Interested in Investing in Restaurants?

Three months ago, Chipotle's CFO made a bold proclamation regarding the company's pricing power. Chipotle's (CMG 5.45%) fourth-quarter results prove he was correct. But how much more can the company raise prices without losing customers? Joining host Chris Hill in today's episode of Motley Fool Money, Motley Fool senior analyst Jason Moser takes a deep dive into the restaurant landscape, including:

• Yum! Brands' eye-popping unit growth over the past year.
• How the economics of Yum's franchise model stack up against Chipotle's decision to own all of its locations.
• Whether Chipotle can get to 7,000 locations.

Motley Fool senior analyst Ron Gross discusses the business of acquisitions, including:

• The different ways that companies fund buying another business.
• Horizontal vs. vertical acquisitions.
• Hostile takeovers.
• Whether investors should wait for an acquisition to close before selling their shares.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Feb. 9, 2022.

Chris Hill: Morning. Do not listen to this episode on an empty stomach. Motley Fool Money starts now. I'm Chris Hill joined by Motley Fool Senior Analyst Jason Moser. Thanks for being here.

Jason Moser: Hey, thanks for having me.

Chris Hill: Ron Gross is going to be here later in the show to talk about acquisitions, what to do when one of the companies in your portfolio gets bought? Which is a timely topic because I don't know if you've noticed Jason there've been some acquisitions lately. People have questions, the dozens of listeners have questions.

Jason Moser: There are some rumors.

Chris Hill: There's more than rumors. We're going to get to that later. I want to talk with you about investing in restaurants. You tweeted something out three months ago, a quote from Jack Hartung, who is the CFO at Chipotle three months ago and they're basically Hartung saying, "We've got pricing power better than pretty much anyone in our industry." Here we are three months later, Chipotle's 4th quarter report comes out, you look at it and that was a bold call for a CFO. Generally, CFOs as a group, it's not in their interest to make statements like that. But when you look at the latest results from Chipotle, they've got pricing power and they are using it.

Jason Moser: It was a bold call, I agree. I think CFOs, for the most part, it's in their DNA to probably be a little bit more soft-spoken and just let the numbers do the talking. But I like the confidence as well. I think certainly that quote from a quarter ago, this quarter's results back that up for the most part. When you look at the numbers, just a very impressive quarter all the way around, total revenue for the company grew 22 percent to two billion dollars comps up 15.2 percent. This was the line item here that caught my attention. It's just because when you think about it in a little bit bigger picture, digital sales, we talked a lot about digital sales with Chipotle and how successful they've been with their app, digital sales grew 3.8 percent for the quarter, accounted for 41.6 percent of all sales. But the interesting thing to me is you go back just a quarter ago, digital sales grew 8.6 percent. If you go back a year ago, they grew 174 percent. 

It's not entirely surprising, but I think the translation there, you can read a few things into that, but I think, ultimately, the translation we're seeing in many places people are simply moving forward with their lives. This isn't 2020 anymore. People are going to restaurants, people are going to movies, they're going to do things, offices are open. The world has gotten back to normal to a degree at least. Now, it's not fully back, the impacts of the last couple of years. We'll see some ebbs and flows in the near term. But generally speaking, I think all of these investments they've made in their digital business continue to pay off. But it's really nice to see too that traffic in the stores continues to grow as well. Just to put a number on how many people love their Chipotle today, Chris, they now have more than 26.5 million members in their rewards program. A year ago that was at 19.5 million. So really a lot of success in that level alone, it gives them a ton of data. Back to that pricing power points you were making earlier, it lets them make informed and really thoughtful decisions on how they're going to push those prices up if and when they need to do it.

Chris Hill: I was doing an interview earlier in the week on one of our affiliate radio stations and got a question about inflation and how much does that factor into your decision-making and part of my answer was to talk about pricing power. Because the consumer-facing businesses that have pricing power are going to be able to exercise it. Brian Niccol the CEO at Chipotle, talked yesterday about how they are getting no resistance. That was the phrase he used, they're getting no resistance from their customers when they're raising prices. Obviously, you can't just go jacking up the prices to whatever degree you like. You have to be very thoughtful about it. But they are doing that. I want to touch on the digital orders for a second because one of the things that we want to see when we're looking at restaurants is, what are their growth projections and part of that obviously is new locations. Chipotle talked about their growth plans and part of it that struck me was, 80 percent of new locations that they've got planned and they've got somewhere in the neighborhood of, I think, it's 230-250 new locations planned for this year. Eighty percent of them are going to have those Chipotlanes, the pickup for digital orders only. Even though, as you say, they talked about their staff and getting back to pre-pandemic levels, people are getting on with their lives. They are planning for digital orders to continue to be a robust part of their future.

