The fast-casual restaurant industry is becoming increasingly competitive, with restaurant operators gaining easier access to capital and retail landlords looking to occupy vacant real estate in the past months. While this could be detrimental to many industry players like Fiesta Restaurant Group Inc. (FRGI) or Jack in the Box Inc. (JACK), one market leader continues to stand out through its recent profitability: Chipotle Mexican Grill Inc. (CMG). And since investment gurus Steven Cohen (Trades, Portfolio) and Jim Simons (Trades, Portfolio) added large amounts of this company’s shares to their portfolios last quarter, I have been wondering what motivated them to do so.
Quality over Quantity
One of the things that is most impressive about this fast-casual Mexican restaurant chain is its ability to focus on a few growth catalysts, but to exploit these the most. As the largest player in the $7 billion in the Mexican restaurant category, Chipotle offers a uniquely customizable menu (65,000 possible combinations) of burritos, tacos and salads made from higher-quality ingredients than most of its competitors. The organic and naturally raised products acquired from local ranchers or farmers, have not only earned the firm a differential market value, but also allow more clout over its suppliers than other chains. Furthermore, the company’s brand strength commands pricing power, which will benefit future profits among elevated food costs.
Chipotle’s unit growth is another enticing aspect of this company, which is expected to outgrow the fast-casual category over the next decade. Currently operating 1,600 restaurants in 43 U.S. states, Canada, the UK, France and Germany, the firm is still far from reaching its saturation point of 4,000 units. Although management’s approach to unit growth has been conservative in the past, 10% average annual unit growth can be expected in the next decade, with 200 new restaurant openings scheduled for 2015. This business expansion will also include Chipotle’s new secondary concepts – ShopHouse and Pizzeria Locale – which will require less capital and lower occupancy costs, therefore boosting shareholder returns. Given customers' strong brand loyalty regarding this restaurant operator, the new concepts should reap similar results for the company’s namesake brand.
A Solid Business Model Boosts Valuation
With $3.2 billion revenues reported in 2013, growing at a 21.1% average annual rate, Chipotle is outplaying the overall fast-casual restaurant industry growth, which is expected to average 10%. This is mainly due to the firm’s highly profitable business model, which has been able to counterbalance elevated food costs with leveraged labor and occupancy expenses. Furthermore, strong consumer demand will continue to support the company’s EBITDA growth of 21.4%, while pricing power allows margin improvements. While 2013 showed no boost in operating margins, remaining at 16.7%, the lower-cost secondary restaurant concepts will boost figures to 23% over the next decade.
ROIC levels, currently at 16.3% are also expected to improve, reaching a profitable mid-20% range (compared to 10.5% cost of capital). And while elevated industry competition could hurt profitability, I’m bullish that Chipotle’s combination of aesthetically appealing restaurant venues, customer loyalty and menu innovations will continue to catalyze this company as the market leader. Also, the EPS growth rate of 22.9% is well above the industry average of 7.8%, which should be appealing to shareholders. However, I must warn investors when it comes to the stock's trading price of 53.10x trailing earnings. Sporting a 121% price premium relative to the industry average of 24.0x, the stock might be overvalued and it would be wise for new entrants to wait until the price has decreased.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned.