Chipotle Could Potentially Become Alot Bigger

Is Chipotle a once-in-a-decade company, and just how large can it become following yet another incredible quarter?

Jul 27, 2014 at 10:20AM
Chipotle

Source: Chipotle

J.P. Morgan Equity Analyst John Ivankoe called Chipotle Mexican Grill (NYSE:CMG) a "once-in-a-decade" type of brand following its blowout second-quarter earnings report, which sent shares soaring higher. However, looking beyond the second quarter and 2014 guidance, is Chipotle really on pace to become an iconic brand? To answer that question, what better comparison is there in the restaurant space than McDonald's (NYSE:MCD), a company that too has changed the restaurant game during its storied history?

Once-in-a-decade brand
It has been a long time since investors have seen a company grow like Chipotle. Sure, we've seen 28.6% revenue growth and same-store sales increases of 17.3%, but normally it occurs with much smaller restaurants, or those with room to expand rapidly. Furthermore, it has been decades since we last saw a restaurant grow at a double-digit rate with quarterly revenue in excess of $1 billion.

In fact, not since McDonald's early days have we seen growth like this. Regardless of what you think of the company today, McDonald's is a company that transformed restaurants with the fast-food concept. Over a 50-year period, McDonald's has become the largest restaurant in the world, with 12-month revenue of $28 billion thanks to its game-changing entry into the restaurant space.

With that said, we can conclude that McDonald's was in fact a "once-in-a-decade" brand, and while growth has stalled today, the company's history is filled with double-digit growth and rapid expansion. Therefore, how can we determine if Chipotle is the next McDonald's?

The next McDonald's
To answer that question, we must compare fundamentals. Now clearly it wouldn't be fair to compare two companies that are completely different sizes. However, if we look back at a time when McDonald's was of similar size to Chipotle and compare growth rates, it would give us an idea of how Chipotle measures against the largest and most dominant restaurant in history. Consequently, we'll see if Chipotle is on track, exceeding, or lagging McDonald's at similar periods of company size.

So, let's go back to 1985, the third quarter, as McDonald's posted revenue of $1.01 billion and net income of $128 million. On a year-over-year basis, McDonald's grew revenue and net income by 10% and 12%, respectively, with a profit margin of 12.6%. If we look further ahead, McDonald's then grew revenue and net income by 7.9% and 9.4%, respectively, on a 10-year annualized rate ending in the year 2000; the company's annual revenue had grown to $14.2 billion by 2000.

Therefore, McDonald's growth was slow and steady but was also driven by global expansion, as it grew to 35,000 stores plus. Meanwhile, Chipotle has just 1,681 stores, meaning it has a long way to go before catching McDonald's.

This is very telling
Nonetheless, based on McDonald's growth in 1985, and what it has become, we can conclude that Chipotle might not be a once-in-a-decade restaurant but perhaps the first of its kind. McDonald's growth proves that we have never seen growth of Chipotle's magnitude, especially once a restaurant surpasses the $1 billion in quarterly revenue mark.

Chipotle's near 29% growth in the second quarter is nearly three-times greater than McDonald's at similar points in each company's business cycle. For investors, this should be very telling for those who consider Chipotle's $20 billion market capitalization to be expensive, as it indicates that the long-term upside in Chipotle shares might be far beyond its current valuation.

Something to consider
A key fundamental observation that many investors might miss is the consumer expectations surrounding both McDonald's and Chipotle. Specifically, McDonald's has remained competitive by lowering prices and keeping value products intact despite rising food costs.

Meanwhile, Chipotle is known for quality rather than quantity and was thereby able to raise menu prices at an average of 6.25% to 6.5% during the second quarter. This is a feat that McDonald's has found very difficult, if not impossible, yet Chipotle has done so without missing a beat.

Final thoughts
Chipotle has the pricing power, consumer appeal, and historic growth on its side in becoming a "once-in-a-decade brand, if not a once-in-a-lifetime company in the restaurant industry. With all things considered, it would be tough to bet against Chipotle becoming the next McDonald's or bigger.

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Brian Nichols owns shares of Chipotle Mexican Grill. The Motley Fool recommends Chipotle Mexican Grill and McDonald's. The Motley Fool owns shares of Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. 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.

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