An Investor’s Guide to Chipotle and Its Customers

Chipotle Mexican Grill, Inc. (CMG) is a limited-service restaurant operating more than 2,500 fast-casual restaurants. Most of the restaurants are in the United States, with a few in Canada, the United Kingdom, Germany, and France. Chipotle has more than 80,000 employees.

Most of the company’s restaurants are Chipotle Mexican Grill, but Chipotle also operated two Pizzeria Locale restaurants as of the third quarter of 2019. Earlier, the company operated 15 ShopHouse Asian Kitchen restaurants. But it closed these restaurants in March 2017.

A fast-casual restaurant is a fusion of the fast-food concept and the casual dining restaurant concept. The fast-food concept includes iconic restaurant brands such as McDonald’s (MCD) and Yum! Brands (YUM), which operates KFC, Pizza Hut, and Taco Bell. The casual dining restaurant concept includes restaurants such as Olive Garden, under the umbrella of Darden Restaurants (DRI), and Chili’s, under the umbrella of Brinker International (EAT). Investors can also find some of these restaurants in the SPDR S&P 500 ETF (SPY).

Chipotle Mexican Grill operates only under the company-operated model, which means the company doesn’t franchise its restaurants like McDonald’s does. This also means the company has a higher capital requirement to open a new location. We’ll discuss this more in detail later in this in-depth article.

To learn more about fast-casual and other restaurant concepts, check out An In-Depth Overview of the US Restaurant Industry.

Chipotle’s food services

Chipotle Mexican Grill serves burritos, burrito bowls, tacos, and salads. And it also offers sides such as tortilla chips and guacamole and serves a variety of beverages. The company offers catering services in addition to on-premise selling at its restaurants.

In this deep-dive overview, we’ll look at Chipotle Mexican Grill’s revenues and same-store sales. We’ll see why Chipotle has been successfully growing sales and unit growth, and we’ll find out how Chipotle is funding its unit growth and how its stock has performed over the years. With this guide, you’ll better understand what it means to invest in Chipotle Mexican Grill.

There may be two brands under the Chipotle Mexican Grill (CMG) banner. However, the majority of the company’s revenues comes from Chipotle Mexican Grill itself. The brand represents about 2,544 restaurants as of the third quarter of 2019. Of these locations, 2,505 are in the US while 39 are international.

The company also operates two Pizzeria Locale restaurants. But let’s go over the main financial activities driving Chipotle restaurants.

Revenue growth in the last ten years

Over the past ten years, Chipotle Mexican Grill’s revenues grew at a 13.5% compound annual growth rate (or CAGR). In the 12 months leading up to September 30, 2019, the company had revenues of $5.4 billion, which grew 13.1% year-over-year from $4.8 billion.

However, Chipotle’s revenue grew at a lower CAGR of 5.7% in the last five years due to a series of food safety issues that the company had to face since December 2015. In comparison, the new entrant to the fast-casual space, Shake Shack (SHAK), has growth at a CAGR of 26.6%. However, McDonald’s revenue has fallen at a CAGR of 4% due to its refranchising strategy.

To invest in several restaurants, consider a broader portfolio such as the Standard & Poor’s depositary receipt (or SPDR) S&P 500 ETF (SPY). This will also help reduce your transaction costs.

High growth in the restaurant industry is more likely to come from the fast-casual restaurant concept. Shake Shack (SHAK) went public in January 2015 at an IPO price of $21. As of December 13, Shake Shack was trading at $58.99.

So what’s driving the high growth for restaurant companies like those mentioned above? Below, we discuss these revenue drivers to help you understand the customer trends that drive customers to these restaurants.

High correlation between same-store sales and revenues

The above chart compares same-store sales growth to revenue growth. You can immediately see that they move almost in conjunction, with a high correlation of 0.93.

The company reported strong SSSG for the first three quarters of 2019, with the latest quarter coming at 11.0%. To read more about Chipotle’s third-quarter SSSG of 2019, check out Chipotle Crushed Q3 Earnings: Stock a ‘Buy’ on Dips?

