Why I Own Chipotle Mexican Grill Shares

Chipotle Mexican Grill (NYSE: CMG) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Chipotle (pronounced “chi-POAT-lay”) shares for the portfolio in April 2012 at a price of US$265 and subsequently made five more purchases (in April 2015 at US$649; in November 2015 at US$605; in June 2016 at US$396; and twice in August 2017 at US$307 and US$311). I’ve not sold any of the shares I’ve bought. 

Four of the six purchases have worked out very well for my family’s portfolio, with Chipotle’s share price being around US$882 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Chipotle shares.

Company description

Chipotle’s business is simple. It runs fast-casual restaurants mainly in the US. Its namesake restaurants serve Mexican food – think burritos, burrito bowls (a burrito without the tortilla), tacos, and salads. A fast-casual restaurant is one with food quality that’s similar to full-service restaurants, but with the speed and convenience of fast food. 

At the end of 2019, Chipotle had 2,580 namesake restaurants in the US and 39 namesake restaurants in other countries. The company also operated three restaurants in the US that are not under the Chipotle brand. That’s it for Chipotle’s business… on the surface.

Investment thesis

I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Chipotle.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

In 2019, Chipotle raked in US$5.6 billion in revenue with its 2,622 restaurants. That sounds like Chipotle’s business is already massive. But it really isn’t. For perspective: 

• Number of Subway restaurants in the US in 2018, according to Satista: 24,798 
• Number of McDonald’s restaurants in the US currently: 14,428
• Total retail sales of restaurants and other eating places in the US in 2019 according to data from the St Louis Federal Reserve: US$670 billion

These numbers show that Chipotle still has plenty of runway to grow. 

2. A strong balance sheet with minimal or a reasonable amount of debt

As of 31 March 2020, Chipotle held zero debt and US$881.3 million in cash and investments. This is a rock solid balance sheet.

For the sake of conservatism, I note that Chipotle also had US$2.9 billion in operating lease liabilities. Given the ongoing restrictions on human movement in the US because of the country’s battle against COVID-19, restaurants in general are operating in a really tough environment. The good thing for Chipotle is that 94% of its total operating lease liabilities of US$2.9 billion are long-term in nature, with payment typically due only from 31 March 2021 onwards.

3. A management team with integrity, capability, and an innovative mindset

On integrity

Chipotle’s CEO is currently Brian Niccol, 46. Niccol joined Chipotle as CEO in March 2018 and was previously running the show at fast food chain Taco Bell. I appreciate Niccol’s relatively young age. The other important leaders in Chipotle, most of whom have relatively young ages (a good thing in my eyes), include:

In 2019, Niccol’s total compensation (excluding US$2.3 million of compensation for legal and tax fees that are related to his initial employment by Chipotle) was US$13.6 million. That’s a tidy sum of money. But of that, 62% came from stock awards and stock options. The stock awards are based on (1) the three-year growth in Chipotle’s comparable restaurant sales, which represents the year-on-year change in the revenue from Chipotle’s existing restaurants; and (2) the three-year average cash flow margin – cash flow as a percentage of revenue – for Chipotle’s restaurants. Meanwhile, the stock options vest over three years. These mean that the majority of Niccol’s compensation in 2019 depended on multi-year changes in Chipotle’s stock price and important financial metrics. I thus think that Niccol’s compensation structure is sensible and aligns his interests with mine as a shareholder of the company. 

I want to highlight too that the other leaders of Chipotle that I mentioned earlier have similar remuneration plans as Niccol. In 2019, they received 69% of each of their compensation for the year in the form of stock awards and stock options with the same characteristics as Niccol’s. 

On capability and innovation

There are a few key numbers that can tell us how well-run a restaurant company is: (1) Same store sales growth, and (2) average restaurant sales. The latter is self-explanatory but some of you may not be familiar with the former. Same store sales growth typically represents the change in period-over-period revenue for a company’s restaurants that are in operation for 12 months or more (it’s 13 months in the case of Chipotle). So what same store sales growth measures is essentially the growth in revenue for a restaurant company from its existing stores. The table below shows Chipotle’s same store sales growth and average restaurant sales from 2004 to 2019:

You can see that the company fared really well on both fronts until 2015, when there were some struggles for a few years before growth started resuming in 2017. When discussing Chipotle’s management, I want to break up the story into two portions. The first stretches from Chipotle’s founding to 2015, while the second is from 2015 to today.  

