Chipotle Still Getting The Benefit Of The Doubt

By Stephen D. Simpson, CFA | February 05, 2013 AAA

Last year was a rough one for Chipotle Mexican Grill (NYSE:CMG). Once a nearly bulletproof growth story, a sharp slowdown in traffic and store comps growth expectations took large chunks out of the stock on multiple occasions. Investors are slow to abandon growth stories (at least outside of tech), and these shares enjoyed a 30% rally to close out the year. Consequently, it's not easy to make a value call on the shares today, and investors should be wary of the expectations that traffic growth will accelerate in the second half of the year.

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Few Surprises for the Final Fourth Quarter Results
Management previously updated guidance about the fourth quarter, so there weren't many surprises left for the actual quarterly report.

Revenue rose 17% for the quarter, with comps up almost 4% and unit growth in excess of 14%. Food costs (particularly protein) continue to be a headwind, climbing 22% for the quarter. That led to a one-and-a-half-point drop in restaurant margins (this industry's version of gross margin) and a nearly three-point drop in the sequential comparison. Operating income still rose 9%, as the company's operating margin fell a bit more than a point.

If It's not Competition, What Is It?
Chipotle management has been pretty stubborn in maintaining that they are not losing traffic to alternative concepts like the Cantina Menu at Yum! Brands' (NYSE:YUM) Taco Bell. Maybe so, but that doesn't change the fact that Taco Bell's U.S. comps were up 5% this past quarter. Likewise, Panera (Nasdaq:PNRA) saw its comps increase more than 5% for the same quarter, so I would argue that there is at least some shift going on at the high end of the quick service restaurant (QSR)/fast-casual business.

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By the same token, Chipotle is doing just fine relative to more established QSR destinations like McDonald's (NYSE:MCD), and Jack In The Box's (Nasdaq:JACK) Qdoba Mexican Grill is showing pretty feeble growth (0.4% comp growth in fiscal Q4 and 2.4% in fiscal 2012). So context matters. It's also worth noting that Chipotle is still small enough (or concentrated enough) geographically that issues like weather can make a difference.

Is a Midyear Price Increase Such a Good Idea?
Management did talk about the possibility of a price increase around midyear. This increase, on the order of 4 to 5%, would be targeted at offsetting the ongoing food cost inflation that the company expects to see.

I'm sympathetic to the idea of preserving margins, but this could be a tricky move. With management expecting pretty soft comps in the first half of 2013, meeting expectations for the full year will require a recovery of comps in the second half. While the performance in the second half of 2012 should make a comp growth recovery incrementally easier, a price hike risks sapping the momentum if Chipotle's customers have decided that Chipotle's price/value balance is just fine where it is. That could be even more relevant given that several other QSR chains have announced plans to begin more heavy advertising of their value menus in the first and second quarters of 2013.

Does Chipotle Need to Think More Like the Competition?
Chipotle has done a very good job of separating itself from the restaurant pack - not only with the type of food it offers, but a model that uses a relatively short list of ingredients to produce a wide variety of offerings (a model that, to be fair, Taco Bell has been using for a long time now).

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That said, I'm not sure being different is always synonymous with being better. Chipotle has frequently under-spent its marketing targets. That hasn't seemed to hurt its U.S. growth much, but management has said sales at its London stores has been disappointing, with substantially lower volumes when compared to North American locations. With brand recognition cited as a contributing factor, maybe Chipotle needs to invest in brand-building.

The Bottom Line
Given a U.S. market that is still under-penetrated and the potential for additional store concepts, I have no problem projecting strong growth for Chipotle. My working assumption is for long-term revenue growth above 10%, and free cash flow growth approaching 20%, as the company increasingly leverages its existing store base. Should the company roll out new concepts more aggressively, I would expect a trade-off between free cash flow margins and revenue (spending more on cap-ex to generate more sales).

Even with 20% free cash flow growth, these shares don't look particularly cheap. I can get to about $300 per share in fair value on that 20% growth assumption, but that's basically where the shares are now. That said, strong growth stories rarely trade at compelling valuations, so investors who can accept the risks that go with growth investing (and potentially overpaying for that growth) could still find something to like in these shares today.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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