Chipotle’s focus on same-store sales

To understand what drives revenues, let’s first look at the single most important value driver: same-store sales. The investor community closely watches same-store sales numbers to check in on the health of their investments in restaurant and retail stocks.

Most of Chipotle’s activities, including reinventing its menu, remodeling its stores, driving more digital strategy such as delivery, apps promotions, promoting loyalty and reward cards, and advertising and marketing, focus on enticing more customers to walk into Chipotle’s doors. This strategy, in turn, will grow same-store sales at Chipotle’s restaurants.

The above chart also compares revenue growth to unit growth. A restaurant’s revenues also grow when it adds more units. We’ll discuss unit growth in more detail later on. But first, I’ll explain why Chipotle Mexican Grill’s same-store sales have been increasing.

When same-store sales are growing, each of Chipotle’s existing restaurants is attracting more customers year-over-year. Same-store sales are a function of traffic and ticket. To learn more about how traffic and ticket impact same-store sales, see What Drives Restaurant Same-Store Sales?

Differentiating Chipotle

So what’s Chipotle Mexican Grill doing differently to attract more customers? During the company’s fourth-quarter earnings call of 2018, CEO Brian R. Niccol credited the company’s culturally relevant marketing, its focus on great taste and real ingredients, and boosting customer convenience by reducing friction in the process for strong SSSG.

Is the CEO strategy working?

Brian Niccol joined Chipotle in February 2018, when the company was going through a rough period after the series of food-safety issues. But Niccol, with his focus on five key strategies, has managed to turn things around. He emphasizes visibility, strong culture, leveraging digital advancements, engaging with customers with loyalty programs, and innovating new menu items.

And all these initiatives have led to Chipotle delivering strong same-store sales over the last few quarters. The company reported SSSG of 9.9%, 10%, and 11% in its first, second, and third quarters of 2019, respectively.

In comparison, Chipotle’s peers, Shake Shack, McDonald’s, and KFC under the umbrella of Yum! Brands have reported SSSG of 2.0%, 5.9%, and 3%, respectively, in the third quarter of fiscal 2019.

Now let’s look at what stands out about Chipotle Mexican Grill’s ingredients. And we’ll also look at what getting food from sustainable sources means for CMG investors.

According to the company, Chipotle sources its ingredients from organic and local products. This approach means Chipotle sources its meats from producers with animals that aren’t given antibiotics or growth hormones. The company uses only “Responsibly Raised” meat, which is free of non-therapeutic antibiotics and added hormones. And it also believes in a strong connection between “how food is raised and prepared to how it tastes.”

Also, Chipotle emphasizes animal welfare and locally grown food. This emphasis includes items Chipotle sources within 350 miles of its restaurants. The company professes an ideology that “the less distance food has to travel, the better.”

Organic food

Chipotle Mexican Grill states that a portion of its beans is organically grown. The company sources its cheese and sour cream from cows that don’t receive the recombinant bovine growth hormone (or rBGH). These cows have access to the outdoors and have a pasture-based diet.

McDonald’s (MCD), Yum! Brands (YUM), and Panera Bread (PNRA) have also taken initiatives to educate their customers by listing nutrition count and nutrition calculators on their websites. But let’s turn now to how Chipotle sources its meat ingredients.

Chipotle Mexican Grill claims that it sources 100% of its pork and beef from producers who raise the pigs and cattle outside. The producers say their pigs are fed a vegetarian diet, and their cattle are grass-fed and never given antibiotics. Chipotle believes that using this technique produces better tasting, healthier meat. This approach fits with its “Food With Integrity” campaign.

US law doesn’t allow growth hormones to be used in chickens. However, producers can use antibiotics in chicken feed. Chipotle claims to use naturally grown chickens that aren’t given antibiotics. To find out more about the chicken production process, check out Market Realist’s Pilgrim’s Pride (PPC) overview, An In-Depth Company Overview of Pilgrim’s Pride Corporation.

