Chipotle’s a Buy, But Yum Brands Has to Go

by Will Ashworth | July 10, 2013 6:45 am

Noodles & Company’s (NDLS[1]) impressive 150% return since going public June 27 has begun to overshadow another fast-casual superstar — Chipotle Mexican Grill (CMG[2]), which is having a pretty good year by its own right, up 30% through July 8.

Although Noodles & Company has several executives on its management team that once worked for Chipotle, Steve Ells — CMG’s founder — is still the creator of better and healthier fast food. He’s the master. And when it comes to burritos, there’s no comparison between Chipotle and Yum Brands (YUM[3]), its low-brow competition.

For this and several other reasons listed below, I believe investors should buy Chipotle and sell Yum Brands:

  1. Sales: Chipotle’s comparable restaurant sales increased by 7.1% in 2012, with price increases accounting for 2.8 percentage points of the growth, and additional customer visits the remainder. This compares favorably to Yum Brands’ U.S. division at 5%. Yum investors could argue that Taco Bell — Chipotle’s real competition — saw same-store sales growth of 8% last year. I would argue that unless Yum Brands spins off Taco Bell into its own company, the real figure includes both KFC and Pizza Hut at 3%, respectively.
  2. Margins: Chipotle’s restaurant margin in 2012 was 27.1%, 110 basis points higher than in 2011, and 66% better than Yum Brands U.S. Chipotle went public with restaurant margins of 18.2%. Since then, it has been able to increase them by 890 basis points, or 148 per year. In terms of sales per store, the average Chipotle generates $2.1 million in revenue and $573,000 in restaurant profit compared to $1.5 million in revenue and $244,000 in operating profit for Yum Brands’ U.S. division. Despite being public for seven years, Chipotle still is delivering above-average growth.
  3. Balance Sheet: If you compare the two companies’ financial situation, it’s pretty clear that Chipotle has the better balance sheet. Chipotle’s net cash position is $508 million, while Yum Brands sits with $2.2 billion in net debt — a difference of $2.7 billion. In addition, Chipotle’s leveraged free cash flow per share is 4.3% of its stock price, compared to 2.9% for Yum Brands. Not only does Chipotle have a better financial position, but it’s also a better buy in terms of free cash flow.
  4. Expansion Potential: 70% of Yum Brands’ operating profit in 2012 was generated by its China and Yum Restaurants International segments. Its future growth prospects are much slimmer than Chipotle’s, which has a mere 12 locations open outside the U.S. While Yum Brands has had good success overseas, it’s eventually going to run out of possible locations. In the meantime, Chipotle can continue to learn about the new markets it has opened and get the formula right. Until then, it can operate a very successful domestic operation, which now includes the ShopHouse Southeast Asian Kitchen brand with one restaurant in Washington D.C., one in Los Angeles and eight more on the way. Stephen Anderson of Miller Tabak + Co. believes Chipotle can add 300 to 400 within the next 10 years. It might not have the top-line growth of Chipotle, but it adds a potent second brand.
  5. Valuation: Chipotle has an enterprise value to EBITDA of 20.2 — half of Noodles & Co.’s 40, but much higher than Yum’s 12.3. Together, NDLS and YUM average an EV/EBITDA multiple of 26.2, suggesting a stock price of $501 (CMG trades at $387). You can argue all you want about whether Yum Brands is undervalued, but in my opinion Chipotle appears to be operating better than both Noodles or Yum. It might not be worth an enterprise value of 40 times EBITDA, but it definitely should be higher than 20. I’m not sure you can say the same about Yum, which essentially sold most of its U.S. stores back to franchisees over the past two years to pay for growth in emerging markets[4] … only to return its focus to the U.S. with GDP growth in these markets now slowing.

Bottom Line

A novice investor will look at Chipotle’s Q1 and assume it was a poor quarter because same-store sales grew by just 1%. But they’d be wrong. Remember: Comp growth is only useful if it’s profitable growth; in the first quarter, Chipotle saw earnings grow 24.4% year-over-year to $2.45 per share. I’d rather have 1% comps with healthy profit growth than healthy comps with mediocre profits.

After all, a business is only a business if it makes money.

On that score, Chipotle continues to do very nicely. Overall, CMG just looks head-and-shoulders better than Yum Brands.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

Endnotes:
  1. NDLS: http://studio-5.financialcontent.com/investplace/quote?Symbol=NDLS
  2. CMG: http://studio-5.financialcontent.com/investplace/quote?Symbol=CMG
  3. YUM: http://studio-5.financialcontent.com/investplace/quote?Symbol=YUM
  4. pay for growth in emerging markets: http://investorplace.com/2012/05/the-dark-side-of-yum-brands-china-strategy/

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