Chipotle: Buy the Steak, Not the Sizzle

Legendary value fund manager Michael F. Price describes his investing strategy as the "steak and sizzle" approach. He focuses on a healthy balance sheet and steadily increasing cash flow (the "steak") and ignores unproven growth opportunities (the "sizzle"). At Chipotle (NYSE: CMG  ) , diners pay for the steak burrito, not the sizzle from the open grill. Can the same be said for Chipotle's shareholders?

Let's grab a fork and knife and take a closer look.

The steak
Chipotle's recipe for success focuses on doing just a few things, but doing them very well. The fast-casual restaurant chain serves up burritos, bowls, tacos, and salads efficiently in a sleek restaurant format. The company invests heavily in training employees, which results in a positive customer experience and reduced turnover.

Over the past three years, this strategy has translated into rapid growth in earnings and cash flow. As shown below, earnings per share increased 273% during the same time frame.

Chipotle Mexican Grill Stock Chart

Chipotle Mexican Grill Stock Chart by YCharts.

Likewise, cash flow has been strong enough to finance future expansion, and the company has minimal debt. Chipotle has been able to fend off competition and even exert pricing power in a highly competitive industry. This consistent operational and financial performance represents the "steak" of a strong, growing business.

The sizzle
The chart above reflects another recent trend for Chipotle: a soaring stock price. Investors are impressed by Chipotle's domestic expansion and are salivating over rising same-store sales. The following table illustrates the trend for this key restaurant metric.

Key Metric

2008

2009

2010

2011^

Same-store sales increase (YOY) 5.8% 2.2% 9.4% 11.2%

Source: SEC quarterly and annual filings. ^Results reflected through the quarter ended Sept. 30, 2011. All other years as of Dec. 31.

This is savory growth, to be sure, but can it continue? Here are a few challenges Chipotle will face along with an overview of management's past performance.

  1. Expand through new restaurant openings. Management has shown mastery in this area, opening more than 120 new outlets in each of the past three years, with less than a handful of closures or relocations. The company expects to open 155-165 in 2012.
  2. Increase same-store sales. In its latest 10-Q filing, management projected same-store sales growth in the low single digits for 2012. This would be a significant departure from the 11.2% year-over-year growth reported for the first three quarters of 2011. However, Chipotle's management has a history of setting a low bar in this category. Management provided "flat" guidance and "low single digit" growth in 2009 and 2010, respectively, and then turned in stellar results. The "lowball" estimate has become a habit for Chipotle, but there will be little room for error going forward.
  3. Beat analyst earnings estimates. Chipotle topped analysts' estimates by an average of 1% for the last three quarters. Prior to that, the company beat the consensus in three straight quarters by an average of almost 12%. Management may find it harder to top Wall Street's expectations going forward, especially in the face of rising food prices.

While Chipotle has proven it can expand rapidly in the U.S., delivering superior quarterly results could prove difficult in the near future. Currently, the company is exploring international opportunities and experimenting with a new Asian restaurant concept in Washington, D.C. Both represent great opportunities, but management could be overreaching. Investors should be wary of paying a premium for these unproven ventures.

For additional perspective, let's take a look at Chipotle's price-to-free-cash-flow multiple and compare it with the competition. A price-to-free-cash-flow ratio relates a company's market price to its level of annual free cash flow. For Chipotle, free cash flow is the cash left over after paying its bills and financing its restaurant expansion.

Company

Market Cap

 Price/FCF

Chipotle $9.6 $54.38
McDonald's (NYSE: MCD  ) $94.1 $22.37
Starbucks (Nasdaq: SBUX  ) $31.0 $24.55
Yum! Brands (NYSE: YUM  ) $24.6 $21.00
Tim Hortons (NYSE: THI  ) $7.9 $19.92
Panera Bread (Nasdaq: PNRA  ) $3.9 $25.10
Wendy's (NYSE: WEN  ) $2.0 $25.17

Source: Yahoo! Finance.

Chipotle looks expensive relative to its peers. Its price/FCF multiple is 136% higher than the average of six comparable restaurant chains. Investors are excited about Chipotle's growth prospects relative to the industry and are willing to pay a premium for that growth. But is it justified? Remember that Chipotle's free cash flow number includes the capital expenditures it's using to expand, but its price multiples are elevated even factoring that in.

Foolish takeaway
At the current stock price, shareholders expect a filet mignon from management every quarter. If Chipotle can deliver only a steak burrito, this could result in heartburn for investors.

Do you think there is too much sizzle and not enough steak in Chipotle's share price? Feel free to share your comments below, or keep an eye on this company by adding Chipotle Mexican Grill to My Watchlist.

The Motley Fool owns shares of Chipotle Mexican Grill, Starbucks, Panera Bread, and Yum! Brands. Motley Fool newsletter services have recommended buying shares of Yum! Brands, Panera Bread, Tim Hortons, Starbucks, Chipotle Mexican Grill, and McDonald's. Motley Fool newsletter services have recommended creating a put butterfly position in Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Isaac Pino does not own shares in any of the companies mentioned in this article. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (15)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 23, 2011, at 1:24 AM, NeedaClue7 wrote:

    I'm curious as to why you reduce FCF by business expansion expenditures. For CMG, this represents an investment in additional income-producing assets. I would agree that capital expenditures to repair or replace existing assets (so-called "maintenance capital") is a valid reduction in FCF as it's the cost to service an existing business that actually produces the FCF that gets input into the price-to-FCF ratio. But the expansion expenditure represents an investment in new businesses and doesn't typically add to FCF in the year incurred. To me, expansion costs should be evaluated based on their potential to produce future FCF and I would have thought that the price-to-FCF ratio is most effective at evaluating the business they already have in place. Seems like you're combining the apples and oranges!

  • Report this Comment On December 01, 2011, at 3:06 PM, cwildfrank wrote:

    I like your chart.

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