On September 6th, we announced a 9.9% stake in Chipotle Mexican Grill (CMG, Financial) which we purchased at an average price of $405 per share. Chipotle has built a superb brand pioneering the “fast casual” restaurant industry with the success of its outstanding product offering, unique culture and powerful economic model. We have followed the business for years, noting how it has disrupted the fast food industry with its high quality, delicious and customizable hot meals that are prepared quickly and sold at affordable prices. The company has been significantly negatively impacted by food safety issues beginning in the fourth quarter of 2015 which caused a peak decline in average unit sales of 36%. In response, the company has implemented best-in-class food safety protocols over the past year, and worked to win back lost customers. While traffic and sales have begun to recover, average unit volumes are still 19% below peak levels.
We have always believed that a good time to buy a great business is when it is in temporary trouble. While Chipotle’s reputation has been bruised, we think that with the passage of time and improved marketing, technology and governance initiatives, the business will not only recover but become much stronger. Chipotle’s sales recovery will be neither smooth nor predictable over the next few quarters; yet, we believe that all of the key drivers of Chipotle’s powerful economic moat and long-term success remain intact. These drivers include:
- A strong and relevant brand built by visionary leadership
- A differentiated product offering with a highly attractive value proposition
- Substantial scale in the fast casual industry and first-mover advantage in real estate
- Strong unit economics and extremely high returns on capital, driven by a well-honed model that facilitates best-in-class throughput
- Enormous growth opportunities including new units and operating enhancements such as mobile ordering and catering
Strong Brand
The Chipotle brand was developed by founder Steve Ells with the philosophy that food served fast does not have to be a traditional “fast-food” experience. This vision later evolved into an ambition to change the way the world thinks about and eats fast food. Chipotle’s authentic brand developed a loyal following, which allowed the company to grow from one restaurant to more than 2,100 relying primarily on customer word of mouth, supplemented by non-traditional marketing techniques including digital and social media, owned content, and local events. Today, we believe that Chipotle is one of the most compelling and authentic large-scale food brands in the U.S.
Differentiated Product Offering
Chipotle’s product offering is differentiated by the fact that it successfully competes in all the desirable attributes of out-of-home fast food. As part of our research, we compared Chipotle’s customer value proposition to those of fast casual, quick service, and casual dining competitors across six key metrics: food quality, taste, in-store experience, customization ability, speed, and value. We believe Chipotle’s food quality is superlative given the focus on cooking from scratch with the best available ingredients. Chipotle’s “burrito line” service format engages customers from the moment they walk in the door, allows exact customization of each order to accommodate individual preferences, and facilitates the fastest throughput in the industry. The product price point offers outstanding value given the quality and quantity of food served. While some other concepts can successfully compete on one or more of these attributes, we believe that few are able to replicate the Chipotle offering at comparable price points at scale.
Enormous Growth Opportunity
Prior to the recent food safety issues, Chipotle’s average unit volumes were approximately $2.5 million, nearly the highest in the industry, despite only serving two day-parts, and with limited store hours, i.e., 11 versus as much as 24 hours for other fast food competitors. We believe that initiatives such as mobile and digital ordering, loyalty program development, catering, and menu innovation including dessert will drive an accelerated rate of same-store sales growth for the foreseeable future, incremental to the impact of recovering lost customers. Returns on capital for new units remain extremely compelling even at today’s lower sales levels. We believe that the U.S. can support about 3,000 additional Chipotle restaurants, a total of 5,000 units representing 2.3 times the current store base.
Food Safety
We have researched the initiatives that Chipotle has taken to address food safety. While food safety risk can never be completely eliminated in any restaurant, we think the company has done an excellent job of significantly reducing the risk of another incident while maintaining the freshness and taste of its food.
Chipotle has a number of other attractive attributes which include limited global macroeconomic sensitivity and foreign currency exposure, a simple business model with limited non-GAAP earnings adjustments, a high effective tax rate of nearly 40% (which means the company will be a big beneficiary of lower U.S. tax rates if implemented by the Trump administration) and an unlevered balance sheet with a strong net cash position.
Valuation
Given Chipotle’s depressed near-term earnings due to the recent decline in sales and its detrimental impact on operating margins, we do not believe it is appropriate to value Chipotle using a multiple of next year’s earnings based on comparables or estimated growth rates. To estimate the intrinsic value of Chipotle shares, we have valued the discounted cash flows of the business over its life using reasonable assumptions. In our base case, we have assumed a long-term restaurant count of 5,000 units, some recovery of lost customers over the next several years, and moderate same-store sales growth over the long-term driven by the impact of new technology initiatives (like mobile, online ordering and loyalty) and day-part extension initiatives (like catering). We conservatively have assumed that profit margins will be at a discount to peak levels reflecting the cost of new food safety procedures as well as increased investments, offset over time by thoughtful management of overhead costs and increased operating leverage.
From Bill Ackman (Trades, Portfolio)'s Pershing Square third-quarter shareholder letter.
