Chit Chat Stocks - Chipotle (CMG) | Not So Deep Dive

Episode Date: July 19, 2022

Chipotle Mexican Grill, more commonly known as Chipotle, owns and operates thousands of restaurants. The company was started in 1993 in Denver, Colorado. Listen closely as Brad, Brett, and Ryan go through the history, financials, and future prospects of Chipotle. Enjoy the show! ******************************* You can listen to this episode by subscribing to CCM+ for $5 a month. Sign-up directly through Spotify or Apple Podcasts. If you listen on another podcast player, use this link and create a private RSS feed: https://anchor.fm/chitchatmoney/subscribe Need more information? Check-out our launch newsletter: https://chitchatmoney.substack.com/p/welcome-to-chit-chat-money-plus Questions? Email us at [e-mail] ****************************** Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (2:00) Industry | (9:43) Management & Ownership | (11:18) Earnings | (16:19) Balance Sheet | (18:55) Valuation | (20:02) Our Analysis | (21:45) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome in. This is the Tuesday Not-So-Deep-Dive episode on Chit Chat Money. And this week, we have our monthly recurrence with Brad Freeman, and you chose Chipotle. You said you use this as

kind of stocks going on your watch list that we might want to research together. So I guess, first thing, why did you choose Chipotle? Is it because the price is down? Do you like the burritos? What was it? Yeah, it's all, I mean, the burritos are delicious. So let's just start there. But other than that, just fantastic brands. Clearly they have pricing power just through news over the last several months. And we've really seen, I mean, if you look at any commodity chart and that's their input costs, they've just gone through the roof and pricing power is really valuable in that environment. But then the flip side of that is, well, commodities are probably going to normalize with their boom-bust cycle, and there's going to be

some kind of bust. So if that pricing power is sticky enough, there could be a lot of margin upside from this crazy volatility that we're getting right now. So that paired with the fact that it's gone from, what, like 80 or 90 times earnings to about 40 times earnings, um really love the ceo i think he's done a phenomenal job so watch i actually maybe i'll stop talking because i don't want to get the whole show brad that is a great we're going to talk about all those uh the dynamics of all that stuff uh throughout the episode first though ryan do you want to introduce i think most listeners understand what chipotle does this is thankfully was an easier show to research because it wasn't a software as a service company but what does

chipotle do yeah well it's turning into a software as a service company brett oh yeah well don't forget chippy what is chippy well we'll get to that okay all right well let's save that uh so i'll go through what they do pretty quickly and then kind of focus more on the history because it's pretty fascinating but chipotle is a fast casual mexican food concept in which all the locations are owned and operated so it's not a franchise model uh there was at one point like a few franchise stores during the McDonald's ownership spurt, which we can talk about in a second, but now it's all owned and operated. And the model's really quite simple. They've got 53 total ingredients that Chipotle does, and they give customers a selection of customizable menu

items to choose from. So once a customer has gone up, chose what they want, they go through an assembly line ordering process where they can add various ingredients that they would like to um, have on their meal until it's complete. And usually from start of your order process to checkout, it's like a minute, maybe less. So it's very quick. Um, it's sort of a subway concept and there's been a lot of, uh, copycats in the restaurant industry, like Cava sweet green, where it's basically the Chipotle of blank. Um, and so they, they really kind of pioneered that model, uh, as for the supply chain component, because, you know, everyone's seems to be talking about this right now, Chipotle has 25 independently owned and operated regional

distribution centers that purchase from a range of local suppliers. So they pride themselves on ordering what they call responsibly raised foods. They're really trying to have high quality produce. And then they, so they ship those items or those ingredients to the 3000 US location based on, you know, whichever distribution center the stores are closest to. That's the basics of their supply chain. And then each Chipotle location averages about $2.6 million in revenue a year. That's, and about 46% of their sales are digital. So you could maybe round up and say half digital, half in person. Hey, can you explain, because digital, what does that mean? So digital can be a number of things it can either be um like third-party delivery services so uh things

like doordash grubhub or it can be online you order in the app and you go and pick it up uh anything that's ordered through the app uh i'm trying to is there any other sources i guess the website i guess it's probably a pretty small portion but website as well website sorry burrito nfts are becoming very hot that is true and well the roblox version as well that was a joke i'm sure everyone knows that but i i need to make it clear in case somebody didn't yeah i wonder if you could actually when they did that roblox thing you could actually order through there was that possible i'm honestly not sure uh but i think we're getting a little sidetracked so each uh each location does about 2.6 million dollars in revenue and just under 600 000 in

in operating profits a year. That excludes their corporate expenses. So purely just restaurant level operating costs. If you deduct those out, you're getting about $600,000 in operating profits a year. As for the history, Chipotle was founded in 1993. It was founded by Steve Ells. He had gone to culinary school. He had gone to, I think it was CU, University of Colorado, Denver, or it might have been Boulder, but he went to college in Colorado. And in the early 1990s, he was working as a chef in San Francisco. And he had aspirations to build his own fine dining restaurant. That's what his dream was, but he needed the cash to do it. So at the age of 28, on an $85,000 loan from his father, he opened a burrito shop in Denver, Colorado. Apparently there were a lot of these

