On Oct. 2, 2012, Greenlight Capital’s David Einhorn described his latest short idea at an annual value investment conference. This time, Einhorn targeted Chipotle Mexican Grill, Inc. (NYSE:CMG). Einhorn outlined the bearish case for the company and focused on two points.
First, he argued that Chipotle Mexican Grill, Inc. (NYSE:CMG)’s business was vulnerable to competition. Jeffrey Gundlach, a famous bond investor, supported Einhorn and stated that “All you need to compete with CMG’s core business is a taco truck.” In other words, it doesn’t take a scientist to make burritos, and everyone can do it successfully enough to become the next Chipotle. This obviously implies that the company has no economic moat whatsoever.
The second point that Einhorn made was about Chipotle Mexican Grill, Inc. (NYSE:CMG)’s valuation. At the time Einhorn first disclosed his short recommendation, Chipotle was trading at an overly rich price-to-earnings of 60x. Einhorn claimed that this valuation was extremely high and unsustainable, especially for a consumer discretionary food business.
But in order to obtain a wider perspective on Chipotle, let’s look at it in the light of other two dominant quick-food-service chains – the giant McDonald’s Corporation (NYSE:MCD) and the tasty Panera Bread Co (NASDAQ:PNRA).
Chipotle will do just fine
I believe that in contrast to Einhorn and Gundlach’s beliefs, Chipotle Mexican Grill, Inc. (NYSE:CMG) will perform well over the next few years, and that’s for the following three reasons.
I think it’s plain silly to say that anyone with a taco truck can compete with Chipotle. It’s like saying all you need to compete with McDonald’s is burger patties and a flattop grill. The fast food sector, as a whole, is very competitive. But once you are able to establish your brand, distinguish it from the rest and make people return to you – then is when your business becomes highly lucrative.
For example, both McDonald’s and Chipotle Mexican Grill, Inc. (NYSE:CMG) enjoy a high profit margin of 30% and 20%, respectively. Such a high profit margin is a great indication of having a sustainable economic moat. In all other cases, such high profit margins aren’t supposed to exist in a truly competitive environment. Panera Bread Co (NASDAQ:PNRA), for example, lags in that aspect — it’s only able to show an operating margin of 13%, which means that some of its rivals are slowly biting into its bottom line.
It’s all in the growth
Chipotle’s business has been growing … and fast. Sales have doubled the last five years and earnings have risen 270%. Chipotle is consistently profitable, with double-digit net margins. The number of restaurants is up 30% in the last three years.
In the most recent quarter, the company reported earnings of $2.45 per share, beating the Zacks Consensus Estimate of $2.14 per share by 14.5%. The earnings grew almost 24.4% from the prior-year quarter, driven by higher revenues, lower taxes and share count.
True, the company’s high price-to-earnings is a bit stretched, but it certainly a far cry from the multiples of various social media companies like LinkedIn Corp (NYSE:LNKD) or Yelp. At a current price-to-earnings of 40x, Chipotle Mexican Grill, Inc. (NYSE:CMG) trades at a little more than twice the average S&P of 18 times earnings. It’s high, yes … but it also grows at four times the rate of an average S&P company. Whereas McDonald’s Corporation (NYSE:MCD), for example, increases its earnings by 1% year-over-year, Chipotle is able to show a magnificent 14% increase in earnings.