In October 2019, Chipotle signed the European Chicken Commitment. This initiative aims to improve animal welfare standards by 2026. Also, the company is also committed to enhancing the animal welfare standards in the US and Canada by 2024.

The company is actively spreading its sustainability message through advertising and marketing campaigns. In 2018, Chipotle had spent 2.9% of its total revenue on marketing and promotional compared to 3.5% of its total revenue in 2017. In comparison, McDonald’s and Darden Restaurants have spent approximately 2.9% and 3% of their revenues on advertising and marketing campaigns.

Chipotle’s advertising campaigns

So Chipotle Mexican Grill’s advertising has been able to drive customers into its doors. But how is Chipotle’s advertising different than other restaurants’?

Chipotle is spreading the message by running several advertising and promotion campaigns that overlap with the company’s philanthropic efforts. For example, it established the Chipotle Cultivate Foundation, which aims to grow food “without exploiting the farmers, the animals or the environment.”

To educate its customers about its ingredients, Chipotle had launched Behind the Foil, a documentary-style advertisement for both television and digital channels, in February 2019. It featured a brief preparation of Chipotle’s ingredients, how its farming partners harvest and delivery the company’s real ingredients, and the impact that Chipotle had on the lives of its employees.

In September 2018, Chipotle had launched For Real, an integrated marketing campaign that focuses on the company’s use of real ingredients. Also, the company launched similar marketing campaigns in the past.

So what kinds of customers is Chipotle targeting with these marketing and advertising campaigns? Let’s take a closer look.

On the company’s third-quarter earnings calls of 2014, then-CEO Steve Ells had stated that Chipotle’s customers are Millennials who would “skip fast food in favor of restaurants like Chipotle.” Chipotle credits Millennials, who prefer quality over price, for the company’s high same-store sales growth over fast-food restaurants such as McDonald’s, KFC (under the umbrella of Yum! Brands), and Burger King (of Restaurant Brands).

However, a series of food safety issues caused Chipotle to fall out-of-favor with customers. But since then, Brian Niccol’s initiatives have won customer back. And his enhancements like food safety programs and quarterly food safety training appear to have won investors back over as well.

The company’s new delivery service, digital orders, and pickup shelves have also helped it expand its customer base. In October 2018, the company launched “Chipotle Rewards,” a loyalty program. And at the end of the third quarter of 2019, 7 million members had enrolled in the program.

Chipotle’s key operating costs are:

1. Food.
2. Labor.
3. Other operating costs.

The above chart analyzes Chipotle’s food, labor, and other costs. The vertical bars indicate the expenses in millions over the last five years, and the horizontal line indicates these costs as a percentage of sales. From the above graph, we can see that Chipotle’s cost of food has increased in 2018 to $1.6 billion from $1.54 billion in 2017.

However, as a percentage of sales, the company’s food cost has declined from 34.3% to 32.9%. The increase in menu prices and decline in avocado prices lowered the company’s food costs as a percentage of sales. But the increase in freight costs, as well as tortilla and rice costs, offset some of these declines. In comparison, Shake Shack’s food and paper costs stood at 28.3% of its company-owned restaurants’ sales in 2018.

Labor and other operating costs

Labor, Chipotle’s second key operating cost, represented 27.3% of the company’s total revenues, or $1.33 billion, in 2018. From last year, the company’s labor cost has increased from 26.9% to 27.3% of total sales. Wage inflation was one of the main reasons for higher labor costs. However, the sales leverage from positive SSSG offset some of the increases in labor costs.

Earlier in this post, we saw that Chipotle doesn’t franchise. So all of Chipotle’s labor costs are undertaken by the company itself. For the comparable quarter, Shake Shack, which operates both company-owned and franchised locations, had reported labor expenses of 26.6% of total revenue in 2018.

Chipotle’s other operating costs include advertising and marketing expenses, bank and credit card charges, restaurant maintenance costs, and utilities. These costs accounted for 14% of the company’s revenues in 2018—a fall from 14.6% in 2017. The sales leverage and decline in marketing and advertising expenses lowered Chipotle’s other operating expenses in 2018.

