founded the company and has shown the ability to manage rapid growth over the past three years.  In addition, Chipotle management has been augmented by several senior executives from McDonald’s.  Overall, it looks like management has a good mix of hands on experience with growing restaurant businesses. 

The management team’s salaries look very reasonable.  I believe that management teams of growth companies should be compensated mainly through stock appreciation and Chipotles Board of Directors seems to agree.   

 

Stock and Options

The company does not have a very shareholder friendly capital structure.  The company will have two classes of stock, with one class having significantly more voting rights than the other.  However, it’s not as bad as it first appears.  The class A common stock is being issued to the public and class B common stock can only be transferred to McDonald’s or its subsidiaries.  The A common stock are entitled to one vote per share while holders of class B common stock are entitled to ten votes per share.  There are certain exceptions such as for purposes of approving a merger or consolidation, a sale of all or substantially all of our property or a dissolution, in which each share of both class A common stock and class B common stock will have one vote only.   Overall, I believe McDonald’s management has over the years shown relatively good governance so I’m not overly concerned with the two classes of stock.  In addition, if McDonald’s spins off the remainder of its Chipotle stock, only one class of stock will remain outstanding. 

Interestingly, the company has valued the stock as highly as $19.50 in recent stock grants. The difference between the fair value estimated by management and the mid range of the offering price of $16.50 is primarily due to the negative impact on forecasted income resulting from our implementation in 2006 of FASB Staff Position No. FAS 13-1, Accounting for Rental Costs Incurred during a Construction Period (FSP 13-1), which was issued in October 2005. FSP 13-1 requires lease rental costs incurred prior to a store opening to be recognized as rental expense, whereas the Company had previously capitalized these costs. The difference also reflects to a lesser extent the dilutive effect of this offering, which management was not able to estimate at the time of the March grant.

Ownership

After the completion of the offering, McDonald’s will beneficially own common stock representing 88% of the combined voting power of our outstanding stock and 69% of the economic interest in our outstanding common stock.

 

Lockup

After the 180 lock up period, McDonald’s may sell all or a portion of its ownership interest or may make a tax-free distribution to its shareholders of all or a portion of that interest, including a distribution in exchange for McDonald’s shares or securities. 

Risks

I’m not going to bore you with a list of boilerplate risks.  Obviously, if you’re growing a company at 30% or more, the wheels could come off at some point.  Management could get stretched too thin, product quality could suffer, the company could enter bad leases in bad locations, etc, etc.  If you want to see what can happen to a great concept restaurant that hits a snag look at California Pizza Kitchen (CPKI).  It’s far from a disaster, but the company did have to retool after making some poor operational and real estate decisions.  Now its back on a growth track because the concept and food is just too good to pass up.  I think the same could happen to Chipotle at some point.

The biggest near term risks I see for the stock are operating margins and same store sales comps.  Management has to grow margins and continue to get operating leverage.  If they don’t, then this is purely a growth story – not a growth and margin improvement story.  And same store sales is what drives the momentum hedge funds to pay higher and higher multiples for a growth stock.  If same store sales continue to come in much lower (below 5% would be a bit troublesome for me), I’m not sure if the stock can get the valuation of a Panera Bread company.  While 3% same store sales growth would be great for parent McDonald’s, it would be mediocre for Chipotles. 

And at the valuation that this stock will come public, the company had better be great, not just mediocre.