Image: Chipotle’s shares look like they are poised to break out of a downtrend on news that its long-term unit restaurant opportunity is bigger than expected and that its pricing power remains intact.
By Brian Nelson, CFA
Chipotle Mexican Grill, Inc. (CMG) and Domino’s Pizza Inc. (DPZ) are two of our favorite restaurant ideas, with the former and Yum Brands’ (YUM) helping to drive restaurant stocks higher after the market’s reaction to their respective calendar fourth-quarter reports during the trading session February 9, 2022.
Year-to-date, the AdvisorShares Restaurant ETF (EATZ) has held up better than most other investable areas, down modestly, and we think the relative strength is a big win for investors in the restaurant sector in light of the pressures many restaurants have faced as a result of the coronavirus (“COVID-19”) meltdown.
From what we can tell by the lack of negative news flow, Chipotle has put its food scandal issues of yesteryear behind it, and CEO Brian Niccol is a big reason behind that. Having turned Yum Brands’ Taco Bell around, the new Chipotle CEO has done a masterful job navigating the firm through the COVID-19 crisis to come out the other side with even brighter opportunities and long-term expansion potential.
During the fourth quarter of 2021, Chipotle revealed total revenue growth of 22% thanks to strong comparable restaurant sales expansion of 15.2% and continued resilient digital sales growth, which now accounts for ~41.6% of quarterly revenue. It was nice to see that Chipotle’s operating margin advanced 80 basis points during the fourth quarter on a year-over-year basis and that adjusted diluted earnings per share leapt an impressive 60%+, to $5.58 per share.
We liked how Chipotle was able to manage costs and drive continued revenue growth at this stage of the economic re-opening cycle, and we expect continued strong performance during the first quarter of 2022, with management targeting comparable restaurant sales growth in the mid-to-high single-digit range. What was most exciting, however, was Chipotle’s revised long-term unit development outlook:
Based on the success of small-town locations that are delivering unit economics at or better than traditional Chipotle locations, we provide the following update to our long-term development opportunity: Over time, we believe there can be at least 7,000 Chipotle restaurants in North America, up from the prior goal of 6,000 restaurants. Given the healthy and improving cash on cash returns, we are building a real estate pipeline that will allow us to accelerate unit growth to be in the range of 8% to 10% per year, with greater than 80% of new restaurants having a Chipotlane.
Note, at the end of December 2021, Chipotle had ~2,950 restaurants in the United States, Canada, the United Kingdom, France and Germany, so the upward revision to its long-term market opportunity in North American is nothing short of huge. Investors loved the news.
Image: The AdvisorShares Restaurant ETF is trying to break out of its downtrend, too.
Chipotle mentioned in its fourth-quarter press release that food, beverage and packaging costs advanced 60 basis points as a percentage of revenue during the fourth quarter of 2021 on a year-over-year basis–especially beef, freight, avocado and wage costs. As with most companies across the restaurant sector, menu price increases will be key to offset inflationary headwinds. Given Chipotle’s premium tilt to a higher-end consumer, we think the burrito maker will be able to push through menu price increases, as needed, but perhaps not too aggressively as to cede market share to other fast-casual providers.
Here’s what Chipotle said on the call regarding an early look at 2022:
As we look ahead to 2022, there remains uncertainty on several fronts, including COVID impacts as well as staffing and inflationary pressures that limit our visibility, and therefore, make it difficult to provide full year comp guidance. These headwinds were significant in January, which also included some challenging weather, which led to a January comp of around 5%. We remain optimistic that as these challenges ease that our comps will accelerate from the January level. While it’s difficult to predict the comp for Q1 with precision, we expect it to land somewhere in the mid to high single-digit range, assuming the effects of COVID continue to subside.
There’s no doubt our restaurant-level margin is messy in the near term. So let me provide some perspective on Q4 and what we expect moving forward. Besides ongoing labor pressures, our Q4 margin was impacted by a higher level of commodity inflation than we originally expected, primarily due to elevated beef and freight costs. As a result, we took a 4% menu price increase in the middle of December to help offset these headwinds.
Given the timing of this pricing action, it had little impact in the quarter, resulting in our Q4 margin being at the lower end of our 20% to 21% guidance range. However, if you look ahead to Q1 where we will see the pricing benefit for the full quarter, our restaurant level margin is expected to be nearly 22% and normalizing for the elevated marketing spend expected this quarter as well as transitory COVID-related cost pressures, the underlying Q1 margin would be in the low to mid-23% range.
The bottom line is that our underlying margin remains healthy, and we believe we still have pricing power to use as needed if inflation continues to rise going forward. Of course, we’ll be thoughtful and patient as we consider these actions to make sure we continue to deliver an excellent value and dining experience to our guests.
Concluding Thoughts
There are a number of restaurant bellwethers, including Starbucks (SBUX), McDonald’s (MCD) and Yum! Brands that offer dividend yields in 1.8%-2.2% range and that may be great for dividend growth investors to consider, but Chipotle is cut from a different cloth.
Its fast-casual focus and premium food offerings coupled with its Chipotlane rollouts and its breakfast “call option” are a few things that give the company a runway for continued strength that may be unprecedented by an established brand, particularly as it sees an even greater opportunity for unit development in North America than it did before.
Because it serves a higher-end fast-casual customer, we think product pricing ahead of inflation won’t be an issue (helping to augment margins), and we’re reiterating our fair value estimate of ~$1,640 per share, above where shares are currently trading at the time of this writing (~$1,580 per share). A more optimistic take on Chipotle could see shares reach the higher end of our fair value estimate range of ~$1,970 per share.
Related: EATZ, PEJ, PSCD, UBER, GRUB, DASH
Tickerized for holdings in the EATZ.
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Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson’s household owns shares in HON, DIS, HAS, NKE. Some of the other securities written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.