First portion of the story

Chipotle was founded by classically-trained chef Steve Ells in 1993. He served as the company’s CEO from its founding to early 2018. Ells created the company’s first restaurant with what I think is a pretty simple but radical idea. According to the first page of Chipotle’s IPO prospectus, Ells wanted to “demonstrate that food served fast didn’t have to be a “fast-food” experience.” The first page of the prospectus continued:

“We use high-quality raw ingredients, classic cooking methods and a distinctive interior design, and have friendly people to take care of each customer — features that are more frequently found in the world of fine dining.”

Ells never floundered on his initial vision for serving great food, not even when Chipotle was owned by – you’ll never guess it – McDonald’s. All told, Chipotle was under McDonald’s for eight years from 1998 to 2006. McDonald’s gave Chipotle the operational knowledge needed to scale from 13 restaurants to almost 500. But Ells frequently clashed with McDonald’s management over cultural differences. Here are two quotes from a brilliant Bloomberg profile of Chipotle’s entire history from 1993 to 2014 that describes the differences:

1. “What we found at the end of the day was that culturally we’re very different. There are two big things that we do differently. One is the way we approach food, and the other is the way we approach our people culture. It’s the combination of those things that I think make us successful.”

2. “Our food cost is what runs in a very upscale restaurant, which was really hard for McDonald’s. They’d say, “Gosh guys, why are you running 30 percent to 32 percent food costs? That’s ridiculous; that’s like a steakhouse.””  

Nonetheless, Chipotle became a fast-growing restaurant company under McDonald’s. Its success even spawned the “fast-casual” category of restaurants in the US. For a feel of what fast-casual means, the closest example I can think of in Singapore will be the Shake Shack burger restaurants here. The food is of much better quality than traditional fast food and the price point is a little higher, but the serving format is quick and casual.

After leaving McDonald’s umbrella via an IPO in January 2006, Chipotle continued to succeed for many years. As I mentioned earlier, Chipotle enjoyed strong growth in same store sales and average restaurant sales from 2004 to 2015. A beautiful example of Chipotle’s relative success over McDonald’s can be found in the Bloomberg profile. There’s a chart showing Chipotle’s much higher same-store sales growth from 2006 to the third-quarter of 2014:

To me, one of the key reasons behind Chipotle’s growth was its unique food culture. The company calls this “Food with Integrity.” Here’s how Chipotle described its food mantra in its IPO prospectus:

“Our focus has always been on using the kinds of higher-quality ingredients and cooking techniques used in high-end restaurants to make great food accessible at reasonable prices.

But our vision has evolved. While using a variety of fresh ingredients remains the foundation of our menu, we believe that “fresh is not enough, anymore.” Now we want to know where all of our ingredients come from, so that we can be sure they are as flavorful as possible while understanding the environmental and societal impact of our business. We call this idea “food with integrity,” and it guides how we run our business.”

This is how Chipotle discussed “Food with Integrity” in its annual report for 2015; the focus on serving tasty, fresh, sustainably-produced food still remained in 2015: 

“Serving high quality food while still charging reasonable prices is critical to our vision to change the way people think about and eat fast food. As part of our Food With Integrity philosophy, we believe that purchasing fresh ingredients is not enough, so we spend time on farms and in the field to understand where our food comes from and how it is raised. Because our menu is so focused, we can concentrate on the sources of each ingredient, and this has become a cornerstone of our continuous effort to improve our food.”

Another key contributor to Chipotle’s strong restaurant performance, in my opinion, is its Restaurateur program. The program, which started in 2005, is meant to improve employee-performance at each restaurant while providing excellent career prospects. Here’s a description of it from a 2014 Quartz article:

“During a busy lunch rush at a typical Chipotle restaurant, there are 20 steaks on the grill, and workers preparing massive batches of guacamole and seamlessly swapping out pans of ingredients. Compared to most fast-food chains, Chipotle favors human skill over rules, robots, and timers. Every employee can work in the kitchen and is expected to adjust the guacamole recipe if a crate of jalapeños is particularly hot.

So how did the Mexican-style food chain come to be like this while expanding massively since the 2000s?

In 2005, the US company underwent a transformation that would make its culture as distinct as its food. As more than 1,000 stores opened across the US, the company focused on creating a system where promoting managers from within would create a feedback loop of better, more motivated employees. That year, about 20% of the company’s managers had been promoted from within. Last year, nearly 86% of salaried managers and 96% of hourly managers were the result of internal promotions.

