Very few investors probably remember that Chipotle (CMG) used to be owned in part by McDonald’s (MCD). McDonald’s had originally taken a stake in Chipotle in February 1998, when Chipotle had but 14 restaurants in Denver. The maker of the Big Mac would go on to own 90% of the subsidiary and eventually spin it off in an initial public offering in January 2006. McDonald’s would receive ~$1.5 billion from the sale, but with Chipotle’s market capitalization now at over $20 billion, it’s clear the burger-and-fries behemoth exited way too early. The most recently-reported results by both restaurants tell the diverging story quite well.
McDonald’s reported relatively disappointing second-quarter results Tuesday. The performance can best be described as flat. Global comparable sales were flat, consolidated revenues were essentially flat, and consolidated operating income was flat (declining modestly in constant currencies). Diluted earnings per share of $1.40 increased modestly, but this was driven in part by share buybacks. McDonald’s continues to be very shareholder-friendly, however, and returned $1.6 billion to shareholders through dividends and buybacks during the period.
Same-store sales in the US at McDonald’s fell 1.5% as a result of “negative comparable guest traffic amid ongoing broad-based challenges.” The restaurant chain that sports the golden arches continues to be squeezed by Starbucks (SBUX) and Dunkin Brands (DNKN) in the premium coffee segment and by Yum! Brands’ (YUM) Taco Bell, Burger King (BKW), and even Subway, among others, in the breakfast arena. McDonald’s Asia-Pacific Middle East and Africa (APMEA) same-store sales results were the bright spot in the quarter, advancing 1.1%, but this was driven by strong comparable sales performance in China. We would expect significant pressure in the APMEA region during the third quarter as a result of the recent poultry sourcing “scandal.” Management has already indicated that July global comparable sales are expected to be negative, but we think there is more risk to the downside as a result of this event.
Chipotle, on the other hand, continues to put up impressive results. The company’s second-quarter results showed revenue increasing nearly 29% and comparable restaurant sales leaping an incredible 17%. Net income growth was north of 25%, and diluted earnings per share expanded ~24%, to $3.50. There are few other restaurants that can come anywhere near the pace of such same-store performance. For comparison purposes, Yum! Brands’ Taco Bell is having one of its best same-store growth streaks in recent memory, but the chain’s US same-store sales advanced only a modest 2% in the second quarter—and this growth has been fueled by a flawlessly-executed and successful national breakfast launch and a well-received and innovative Cantina Bell menu. Chipotle now expects mid-teens comparable restaurant sales increases for the full-year 2014, up from high-single-digit expectations previously.
Valuentum’s Take
Though McDonald’s expects to return as much as $20 billion as part of its 3-year cash-return target between 2014-2016—a range that is 10%-20% above the amount of cash returned in the prior 3-year period—we think its prospects as an income vehicle have waned (at least temporarily) for dividend growth investors. We can think of a variety of firms in the Dividend Growth portfolio that can deliver both a better dividend yield and dividend growth prospects than the inventor of the Big Mac.
Chipotle is not listed as one of the most overvalued stocks on the market for no reason. The firm is clearly a great concept with tons of growth ahead of it, but growth is a component of value, and its shares are far from cheap at present–even after factoring in rapid and sustainable expansion. Readers, however, should expect an upward bias to our existing fair value estimate of Chipotle upon the next update, but the share price will most almost certainly still reside above the updated fair value range.
Only investors that have the view that Chipotle will exceed the rapid growth prospects already embedded in its current price should consider dabbling in shares. The value and price of a stock is based on future expectations of earnings and cash flows, and at ~40-50 times expected 2014 earnings, the company should only be considered an idea for the investors/speculators with the highest of risk appetites.
Even a minor slip-up at Chipotle could send shares tumbling 15%-20% or more, and the market (and us) would think nothing of it. Perhaps needless to say, you won’t find us going anywhere near Chipotle at present levels (~$660 per share).