Chipotle Mexican Grill (NYSE:CMG) shares have retreated more than 33% since its Q2 earnings were announced last week. Markets were disappointed with the comparable sales growth figure for the quarter which stood at 8%, well below its first quarter’s 12.7%. Hence, the revenues fell short at $690 million against a general market consensus of $705 million. On its decline, we believe the market has over reacted, and we expect the shares to recover.
Here we look at some drivers to its value.
1) Long-term comparable sales growth of 6-8%
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Chipotle’s comparable sales growth stood at 12.7%; partly helped by the menu price increases in the first half of 2011. Thus, on excluding the menu price hikes, we would have gotten a figure closer to the second quarter’s 8% comparable sales growth. Moreover, as the number of restaurants keep rising, it becomes more and more difficult to maintain that sort a growth figure over a larger base.
You could also argue that the increase in the number of restaurants has a cannibalizing effect as well, but the argument in favor of opening up new restaurants is that the net profit added by the new restaurant additions more than offsets the profits lost out due to cannibalization.
Thus, in the years to come, we have assumed comparable sales growth to be in the region of 6-8% i.e. ~8% in 2012 but declining to ~6% in the long term. Furthermore, we have broken up the comparable sales growth into ‘average spend per visit’ and ‘average number of visitors’. We expect the average spend per visit to rise at an annual rate of 4% mostly due to Chipotle’s strong pricing and a general increase in menu prices with time, which is roughly in line with the industry so we don’t that will be a deterrent for the consumers).
We expect the average number of visitors per restaurant to rise by 2% in the long run as more and more Americans show a predilection to eating natural and organic food. The fact that Chipotle has a good public perception certainly helps. If McDonald’s or Wendy’s come out with a new menu product claiming to be all natural and healthy, it is generally dismissed as a marketing ploy. The same doesn’t hold for Chipotle, which has held its principles since the beginning.
Note that the two drivers are interrelated. Currently, Chipotle has a simple, no frills menu. But if it were to introduce new, inexpensive items to lure customers, we could see the average spend growing at a slower rate. You might also expect the average visitors per restaurant to increase at a faster pace. You can drag the trend lines as per your own estimates.
2) Restaurant Additions
Chipotle plans to add 155-165 for the full year 2012. It is on track to meet this target as the company added 55 restaurants in Q2 and 32 in Q1 thus making a total of 87 new additions in the first six months of the year. Management’s guidance beyond 2012 isn’t available currently so we have assumed the restaurant additions to slow down. It is natural that the rate of expansion slows down as the number of restaurants increase beyond a certain point. However, Chipotle has plenty of scope to grow internationally, and our estimates may prove conservative. The company has only 4 restaurants in Canada, 3 in the U.K. and opened its first restaurant in France in the second quarter itself.
The company has also been experimenting with its Chinese cuisine restaurant named ShopHouse Kitchen. So, we could see an upside to the number of restaurants added in the subsequent years.
In the past, Chipotle’s margins have benefited from strong comparable sales growth. The rate of growth of same store sales have outpaced the growth of costs, thereby leading to improved margins. The costs of food, beverage and packaging (generally treated as variable costs) have generally crept up over the years although they declined on a y-o-y basis in the recently announced Q2 earnings. However, we estimate the variable costs will remain firm and expect the figure to remain in a similar territory, with a slight upside bias.
Fixed costs such as labor, occupancy and other operating costs continue to decline. So, we expect some margin improvement in the next couple of years as well. But since we expect the comparable sales to slow down to around 6% in the long run, we estimate the incremental revenue would be just about sufficient to offset the general rise in the total costs. (All cost figures being talked about are as a percentage of revenues). Thus, continuous margin improvement might not be possible. We estimate the margins to stabilize beyond 2014.
Note that our EBITDA margins are different from company reported margins since we exclude one-time expenses and capitalize the operating leases.
Some of the other assumptions we have made:
a) Capitalized their operating leases which translates to a debt of around $1.9 billion as per our calculations.
b) Tax rate of 39% which is consistent with the historical tax rates.
c) A discount rate of 9%
d) Changes in net working capital and net operating assets- you can view them below
e) Capital expenditures – see below
Note that you can modify all of these values to arrive at your own customized price. To view the entire model, click here.
Using these assumptions, we get a price estimate of $402, which is around 30% ahead of the market price.