Fundamental to this transformation is something Chipotle calls the restaurateur program, which allows hourly crew members to become managers earning well over [US]$100,000 a year. Restaurateurs are chosen from the ranks of general managers for their skill at managing their restaurant and, especially, their staff. When selected, they get a one-time bonus and stock options. And after that they receive an extra [US]$10,000 each time they train a crew member to become a general manager.”

The Restaurateur program was the brainchild of Monty Moran. Moran joined Chipotle as COO (Chief Operating Officer) in March 2005 and became Co-CEO with Ells in January 2009. Moran stepped down from his position as Co-CEO in late 2016. 

Second portion of the story

2015 was a turning point for Chipotle. In the second half of the year, a food-safety crisis erupted. Around 500 people became ill from E.Coli, salmonella, and norovirus after eating at the company’s restaurants. This badly affected consumer confidence at Chipotle, which manifested in the sharp declines in the company’s same store sales growth and average restaurant sales in 2016. 

What were initially strengths – Chipotle’s food and people culture – ended up causing problems for the company. “Food with Integrity” meant that every restaurant used a lot of raw food ingredients and had to do a lot of food preparation within its own four walls; the company’s people culture involved measuring performance based on a restaurant’s throughput (or how fast it can take an order, make the order, and serve it). These two things combined meant that food safety could at times be compromised.

After the late-2015 food safety issue flared up, Ells and his team embarked on fixing the issues at the company. But they struggled, and 2016 became a painful year for Chipotle. Monty Moran left as Co-CEO in late December 2016; around a year later, Ells stepped down from his CEO position and assumed the role of executive chairman. Ells left Chipotle completely in March this year. Brian Niccol, who already had leadership experience at a fast food chain (Taco Bell), succeeded Ells as CEO in March 2018. 

When Niccol first came onboard, I remember being worried. I was concerned that he would dilute Chipotle’s food and people culture by introducing a more sterile way of doing business, such as the methods found in traditional fast food chains. But Niccol and his team have managed to retain what is special about Chipotle while improving the areas that needed fixing. 

In Chipotle’s latest annual report (for 2019), the company still placed an emphasis on “Food with Integrity”:

“Serving high quality food while still charging reasonable prices is critical to ensuring guests enjoy wholesome food at a great value. We respect our environment and insist on preparing, cooking, and serving nutritious food made from natural ingredients and animals that are raised or grown with care. We spend time on farms and in the field to understand where our food comes from and how it is raised. We concentrate on the sourcing of each ingredient, and this has become a cornerstone of our continuous effort to improve the food we serve. Our food is made from ingredients that everyone can both recognize and pronounce.

We’re all about simple, fresh food without the use of artificial colors or flavors typically found in fast food—just genuine real ingredients and their individual, delectable flavors.”    

The Restaurateur program still exists, but there is a more holistic framework at Chipotle for evaluating and improving employee performance compared to the past. 

Niccol and his team have also directed Chipotle to invest heavily in digital and other initiatives, such as: Digital/mobile ordering platforms; digital pick-up shelves; digital order pick-up drive-through lanes that are cutely named “Chipotlanes”; delivery and catering; and a rewards program. These investments have seen massive success. Here are some data points:

• In 2017 Chipotle started upgrading second-make lines in its restaurants to specifically handle digital and delivery orders, so as not to disrupt the company’s in-restaurant food preparation procedures; the company ended 2019 with nearly all restaurants having these upgraded second-make lines.
• 2019 also saw Chipotle complete the rollout of digital pick-up shelves across all its restaurants, and expand delivery capabilities to over 98% of its store base. 
• In 2018 digital and delivery sales grew by 43% and accounted for 10.9% of Chipotle’s overall revenue; in 2019, digital and delivery sales surged by 90% and accounted for 18.0% of total revenue; in the first quarter of 2020, digital and delivery sales were up 81% and were 26.3% of total revenue; digital and delivery sales were in the “high 60s” percentage range of total revenue for the month of April so far.
• Chipotle introduced a rewards program in March 2019 that kicked off with 3 million members. At end-2019, there were 8.5 million members; in the first quarter of 2020, the member count has jumped to 11.5 million.
• Chipotle enjoyed a strong uptick in same store sales growth and average restaurant sales in 2019; in the first two months of 2020, same store sales growth was a sensational 14.4%. 

