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  5. CMG – Chipotle Mexican...

CMG – Chipotle Mexican Grill, Inc.

We share our proprietary research and key differentials regarding our Chipotle investment.

Fri, Dec 1 2023

Written by Pouya Yadegar

CHIPOTLE We share our proprietary research and key differentials regarding our Chipotle investment.

The beauty of this particular example is that I have not had the luxury of reinterpreting my analysis in hindsight. The following is taken verbatim from a letter I wrote to Warren Buffet in 2008, in response to his

My Favorite Investment

I like CMG for the reasons outlined below, but the bottom line is that I expect it to be worth a little over $400 per share [emphasis added] in three years based on the compounding effect of my expected earnings, store growth, and having a lower P/E ratio than where the stock is currently trading; with extraordinary results continuing into subsequent years.

  1. First and foremost: The food is GREAT. …I learned about CMG by eating there, and then researching to find it’s a public company. You must try the food, and the ways it’s served to really understand what I am saying—otherwise this may sound just like another fast food restaurant… One of management’s biggest goals is to figure out how to speed up the lines further; the lines at these restaurants are out the door… because the food is so good.
  2. Besides great food, the prices are very cheap. I won’t even say economical, I say
    cheap because on a nominal [basis] the prices are low, and on a value basis they are exceptionally [low]. …A meal there will cost about $7-8 per person after taxes, and there will be enough for some take-home unless you have a strong appetite. The
    portions are huge… I believe if their prices went up 15 to 20%, there would be a very marginal reduction in demand (I know that’s a little hard to believe). Their food is so much better than any competitor’s in terms of value that that is what I think they should do, and the company has acknowledged implementing marginal price increases— and have concurred that they have seen surprisingly low demand decrease as a result… Even without these steps, the company’s earnings and margins are
    substantial based on almost all matrices.
  3. There is great marketing accentuating [the quality of the food]. The founder and CEO is a chef, and his premise is to have great tasting quality food in a fast food environment. The slogan of the company is “Food with Integrity.” Most of the food (100% of the pork, nearly 60 percent of the chicken and more than 40 percent of the beef) is naturally raised, hormone free. The goal is to get all three to 100% natural. In short, you cannot compare this quality or taste to “fast food”—at all.
  4. So simple. Replication of locations is easy—no chefs needed, no waiters, only 10-12 ingredients, served in a “cafeteria” style factory line. The food from one location to the next does not vary much at all because the process and ingredients are simple. I generally don’t like companies that can’t duplicate their performances and growth by just expanding what they do easily. I’ve tried different locations, and they use the same ingredients, store layouts, and consistent styles.
  5. No franchises. They had a few early on that they bought out. Growth [and] quality (as well as profits) are left to the company. In this case I think that is a good thing.
  6. Actual proven results—with more to build on. High earnings growth of well over 50% consistently on a year over year basis for the past four years and Chipotle has grown quarterly earnings at least 46% in each of its seven quarters as a stand-alone public company. Year over Year same store sales have been strong, consistently in the low to mid teens—while they are seeing new locations ramp up much more quickly than when they started because they are starting to reap the benefits of recognition. CMG has also consistently beat analysts’ estimates (not that that is the holy grail) by a minimum of 17% in each of the seven quarters they have announced their results. …I m think that is happening because the analysts haven’t tried the food…
  7. A lot of room to grow: Chipotle is in its relative infancy and has been growing stores at approximately a 25% growth rate, and currently has about 650 stores. Management
    has mentioned they want to open thousands of restaurants in the U.S. before going overseas. I anticipate they can maintain growth rate of 25% annualized for the next seven years, at which time there will only be approx. 3,100 stores. I believe that at that store growth rate, they will achieve over a 50% profit growth rate each year. …This concept and the serving styles offered, I believe, [have] more universal appeal and regional/cultural consistency than hamburgers—not to take anything away from a good burger.
  8. Huge international opportunity. Chipotle is not really “Mexican Food” in the traditional sense. The main ingredient options are pork, two styles of beef, and