Jason Moser: Absolutely. When it represents closing in on half of the revenue that you're bringing in, you better depend on it. You better count on it because it's been a wonderful lever that didn't exist really a decade ago when we loved Chipotle even back then. This is a little bit of a different story, but it is fascinating to look at the growth opportunity on the store side of things. I mean, the company today they have just under 3,000 restaurants. Previously, we'd heard them talk before about this opportunity of 5,000-6,000 stores potentially here in North America. Now the advent of the Chipotlane, this is opening up the playing field for them a bit. You referred to that greater than 80 percent of new restaurants having Chipotlane and what it's doing, it's opening them up to, I think, an entirely new potential market. They mentioned in the call small towns. I think up to this point, they've really focused on getting real estate in prime locations, heavily trafficked areas where they can justify the economics of the real estate itself. 

But a Chipotlane obviously carries a much smaller footprint and therefore, it's easier to justify the economics of opening those up, even if it's just a stand-alone Chipotlane store. Chris, you know a couple of months I'm going to fly down in Moultrie, Georgia and I'm going to see my mom and dad. Who knows, that's a small town. Maybe one day we'll see Chipotle there. That would be awesome. I know they want one. My mum and dad like Chipotle. They're bummed they don't have one. But I think that's really the interesting thing to think about there because now, this was something they noted on the call and I think you got to take note of here as they've up that market opportunity, they are talking about now the potential for 7,000 stores in North America all in. It's neat to think about how this story has evolved because it wasn't all that long ago when we were kicking that 7,000 number around, but in a different context. We were talking about Chipotle and them taking that platform that they've developed and coming up with different concepts, whether it was burgers or whether it was Thai food or pizza. We know how that worked out.

Chris Hill: It didn't. That's how it worked out. It didn't work out. [laughs]

Jason Moser: Exactly. It didn't work out. I think that's where you need to keep those types of estimates, those types of forecasts, those types of goals. Take it with a little bit of grain of salt. I would say a smart investor will look at that 7,000 number and discount it back a little bit. Let's think maybe 7,000 is an aspirational goal. What if they don't get there, what if they get to six? How does that changes the potential of this investment? But even at six, you can see they're essentially doubling their store count from today. If they're targeting that new unit growth rate of 8-10 percent per year as they stated in the call, that gives them a pretty long runway ahead to continue opening up stores, growing that loyalty program. Ultimately over time, because you have that bigger store base, because you own all of those stores, the economics continue to work better and better for you as you continue to scale up. There's a lot of potential for this business still. I know folks look at that stock price today in 15, $1,600 and like, "Wow, that's expensive." Remember the stock price is a function of really ultimately how many shares are outstanding. This is a business, still with a lot of opportunity in front of it, and I think investors should be very encouraged.

Chris Hill: There is a way for them to open more locations more quickly. Because when you look at Yum! Brands, parent company of KFC, Taco Bell, and Pizza Hut, they just closed their fiscal year, they opened [laughs] nearly 4,200 locations in their fiscal year.

Jason Moser: That's amazing.

Chris Hill: But of course, they'd have to go to franchise route to do that, and it's clear that Chipotle doesn't want to do that.

Jason Moser: No, they don't and I understand. I don't think it's really right or wrong. I think it's just a matter of the business strategy that they opt for, but you can see certainly how it plays out. You've got Yum! with something like 50,000 total stores around the world, all-in with your Pizza Huts, and KFCs, and Taco Bells, and whatnot versus Chipotle, is what? Three thousand. The funny part is, Chipotle chalked up about seven-and-a-half billion dollars in revenue over the last 12 months, and Yum! brands was closer to six-and-a-half billion, I believe. Again, that's not to say that Chipotle is a better business. But that marks the difference in the model because with the franchise, you're essentially introducing another business partner into the mix. It adds some risk, it relinquishes some control to a degree. But on the flip side, it can also help spur growth. You look at how the numbers play out for these two businesses. Chipotle, they're bringing in a net margin, 8.7 percent on seven-and-a-half billion dollars in sales. 