Let’s focus now on Chipotle’s occupancy costs and general and administrative or G&A costs. Also, we’ll see how they impact CMG’s operating income and margins.

Occupancy costs

In 2018, Chipotle’s occupancy costs as a percentage of sales were 7.1% of the company’s revenue, or $347.1 million. Occupancy costs as a percentage of sales fell from 7.3% in 2017. Its occupancy cost has a higher percentage of fixed cost. So sales leverage lowered the cost as a percentage of CMG’s total revenue.

Several restaurants are increasingly trying to use their existing locations to improve operating leverage. For example, McDonald’s and Taco Bell are trying to attract customers to breakfast during nonpeak hours.

G&A expenses

In 2018, Chipotle’s G&A expenses increased from 6.6% of its total revenue in 2017 to 7.7%. Expenses relating to corporate restructuring, annual bonus programs, and biennial all-managers’ conference expenses took the blame for the increase in G&A expenses in 2018.

Operating income and margins

In 2018, CMG reported an operating income of $258.4 million. That year, the company’s operating margin was 5.3%, down from 6.0% year-over-year. From the above graph, you can see that the company’s operating margin has declined significantly from 17% in 2015—before food safety concerns struck the company.

However, in the first three quarters of 2019, CMG has shown significant improvement in its operating margins. For the period, the company reported an operating margin of 8.3%, versus 6.0% in the corresponding quarters of the previous year. CMG’s sales leverage from positive SSSG has helped improve the company’s operating profits over the last three quarters.

In the chart below, you’ll see that Chipotle’s net profit margin took a dive in 2016 due to its food safety struggles. However, CMG is making a significant improvement this year. In the first three quarters of 2019, the company reported net profits of $277.7 million, which represents a net margin of 6.7%. This figure is also an improvement from 4.0% in the corresponding quarters of the previous year.

What boosted Chipotle’s net profits in 2019?

Strong growth, at 13.9%, in Chipotle’s revenue for the first three quarters of 2019 drove the company’s net margins. Also, CMG’s net income got a boost from lower impairment expenses and effective income taxes. For the first nine months of 2019, Chipotle’s effective income tax stood at 22.3%, versus 35.8% in the corresponding quarters of 2018.

But you should note that Chipotle doesn’t have any interest expense. In other words, CMG has no debt.

Good or bad for investors?

Since Chipotle has no debt, investors can claim the company’s profits without worrying about debtholders. However, leverage can drive your return on equity. If the company can generate returns higher than interest rates, financial leverage would be good for the company.

Chipotle’s peer McDonald’s had a debt of $31.1 billion in 2018, while Yum! Brands’ debt stood at $10.1 billion. Shake Shack had a total debt of $20.8 million at the end of 2018 while Potbelly Corporation had no debt.

Chipotle Mexican Grill is still growing without taking on any debt. And that trend makes you wonder how CMG is growing restaurant units. Let’s explore that question now.

Unit growth is equally important for a company to grow revenues. When a restaurant has reached maturity, its revenues are growing at a stable low single-digit rate. And when that happens, a company can supplement its revenue growth by adding more units in newer, untapped markets or locations.

CMG’s correlation between unit growth and revenue growth

The above chart shows the relationship between Chipotle Mexican Grill’s unit growth and revenue growth. In the first nine months of 2019, the company net-added 55 new restaurants. And in 2018, CMG net-added 83 new units. Then, in 2016, it increased its units count by 240 units.

Now, since its food safety issues, the company has slowed down its expansion plans. Due to the disruption from food safety concerns, CMG’s correlation between unit growth and revenue has fallen to 17%. By the end of the third quarter of fiscal 2019, the company operated 2,546 restaurants.

In comparison, McDonald’s operated 38,298 restaurants across the world. Meanwhile, Burger King, has more than 18,232 restaurants. Restaurants such as McDonald’s, Burger King, and KFC have a high restaurant count. But bear in mind that these companies actively franchise their restaurants, and Chipotle Mexican Grill does not.