sort of fast casual type Mexican food places in San Francisco, but they hadn't really seen that model in Colorado. And so the first shop was in Denver. The goal was basically to have this just be a cash cow that would finance his fine dining restaurant. He figured that if they could sell, I think it was 107 burritos a day, the business would be economically viable. I think they sold more than a thousand a day within a month. So they were off to a pretty good start and more and more people kept coming in. Apparently when kids or when all the students came back to school, they really started to grow. And after a few months, they were profitable enough for Steve to be able to pay back his father. A year and a half later, Steve Ells was having so much success with his

first location that he opened a second one with the cashflow from the original restaurant. And by 1996, they added a third with a small business loan. Around this time, they began to sort of professionalize the whole operation. They added a board of directors. Steve Ells' father invested an additional one and a half million, and they also raised some outside capital. And then in 1998, McDonald's gave them $360 million of growth capital and became the largest investor in the company. At one point, I think they had 90% ownership of the business and they largely let them run their own operation. Their eventual liquidation, $360 million investment turned into, I think, a billion and a half. So it was a good investment on their part, but they sort of wanted

them to get into the franchise business. They tried it out, basically ended up shutting those down. And part of the ironic part as well, they also said, you know, maybe you should try drive throughs. And Steve Ells said, no, we're not interested in that, which is kind of funny, given that they're getting back to that. Well, they're not, they're Chipotle Wayne's. All right. Whatever you want to call it. I'm sorry, but that's, that's so clever. It's a clever name. It's funny though, that they will not say drive through. I've not heard him say that. Anyway, fast forward to 2006. They've got a little over 500 stores. They go public. I think the stock jumped more than 100% on the first day.

McDonald's liquidated their stake. Everything was going pretty well up until about 2015 when there were E. coli and norovirus outbreaks at several of their locations in Washington and Oregon that led to about 1,000 people falling ill. After that terrible news cycle, same-store sales declined by about 30% to 40%. The stock dropped as much as 70%, which led Bill Ackman's firm, Pershing Square, to take a 10% activist stake. I believe there were already investors, but this allowed them to buy more into the business and provoke more change. They replaced Steve Ells, the CEO, with Brian Nickel,

who was the ex-Taco Bell CEO. This ended up being a really good change. They also began revamping their supply chain model. If you want to know, I guess, how they revamped their supply chain model so that it was more sanitary and it de-risked any illnesses, there's a good episode on business breakdowns that covers it as well. And he goes into sort of the actual precautions they took. And then they began also investing heavily into their digital offering. Since that point, the stock is a five bagger. It was, I think, almost a 10 bagger a year ago, but the stock has since come down. So that's a little bit about the business. It's been sort of a wild ride over the last six years. But kudos to Bill Ackman for having the foresight to think this is a good brand

with temporary problems that they could turn around. That's right. And he also, I don't know if he does this, but he claims he eats lunch at Chipotle. There's a funny picture of him in line at Chipotle online, if you want to find that for Bill Ackman as a side note. but let me hit industry and competition. Very simple one. We've discussed before past restaurant concepts like Sweetgreen or Portillo's. I believe those are the ones we've covered recently. And the restaurant industry is really easy to understand. People need to eat and all these places are competing for where customers are going to spend. Total restaurant spending in the United States was estimated to be at $799 billion in 2021. And that is down around $65

billion from 2019. So in 2021, there was still lingering COVID effects. And you can kind of, at least as the industry as a whole, they should get volume. It depends how they, I guess there's some macroeconomic factors that could tighten consumer pocketbooks, but they should get more volume in 2022 as we kind of recover to those 2019 levels. And then if we look at competitors, again, there are some close ones, which I'd probably say, you know, Panera Bread, Sweet green, maybe a Panda Express, that lunchtime place that a lot of people go to that are those quick service chains. But, you know, listeners are going to know many others. We don't have to talk about them all here. I know they're probably competing more with a sweet green than probably

a McDonald's, but they really are competing with McDonald's as well. And again, I would really focus on the lunch crowd. And that is, I guess, in your mind as an investor, that is where you got to focus and have their, their value proposition, uh, you know, that, that fast lunch rush, getting in, getting out, um, that is their bread and butter for what they're offering to customers. All right, Brad, do you want to talk management and ownership? Not much, I guess you'll probably know this, but not much insider ownership, right? Yeah. Um, so leadership teams changed hands a couple of times. You had the 90% McDonald's stake and they liquidated. So, um, not super surprising, but like you said, very little insider ownership, but starting with the, the, the team,