Yum! brands, you're talking about something closer to the neighborhood. They're what I say, six-and-a-half billion dollars in sales, but a business that's bringing in net margins closer to the 24 percent range. It's just a matter on the difference of the models. I know at one point, very early on in its inception, Chipotle and its relationship through McDonald's, there was a franchise dynamic to it. They got out of that real quick because I do think they felt like the strategy was grow it slow methodically, be very thoughtful about the offering. They were all-in on the one concept at the time, and that's worked out very well. I know I've referred to this before on our shows and I know you remember very well because it was Jerry Murrell, the founder of Five Guys who came in and spoke to us one day at Fool HQ years ago. I think there was a question that was asked of him at the time. If you could go back and change something, what would you change? He was very quick to say, "You know what? I would go back and buy back every single one of those stores." It wasn't really because he hated the franchise model, it's just because he felt like owning those stores was a superior option. He felt like he was leaving money on the table, he was leaving control on the table. I thought that was just interesting to glean from a founder of what is clearly a very successful restaurant company today.

Chris Hill: Shares of Yum!, you know, not terrible, up 90 percent over the past five years. Although you compare that to Chipotle, up 280 percent over the same five-year period. As you said, stop saying the one is better than the other. But when you look at the economics, what is the diversion of both of these approaches to restaurants, and what is the best version of that? The best version of the we-own-everything model. It seems to be working up better.

Jason Moser: Yeah, I tend to agree. I do own shares personally in Chipotle and have for a long time, I don't own shares in Yum! Part of that just is reflective of my personal preference, honestly. I never go to Yum! brands properties, but I frequent Chipotle a lot and I just think it's a quality offering at a reasonable price. As long as management is able to continue controlling the quality of that offering while remaining thoughtful about the prices, the value proposition that it's offering customers, I don't see why they shouldn't continue to succeed. I think the biggest question marks for Chipotle today, and I would encourage investors to think about these questions because is good as this quarter was, is well as the stock is done, you have to at least ask yourself a question. If they're so confident about pricing power right now, what flips that on its head? How far can they go with that? Because you just can't go on with that forever. That at some point or another, you do start to hit a ceiling there. What does that potentially look like? Then just the growth targets. Seven thousand is a great number to hear, I love it. I'm not modeling for 7,000 though, Chris. [laughs] I think any investor worth his or her salt would probably ratchet back that forecast a little bit and try to see how does this investment look if you target 5,500 stores or 6,000 stores. At least get that insight there to be able to understand a few different scenarios. But on the whole, I think this is the business doing a lot of things well, and it sounds like that's a poised to continue.

Chris Hill: Jason Moser. Thanks for being here.

Jason Moser: Thank you.

Chris Hill: Microsoft is buying Activision Blizzard, Take-Two Interactive is buying Zynga. If January is any indication, then 2022 is shaping up to be a big year for acquisitions and probably not just in the gaming industry. How does it affect you if a company in your portfolio gets bought by another company? Well, here to talk through some of the nuts and bolts is Motley Fool Senior Analyst, Ron Gross. Thanks for being here.

Ron Gross: It's a pleasure, Chris. How are you?

Chris Hill: I'm doing well. I want to get to a couple of things. Let's start with how the execution takes place. They can buy with cash, they can buy with stock, they can buy with a mix. Does one of those tell you more about the acquisition than the other, or is it all the same? [laughs]

Ron Gross: Well, sometimes the company would like to use all cash perhaps, but just they don't have that kind of capital, that cash on the balance sheet. There is the potential to use debt to do that. But very often the capital just as not available and that's one reason you might turn to stock, instead of cash. When you use cash to buy a business, the acquiring company is then taking 100 percent of the risk going forward. That acquisition makes sense, that the synergies, whether they be cost synergies or process synergies are realized, that the growth perhaps that they're looking for will be realized. Because the other shareholders they're out, you paid them cash, they're gone, bye. Now if you stock, both parties are absorbing some of the risk that this will or will not work out by the synergies being realized. If you are on the side of the acquiring company and you're a shareholder, you have to evaluate whether you're happy or not with A, the purchase price because yes, you will likely be taken out at a premium to where the stock was trading at the time of the announcement. 

But perhaps you thought the stock was worth more than that or would be worth more than that because you're a long-term shareholder and you're going to own this company for five, 10 years and the acquiring company in your opinion is getting off cheap perhaps. Then if its stock you have to say to yourself, well, I've bought this company that I own because I believe in the management team and I believe in the company, and I believe in the end-user markets and the opportunity. I am not sure I want to be a shareholder of this new company that's giving me stock, and so you have to make that determination too, about whether you're actually happy about becoming a shareholder in a new company that perhaps you never intended to be in the first place. Of course, there can be a combination of cash and stock we saw that with Take-Two acquiring Zynga, where it was part cash and part stock, which you'll see quite often. Companies nowadays have so much cash on the balance sheet, especially the Mega Big Boys, we talk about whether it's Apple, Amazon, Facebook, Microsoft, that cash is not a problem, they could almost do any acquisition they want. That's across a wide range of companies, balance sheets or full. Cash becomes an even bigger option during these types of times where they have the capital to do it and they don't need to go the route of stocks.

