Image Source: Valuentum
Chipotle and Domino’s Pizza have very little in common, in our view, but let’s take a look at what has been causing volatility in each company’s stock of late.
By Kris Rosemann
Burrito giant and once-beloved Chipotle (CMG) continues to attempt to battle back to prominence in the fast-casual restaurant space–an area in which it was once the golden child but now looks to be a prodigal son at best. The burrito-maker’s comeback story experienced a bit of a setback as shares dropped nearly 15% in the trading session October 25 after releasing third quarter 2017 results after the close October 24. Revenue grew nearly 9% in the period on a year-over-year basis in the quarter, restaurant level operating margin expanded 2 percentage points from the year-ago period to 16.1%, and net income more than doubled compared to the third quarter of 2016 to just under $20 million.
However, comparable restaurant sales advanced a meager 1% at Chipotle in the third quarter, a figure that may not have been as significantly disappointing had comps not dropped 22% in the comparable period of 2016. Such performance suggests the company’s recovery is lacking any form of meaningful momentum. Management continues to expect comparable restaurant sales growth of 6.5% in the full year 2017, but the Street was clearly very disappointed in the lack of progress being made at the firm in returning to pre-food safety crisis performance levels.
Let’s be clear, Chipotle is not going away anytime soon. The company remains materially free cash flow positive, it holds no debt on the balance sheet, and it is growing–management expects to open just under 195 restaurants in 2017 and 130-150 more in 2018. However, expectations from investors continue to be reset lower in a material way, and we can’t conclude with any sort of certainty which reset will eventually prove to be appropriate (this line of thinking is in part why we employ a fair value range in valuation). Such is the nature of consumer facing concepts, too–consumer preferences can change on a dime with little-to-no warning–and a reality that is accentuated in a meaningful way by the recent public safety issues Chipotle has been battling.
Image shown: Chipotle’s stock has been punished since late 2015 as food scandal after food scandal has scared investors away.
Management has worked to stir up renewed interest from consumers and investors with new items such as queso and to stem fundamental deterioration with initiatives such as pricing increases, but it appears as though neither is generating the response as had hoped. A clear path to recovery for Chipotle may not exist, and while we assumed it would have an uphill battle in returning to pre-crisis performance levels, we have underestimated just how steep a grade it will face. After resetting our top-line growth trajectory, we’ve reduced our fair value estimate for shares to $350 at the time of this update. However, we would not be surprised to see shares continue to languish in the lower half of our fair value range, which is wider than that of a typical company in our coverage universe due to the amount of uncertainty surrounding the firm’s future free cash flow trajectory, as a result of the ongoing consumer-perception and competitive risks that it continues to struggle with.
Yum Brands’ (YUM) Taco Bell and Jack in the Box’s (JACK) Qdoba have been a prime beneficiaries of Chipotle’s troubles, in our view, though arguably the former more than the latter. Yum Brands’ Taco Bell Division system sales increased 7% in its fiscal second quarter, as it opened 56 new restaurants. The Taco Bell Division restaurant margin advanced 0.5 percentage points during the period thanks in part to better-performing existing restaurants. In August, Jack in the Box CEO Lenny Coma had the following to say about the fundamental trajectory of Qdoba (of which a spinoff is a possibility in the near term):
System same-store sales at Qdoba restaurants turned positive in the quarter, as guests responded favorably to menu innovation, including the launch of Fire-Roasted Shrimp. Company restaurant margins at Qdoba improved sequentially to over 16 percent in the quarter as we were able to manage labor costs more effectively.
As competition remains hot in the “Mexican-style” restaurant-themed markets, Domino’s Pizza (DPZ) can be considered in some ways the anti-Chipotle in terms of the consistency of its performance of late. The third quarter of 2017, results released October 12, marked the 95th consecutive quarter in which the company was able to grow its international same store sales (up 5.1%) and the 26th consecutive quarter of positive sales growth in its domestic business. Domestic same store sales jumped 8.4% in the quarter on a year-over-year basis. In addition, the firm added 53 net new domestic stores and 164 net new international stores and has added 1,182 net new stores over the past four quarters–all the while the company has remained impressively free cash flow positive.
Domino’s is able to run a capital-light business, a driver of its free cash flow generating prowess, thanks to it its highly franchised business model. As of the third quarter of 2017, the company had 14,434 total stores, of which only 399 were company-owned. That’s a 97% franchise rate, and all of the company-owned stores are located in the US. Such a business model is also the driver of the company’s tremendous Economic Castle rating, which currently ranks as one of the highest in our coverage universe. Through the first three quarters of fiscal 2017, Domino’s reported free cash flow of ~$183 million, up from just over $124 million in the comparable period of fiscal 2016.
However, the company holds a material debt load that totals nearly $3.2 billion, and though we would expect its free cash flow generation to be able to manage the obligations associated with such a debt load, management has been scooping up its own shares at a tremendous rate, a practice we are even less fond of after considering the premium to our fair value estimate at which shares have traded of late. Through three quarters in fiscal 2017, the firm has repurchased more than $1 billion of its own shares while raising (on a net basis) a similar amount of debt. Holding such leverage is directly in-line with management’s strategy, as its most recent investor presentation pegs its debt-to-EBITDA ratio at 5.9 times–within its target range of 3x-6x. We peg its net debt-to-EBITDA ratio at 5.8 times as of the end of the third quarter of fiscal 2017 after annualizing its 9-month EBITDA performance.
Though we are big fans of Domino’s Pizza’s franchise operating model, its massive debt load is simply impossible to ignore. It may be one of the few entities on the market with a dividend yield of ~1% that trades at more than 32 times current year consensus earnings estimates, while holding a leverage ratio near 6 times. It is also worth noting that the market has become accustomed to the company’s tremendous performance of late, and one need look no further than its fiscal 2017 second quarter report for evidence of this. Shares have been a bit more volatile in recent months as a result but continue to trade in the upper half of our fair value range and well above our fair value estimate of $159.
Image shown: Domino’s stock has been one of the best performers in recent years thanks to its focus on digital ordering and its capital-light business model.
Despite Domino’s Pizza’s impressive consistency in recent years and lofty Economic Castle rating, we continue to view shares as a highly-volatile, high-beta consideration, which may not be for everyone. A massive debt load and tremendously high expectations from the Street are not characteristics of a typical Valuentum stock, and neither is a current P/E ratio in the low 30s range. Similarly, Chipotle’s fundamental struggles and brand-quality deterioration keep it from garnering material consideration from us. Though shares of Chipotle have been beaten down badly, we don’t view Chipotle as particularly undervalued at the moment, and a great deal of the “hair” surrounding the company would have to be trimmed before we contemplated adding exposure to a restaurant that was once battling for the king of fast casual crown. How far Chipotle’s perception in the eye of the ‘consumer’ has fallen…
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