The work isn’t done. Chipotle’s restaurant-level operating margin was 20.5% in 2019, up from 18.7% in 2018 but a far cry from the high-20s range the company was famous for prior to its late-2015 food safety issue. But in all, I give Niccol an A-plus for his time at Chipotle so far. He has only been at the company for a relatively short while, but the transformation has been impressive.

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

I think it’s sensible to conclude that restaurant companies such as Chipotle enjoy recurring revenues simply due to the nature of their business: Customers keep coming back to buy food. 

5. A proven ability to grow

The table below shows Chipotle’s important financials from 2005 to 2019:

A few key points about Chipotle’s financials:

• Revenue compounded at an impressive rate of 21.8% from 2005 to 2015. Net profit stepped up at an even faster pace of 28.9% per year over the same period. Operating cash flow was consistently positively from 2005 to 2015 and compounded at a similarly strong annual rate of 24.3%. Free cash flow was positive in every year from 2006 to 2015, and became strong from 2008 onwards. 
• 2016 was a year where Chipotle reset its business after it suffered from food safety issues, as mentioned earlier. Some of the 2019 numbers for Chipotle are still lower than in 2015. But it’s worth noting that net profit, operating cash flow, and free cash flow compounded at 40.9%, 24.1%, and 24.2%, respectively, from 2017 to  2019. It’s also a positive, in my eyes, that Chipotle managed to produce solidly positive operating cash flow and free cash flow in 2016, at the height of its struggles with the food safety problems. 
• Chipotle’s balance sheet was rock-solid for the entire time period I’m looking at, with debt being zero all the way. This is made even more impressive when I consider the fact that the company had expanded its restaurant count significantly from 2005 to 2019 (see table below). I salute a restaurant company when it is able to grow without taking on any debt.
• Dilution has not happened at Chipotle, since its diluted shares outstanding has actually declined from 2006 to 2019. 

In the first quarter of 2020, Chipotle’s business encountered some speed bumps through no fault of its own. The US has been hit hard by the ongoing pandemic, COVID-19, with most states in the country currently in some form of lockdown. The lockdowns have understandably affected Chipotle’s business, but the company is handling the crisis well, even though there will be pain in the coming quarters. Here are some data I picked up from the company’s latest earnings update and earnings conference call (I had already discussed some of them earlier in this article):

• Revenue increased 7.8% year-on-year to US$1.4 billion in the first quarter of 2020.
• The balance sheet remains robust with zero debt and US$881.3 million in cash and investments as of 31 March 2020.
• Chipotle was still profitable in the first quarter of 2020, with profit of US$76.4 million, down 13.3% year-on-year.
• Operating cash flow for the first quarter of 2020 was unchanged from a year ago at US$182.1 million; free cash flow was down 12% to US$104.4 million.
• Same store sales in the first two months of 2020 were up 14.4%. In March, it was down by 16%, with the week ending March 29 being the worst with a decline of 35%. April’s same store sales for the most recent week was in the “negative high-teens range.”
• Digital and delivery sales were up 103% year-on-year in March to account for 37.6% of Chipotle’s total revenue; in April, digital and delivery sales were nearly 70% of total revenue. Digital sales have traditionally been stickier for Chipotle. 
• The company is continuing to reward its employees: (1) Employees who were willing and able to work between 16 March and 10 May were given a 10% increase in hourly rates; (2) a discretionary bonus of nearly US$7 million for the first quarter of 2020 was given to field leaders, general managers, apprentices, and eligible hourly employees; (3) US$2 million in assistance bonuses have been made available for general managers and their apprentices for their services in April; and (4) Emergency lead benefits were expanded to accommodate those directly affected by COVID-19.
• Chipotle is continuing to develop new restaurant units (although there are construction-related delays) and the availability of sites have increased as other businesses have pulled back spending.
• Chipotle’s rewards program has increased from 8.5 million members at end-2019 to 11.5 million in the first quarter of 2020; daily signups to the rewards program have also spiked by nearly four fold in the last month.
• In the first quarter of 2020, Chipotle opened 19 restaurants, of which 11 have a Chipotlane, the company’s digital-order pick-up drive-through lane. Even before COVID-19 struck, stores with Chipotlanes had opening sales that were 5% to 10% higher than those without Chipotlanes; now, the outperformance has reached over 30%. What’s more, stores with Chipotlanes have a digital mix of nearly 80%; the mix of “higher margin order-ahead and pick-up transactions has more than doubled” for Chipotlane restaurants compared to pre-COVID times. As a result of the continued strong performance at restaurants with a Chipotlane, and lesser competition for new sites, restaurants with a Chipotlane will comprise an even greater proportion of Chipotle’s future restaurant openings.
• Assuming a same store sales decline of 30% to 35%, Chipotle’s balance sheet can sustain the company for “well over a year.” It’s worth noting that Chipotle’s same store sales has increased to the negative high-teens range in April. The company still has room to make additional adjustments to reduce expenses if the recovery from COVID-19 takes longer than expected.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

There are two reasons why I think Chipotle excels in this criterion.