Chris Hill: We talked earlier in the week about Peloton and the reports of whether it's Amazon or Nike or whoever may be acquiring them. Part of that story involves activists investors, in a previous life you yourself were an activist investor. Which leads me to this. Some of these acquisitions are not friendly. Some of them are very much partnerships in the making and others are hostile takeovers. If you are looking at your portfolio and you find out that, one of your companies is involved in whether it's friendly or hostile, does one indicate more red flags than the other?

Ron Gross: It's certainly cleaner when it's friendly because the management teams get together, the board of directors is just there, they negotiate a price. They're able to share information so they can see what kind of synergies can be realized or what incremental growth can be realized. There's a meeting of the minds and it's much, much cleaner. When you get an unsolicited offer, let's use the friendly term. Unsolicited [laughs] you don't get a lot of those things. You see that going on with coal right now, Acacia Research, which is backed by old friends of mine from Starboard Value, really strong activists, are going to offer or offer to pay I think $64 for coal, but that was not solicited. That came from an activist. Typically when it comes from an activist, it is either unsolicited or potentially hostile. Then it becomes this whole battle. The acquiring company goes really right to the shareholders rather than through the board of directors to try to make this argument that yes, you should tender to your shares, what we're offering you make sense. It just gets messier and sometimes they happen, quite frankly, sometimes they don't. Whereas in a typical friendly acquisition or merger, it's more likely to actually close unless there is something going on, like antitrust or something with the justice department like we're seeing now people potentially with the Microsoft Activision deal. People wondering, well, these big mega tech companies are under lots of scrutiny from a monopolistic perspective and the government doesn't want them to have too much power and even though that's a friendly deal, there's a risk that perhaps that it wouldn't get done.

Chris Hill: I want to come back to Microsoft and Activision Blizzard in a minute. But first, in terms of the types of acquisitions, because here's one more way for investors to look at this. There are horizontal and there are vertical. Is there one you'd rather see than the other?

Ron Gross: Not necessarily. I think it depends on the individual circumstance. Just today, we see Frontier and Spirit Airlines getting together in a merger. Merger is really, their two companies when they're combining. The word merger is more appropriate versus when one company absorbs an entire other company then the word acquisition is more appropriate. This is a merger and it's horizontal because it's two competing companies, that are combining to become one bigger company and in fact, they'll be quite large. Certainly top 10, maybe top 5, top 6 airlines out there. That makes sense. The Microsoft Activision acquisition, that's more vertical because they're not necessarily competing. Microsoft has their Xbox platform and Activision creates games, and this is a marriage made in heaven theoretically, because now Microsoft can bring that in and just increase their whole consumer side of their business. That's an example of something that's more vertical.

Chris Hill: They're buying Activision Blizzard at $95 a share and I get that the deal is not expected to close until 2023. But as of this conversation right now, shares of Activision Blizzard are around $80 a share. Leading a lot of shareholders to ask, OK, what do I do here? Do I wait until this deal actually closes? Because $15 a share, that's a decent amount of money. Do I just sell now and take the 80? How should people think about something like that?

Ron Gross: Yeah, each circumstance is different, specific to this one. You laid out the numbers. There is a 20 percent upside on the table if you hold and the deal gets done. That's a pretty big difference there. It's not usually that big. What the markets are telling you is that there is actually a bigger risk than normal, that the Justice Department is going to put a stop to this acquisition. Now, I personally don't think that's going to happen and I do think it's going to go through. Investors actually have an arbitrage opportunity to come in right now if they don't own Activision at all, buy it here, hold on and make a quick 20 percent assuming it goes through and you will for sure see institutional investors and arbitrageurs come in and do that. The risk is that if it doesn't go through, then you're going to see Activision go back to where it was before the announcement, which was in the 60s and you have an upside downside risk reward conversation with yourself to figure out if that makes sense. In this particular example, I think the risk does make sense because the rewards of 20 percent is pretty significant.

Chris Hill: Ron Gross, thanks for being here.

Ron Gross: Thanks, Chris!

Chris Hill: That's all for today, but coming up tomorrow, we'll take a closer look at what a new customer is worth to a business and how much companies are willing to pay to get one. As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against. So don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.