Let’s look now at how Chipotle is funding its unit growth without incurring any debt. Chipotle sources its capital requirements for new restaurant construction from its cash and investment balance as well as cash flows from operation.

By the end of the third quarter of 2019, the company had cash and cash equivalents of $815.4 million. The company expects to meet its capital requirement for expansion, maintaining and refurbishing its old restaurants, repurchasing shares, and general corporate purposes through already available cash and cash from operations.

Chipotle Mexican Grill doesn’t have high payables because of the nature of its inventory, which is mostly fresh. The company also has the availability to pay within ten days after receiving its ingredients. And this factor lowers its working capital requirements because the company can quickly turn over these ingredients and receive cash from customers.

Why does Chipotle need higher capital?

When a company franchises its restaurants, it doesn’t need to invest its capital in property, furniture, signs, labor, and other restaurant-related operating costs. Restaurant franchisees have to take on these costs instead. The franchisor—such as McDonald’s, Burger King, or Yum! Brands—collects the royalties and fees. And through the franchise model, a restaurant can grow faster.

But there are some downsides to the company-operated model as well as the franchise business model. To learn more, check out An Overview of the US Restaurant Industry.

After tasting success in its first restaurant concept, Chipotle Mexican Grill, Chipotle had introduced two more concepts and two new types of cuisine.

ShopHouse Southeast Asian Kitchen

One of Chipotle Mexican Grill’s new concepts is ShopHouse Southeast Asian Kitchen, which served southeast Asian cuisine. It used the same assembly-line format as Chipotle Mexican Grill. The company had opened 15 restaurants. But in March 2017, CMD decided to shut down all the 15 restaurants.

Pizzeria Locale

Chipotle’s second new concept is Pizzeria Locale, which serves—you guessed it!—pizza. The restaurant uses a format similar to the Chipotle Mexican Grill assembly line. A customer can order a classic pizza or build one. The customer starts by choosing a red or white base. They have a variety of toppings available, not unlike the format of Domino’s Pizza (DPZ), Papa John’s (PZZA), and Yum! Brands’ Pizza Hut.

But Pizzeria Locale differentiates itself from these successful chains by having the “pizza made in front of you in minutes.” By the end of the third quarter of 2019, CMG operated two Pizzeria Locale restaurants.

Now let’s look at Chipotle Mexican Grill’s stock performance over the last few years and see what Wall Street analysts’ estimates are for the company’s key metrics.

In the above chart, you can see that Chipotle Mexican Grill stock has underperformed its peers since the beginning of 2015. If you had invested $1,000 in Chipotle at the beginning of 2015, you’d have earned 19.1% returns as of December 13. However, during the same period, McDonald’s, Yum! Brands, Domino’s Pizza, and the S&P 500 Index have returned a much more considerable 110.4%, 213.2%, 91.1%, and 53.9%, respectively.

Nevertheless, Chipotle stock has delivered strong performance over the last two years. And since the beginning of 2018, the company has returned 182.1%. Meanwhile, peers McDonald’s, Yum! Brands and Domino’s Pizza as well as the S&P 500 Index have returned 14.5%, 56.1%, 22.7%, and 18.5%, respectively.

Chipotle Mexican Grill is scheduled to report its fourth-quarter earnings of 2019 on February 4. For the quarter, analysts are expecting the company to report revenues of $1.40 billion, which implies year-over-year growth of 13.9% from $1.23 billion in the fourth quarter of 2018. Also, analysts are expecting the company’s adjusted EPS to rise 56% to $2.68.

Analysts’ recommendations

Of the 35 analysts who follow CMG stock, 15 analysts have a “buy” rating as of December 13. Meanwhile, 17 analysts have a “hold” rating while three analysts have a “sell” rating. Analysts’ consensus price target stands at $851.36, which implies a 12-month return potential of 4.4%.

Originally published in December 2014 by Adam Jones, this post was extensively updated in December 2019 by Rajiv Nanjapla.