Firstly, the restaurant operator has done very well in producing free cash flow from its business for a long time. It even managed to produce a solid stream of free cash flow in 2016, when it was mired in its food safety crisis.

Secondly, there’s still tremendous room to grow for Chipotle. Yes, there’s plenty of short-term uncertainty now because of the COVID-19 pandemic. But when it clears, customers should still continue to flock to the company’s restaurants. Chipotle is nowhere near saturation point when it comes to its restaurant-count, and the US restaurant market is significantly larger than the company’s revenue. I want to repeat that digital sales have traditionally been sticky for Chipotle. So the current surge in digital sales for the company during this COVID-19 period could become a strong foundation for Chipotle’s future growth when the pandemic eventually clears.

Valuation

I like to keep things simple in the valuation process. In the case of Chipotle, I think the price-to-free cash flow (P/FCF) ratio is an appropriate measure for its value. The company operates restaurants, which is a cash-generative business, and it has been adept at producing free cash flow over time.

On a trailing basis, Chipotle has a trailing P/FCF ratio of around 67 at a share price of US$882. There’s no way to sugar-coat this, but Chipotle’s P/FCF ratio is high. The chart below shows Chipotle’s historical P/FCF ratio over the past 10 years:

We can see that Chipotle’s current P/FCF ratio is also high when compared to history. The next few quarters will be a massive test for the company. But Chipotle is well-positioned to survive the COVID-19 crisis as I discussed earlier. It is also putting in place the building blocks for future growth – such as well-designed drive-through lanes and digital/mobile ordering platforms – once the ongoing health crisis becomes a memory. So I’m still comfortable staying invested with Chipotle despite the seemingly high P/FCF ratio, which should become even higher over the next few quarters as the company’s free cash flow falls, temporarily. 

The risks involved

The biggest risk confronting Chipotle at the moment has to be the economic slowdown and restrictions on human movement in the US that have appeared because of COVID-19. But I also discussed earlier in this article how Chipotle is faring relatively well during the pandemic. Nonetheless, I’m still keeping an eye on things here. 

Another big risk affecting Chipotle is food safety. Chipotle was well on its way to recovering from its food safety issue that flared up in late 2015 before COVID-19 struck. The company has dramatically improved its food safety measures compared to in 2015, but I don’t think it’s possible to completely eliminate the chances of food safety problems appearing again in the future. If Chipotle is unfortunate to have to deal with another food safety problem during this ongoing COVID-19 pandemic, its reputation with consumers could be dealt a crippling blow.

The last big risk I’m watching are changes to Chipotle’s food and people culture. CEO Brian Niccol has done a great job in improving Chipotle’s business operations while retaining the things that make Chipotle special. But if Chipotle’s food and people culture were to change in the future, I will be watching the developments. I think that Chipotle’s food and people culture have been tremendous drivers of the company’s growth, so I want to keep track of changes in these areas.

My conclusion

Chipotle’s a fast-casual restaurant company with a unique people and food culture. From its founding in 1993 to 2015, it managed to grow tremendously under the watch of founder Steve Ells – and it grew without using debt, which is a mightily impressive feat. Food safety issues erupted in late 2015, which caused setbacks for Chipotle. But new CEO Brian Niccol came in and made significant positive changes at the company. Chipotle was well on its way to recovery when COVID-19 struck. Thankfully, the changes that Niccol has implemented, such as the digital investments, have served Chipotle well. The company looks well positioned to survive the current COVID-19 crisis, and changes to consumer behaviour in the current environment also appear to be building a solid foundation for Chipotle’s future growth when the crisis ends. 

There are risks to note of course. A prolonged recovery from COVID-19 could hurt Chipotle’s business near-permanently. The occurrence of another food safety issue during COVID-19 will also be disastrous for the company. But after weighing the pros and cons, I’m happy to continue owning Chipotle shares. 

And now it’s time for me to find some delivery or takeaway for great Mexican fare for lunch…

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.