    chicken, either wrapped in a burrito OR served in a plate with your choices of cilantro rice, corn, bell pepper and onions, lettuce, sour cream, two styles of beans, salsa, or avocado (extra)… [M]anagement has stated that even though it is “Mexican food,” stores they have opened all over the U.S… are doing about the same levels of business—not just in areas that are used to the Mexican food culture… The way I look at it, with the different combinations of burrito style or bowls that are prepared, it goes well with not only different states in U.S., but all kinds of cultures—from China, to India, to Europe, to the Middle East. Basically, a combination can be made from the options available at CMG that has great similarities to indigenous foods and dishes almost everywhere… That is an amazing opportunity in my opinion. Not to mention the natural, anti-hormone food used and the global clamor surrounding it. The first foreign CMG restaurant is planned to open in Canada early next year.
  9. The P/E looks “high,” but when evaluated on [the] earnings growth being experienced and expectations over the longer term (5 to 7+) years, this stock is priced cheaply. Moreover, this is where the P/E can be “tweaked.” P/E measures the average of [the] last four quarters, and that is okay for a company growing at let’s say 7 to 8 percent yearly, but [for] a company with this really high growth rate (74% increase last quarter year over year), it takes away a lot when you average the last four quarters, and a solid argument can be made that with new stores coming on line that there is a very slim chance that you are going to see any earnings drops… [F]inally, there haven’t been any extraordinary items in previous quarters—so if you look at last quarters P/E, this stock P/E on the B shares is less than 45. With a growth rate that I would expect being at more than 6 times the average company’s earnings growth (when compounding is included it even looks better), this P/E looks very reasonable to me.
  10. This is one of my favorites… No debt! This company is debt free and believes it can grow all its future stores and hit its growth targets from income generated. That is amazing and a big relief when investing in a company. Talk about avoiding (read: substantially reducing) potential disaster in a long-term investment.
  11. Finally, other “intangibles”:
    • No Breakfast items yet. Breakfast is McDonald’s and many other fast food restaurants’ highest profit margin item and CMG doesn’t even serve breakfast yet. There is certainly an opportunity here. …[T]hey are looking into… a breakfast item…
      which is just more upside.
    • The stores are built in such a way that major upkeep… [is] minimized. There is no fabric in any of the locations. All table tops, and counters are stainless steel, the
      chairs and booths are solid sturdy wood that look like can take a lot of punishment. There is no paint on the walls as they are covered with textured steel-like designs that actually look good. The art is also stainless steel and wood. This place gets a LOT of traffic; I have been in there when the line has had probably over 45 people waiting— and has gone out the door. There is a lot of wear and tear with [such] high turnover— so good infrastructure is important for keeping… expenses and upgrade time low in the future years. Another example of things well planned for the future.
    • B-shares [are offered at a] substantial discount (approx 10%) to A shares. Why, I don’t know and neither does their investor relations department. The B-shares have ten times the voting rights of A shares except when it comes to M&A decisions,
      [where] both classes have equal rights. Because the B shares have more voting rights, they should objectively be worth MORE than the A shares, but are trading at a discount. The only possibility is that people don’t know about the B shares (even
      though there are actually more B shares than A shares, B shares are traded [at] about 1/10th the daily volume). Needless to say, my entire investment is in the B shares. The A and B shares were created as part of the spin-off from McDonald’s about a year ago.
    • McDonald’s management experience. The current founder initially sold the franchise to McDonald’s and has worked under McDonald’s management and has enjoyed their restaurant management expertise for several years before being spun off as a private company.
    • I believe the U.S. is headed for potentially long-term (three years) slowdown, and I think this stock will do exceptionally well whether there is a major slowdown or not (as compared to the market and on an absolute basis). There are strong advantages of a protracted slowdown with CMG, like: lower rent and more prime locations to expand into, people that usually dine in higher end areas will come to CMG, and the value proposition I outlined… becoming more important—portions are huge (so they can even be shared) and costs are low, especially on a value basis. These are things people look for when the economy is not doing so well; even more so than when it is doing well.

Excerpt, Letter to Warren Buffet, 2008

The logical process I employed in this analysis was sound and ended up bearing fruit in reality. As stated previously, Prime first bought the stock at $45.30 in January 2009, and the B shares did fold into the A shares (in December 2009). As our analysis predicted, CMG hit $400 (on March 13th, 2012—it took four years instead of three), and has been one of the S&P 500’s top performers over the time we’ve held the stock. Since last year, the price has come down to $320.15. But that is just one of the reasons we are still holding the stock with vigor

Photo by Andrew Relf on Unsplash

It is difficult, of course, to find such amazing opportunities, wherein you have such huge upside with such limited downside—hence our enthusiasm for this investment. It is true that we may not be investing in CMG with the same zeal we once were—some of the value we foresaw in the stock has now been realized, so we have trimmed our position—but we are still quite enthusiastic about this stock. That’s not because we have an emotional attachment to it, but because many of the facts used in our initial analysis still hold true. ( We spend a great deal of time analyzing our current investments, and so we are fully prepared—at any time—to enter or exit a position based on its merit or lack thereof.) It’s all about striking the right balance between current price and the true intrinsic value over the longer run. Based purely on the facts on the ground, CMG still has a lot of room to grow. For example, since I wrote the above piece in 2008, the following factors have emerged:

  • Same Store Sales have continued to dramatically increase—over 30% in the past three years alone! And that has been accomplished with little marketing as compared to other restaurant chains. The simple reason is the tremendous value consumers are seeing. Case in point: If you weigh the food at Chipotle and compare it to McDonald’s, Chipotle is actually 30% cheaper per gram! Analysts and many others are still failing to recognize the tremendous value CMG offers.
  • Each of Chipotle’s 1400+ restaurants, on average, brings in over $400K in income per year. I sometimes joke with investors that if I weren’t running my fund I would start opening Chipotle restaurants. But of course, why not just keep investing in the stock, which is managed by a terrific, well-grounded team, and spend my time finding other great investment opportunities?
  • CMG has no debt today, has over $800 million in cash (even after purchasing $500 million of its own stock over the past few years at an average price of $130 per share), and has the current structure to be earning over $500 million per year. The cost of new openings has come down to approximately $800K—for restaurants that are making $400K a year. So each new restaurant is essentially paid for in two years.
  • Contrary to what some may think, Chipotle is not saturating the market. By comparison, McDonald’s has over 30,000 restaurants and opened over 2,000 restaurants in one year alone. Subway now has even more locations than McDonald’s. In fact, the top ten chains in the quick-serve/fast casual category have over 150,000 restaurants. That helps put CMG’s 1400 locations into perspective.
  • The strongest evidence that fears of over-saturation—or of too much competition from Del Taco and the like—have been exaggerated is that (as discussed in their Q3 2012 conference call) new stores are opening up at their highest sales volumes ever! If you add in the fact that CMG owns all of its restaurants outright, and therefore keeps all the profits from the $400K per restaurant, you see how much more profitable the company can be than a chain that only gets a small franchise fee from its individual store owners.
  • And talk about international prospects. The fact that Chipotle’s menu appeals to an international palate is being proven daily. It has opened up five stores in Canada, three in London, one in Paris, and one in Germany, and these shops are doing exceptionally well. There is huge room to grow internationally, and that is what CMG is prepping for. Additionally, it has opened up a Thai-themed “shop house” restaurant that uses the same basic principles of great food priced very aggressively and aimed at the mass market. This new store is doing exceptionally well (CEO Steve Ells says customers’ reactions remind him of when the first Chipotles were rolled out) and adds a whole new dimension of growth prospects to CMG.

CMG is that rare stock that provides true upside potential with limited downside potential. For example, everyone has to eat three times a day. There is not going to be some new technology that comes along overnight and renders CMG obsolete. Even if a company decides to open thousands of identical restaurants, we will be able to see it from a mile away and adjust accordingly. CMG has put itself in its enviable position by keeping its profit margins per serving down and making its money on volume. Even when Taco Bell, known for the lowest-priced food, came out with its version of an imitation product (which could not match the quality, atmosphere, dining experience, or meal- customizing possibilities of CMG), it was only able to price its food about $1.50 cheaper—and that’s for food that’s pre-cooked and is not hormone-free, cage-free, or of nearly the same quality as Chipotle’s.

CMG is just one stock, but it’s one I have been particularly excited about, not only because of the tremendous potential for growth, but the limited risk described in our analysis as well. “No pain, no gain” may be a good motto for people embarking on an exercise program, but it shouldn’t apply to sound fundamental investing. I like Chipotle because it’s a business I can understand, and, as Buffett says about razors and Gillette, it’s a product that is not going out of style. This is even truer about food than razors—especially high-quality food at low prices.

Over the past four years, I have been able to find more and more positions that hit the fundamental value threshold I’m looking for. We currently have about 45 positions in our portfolio, and are well diversified. Although we agree that it is not easy to find outstanding companies that are substantially undervalued, we believe we have demonstrated that they are out there, and when we do find them we invest accordingly. As an indication of our level of diversification, our biggest long was down 11.93% last year, and we were still up 11.39% overall, net of fees.