Brian Nichols, the CEO, a very impressive resume CEO of Taco Bell for four years before taking over. The president of Yum! Brands and the CMO there before that. And then before them, one of Yum! Brands' brands, which is Pizza Hut, he was the GM and CMO of them before that. So some really impressive experience with a very successful restaurant conglomerate. Jack Hartung is the CFO. He's been there since 2002. too. So that was music to my ears. He's been there for 20 years in that role. That's his only experience item on LinkedIn. So just to give you an idea of how much of a Chipotle homer this guy is, which we love to see. That's impressive. I know. Kurt Garner is the CTO. Been there since

2015. So we talked about Bill Ackman coming in and saying it's time to invest heavily in digital. And this was the guy they brought in to kind of spearhead that along with Brian Nickel. Yeah, Ryan, go ahead. Yeah, and Bill Ackman or Pershing Square, I believe, had a period where they, prior to their big investment in Chipotle, had invested in Starbucks and seen how successful their digital transition was. So that was part of the push towards Chipotle. And I imagine the inspiration for bringing in Kurt Garner. Yeah, because, I mean, his resume, he climbed the ladder with Starbucks for over a decade to some executive roles and senior roles. So that would make a lot of sense and good added color in terms of direct

ownership. Now we'll get into restricted stock units and preferred stock units, but in terms of direct equity ownership, nickel and hard tongue and then all directors and executives together, actually let's start with nickel and hard tongue. They own way less than 1% of the company and then combined all directors and executives on 1.01%. But then you've got Vanguard and T-Row price and BlackRock owning 23, 24% of the company combined.

um there are another 526 000 shares uh in future options to be issued so compared to total stakes right now that's about double the the outstanding common equity that that all directors and executives own right now also keep in mind nickel got a 12 million dollar bonus in 2021 uh his team members got another 12 million um yeah so his his um his compensation he got paid he gets paid about a million dollars a year in equity compensation and 18 million total um among options packages and stock packages and restricted stock units all these vehicles that they pay him and pay their their leadership team aggressively um to compensate so while they have way less than one percent outright they they do have um some pretty hefty packages in terms of equity stakes that they're

paid out pretty much every year yeah and i did see you have a note here that they're getting their bonuses are based on cashflow. I think I saw it was also based, like part of it was comp sales as well. I really liked seeing that. Right. So the PSUs, and I think I didn't even check this. So if it's not preferred stock units, I apologize. I think it's performance. I think it was performance. Yeah. Okay. So thank you for that. Performance stock units is based on cashflow generation. And then the RSUs, restricted stock units are based on what you just referred to. Ah, gotcha. Gotcha. Yeah. Did you also see on the proxy that they all had to give out their order? yeah that was that was fun that is kind of part of their they're trying to be more

like there was a good qsr magazine article on them they were trying to become more fun and uh have a better social presence and that's a tiny part of it but that's why they're the number one i think they're number one among teenagers in like food brands so okay the brand is trying to be more fun yeah exactly i thought you meant the executives no i mean I mean, that's kind of like the investor base. No, no, not for the investors. I'm saying like they're basically when they're talking to anyone, they want to be, you know, a fun brand for people to interact with.

This is kind of like a sidebar, but I like their marketing strategy of using a lot of professional athletes because it is sort of among the fast casual or fast food restaurants I can think of one of the healthiest. Definitely. So maybe sweet green. Yeah. Yeah, I really like that. I think it is probably good. It's almost like Nike for food, I guess. Yeah, well, let's hold our horses there. But sorry, Brad.

In terms of marketing strategy. I see where you're going there. Brad, you had something too? Yeah, just another random note. I mean, Duolingo is opening a taco shop in Pittsburgh, so they dominate the social media landscape. So maybe some kind of partnership merging these two companies would be extremely weird, but also extremely interesting. Well, I mean, the Spanish language stuff, Tex-Mex, or I don't even know if it's Tex-Mex, American Mexican food. But let's move on to earnings. Ryan, what do you got for us for Q1, correct? Yeah, they actually had a pretty good Q1. So first quarter revenue was $2 billion. That was up 16% year over year, comp sales. So I guess for anyone who isn't familiar analyzing like a restaurant, basically just the revenue growth on a per restaurant basis. So how much they're

generating compared to last year was that that increased 9%, which is quite strong. They also opened 51 new locations during the quarter for a total of just over 3000 locations. They're growing their total location by about seven and a half percent year over year. Keep in mind, they are struggling a little bit to expand store count just because there's a lot of construction labor shortages. And procuring the supplies to build out the new stores isn't always easy, especially given the current environment and supply chain problems. So it might be a little diminished currently and over the next year than it would typically. But the restaurant level operating margin was 21%, which is actually down year over year. A lot of that is related to the labor

or cost pressure that they've seen. So it was 22.3% last year, 20.7% this year. Over the last 12 months, they have generated about $1.3 billion in operating cash flow. But keep in mind, this is a cost-intensive business. So they spend a lot on capital expenditures or purchases of property and equipment because they're either expanding store count or they're revamping some of their existing locations to add Chipotle lanes, which obviously costs money to do that. So try to look at it on a free cashflow basis. They had about 800 million, 807 to be exact, in free cashflow over the last 12 months. They're right about, that's a little bit, the last 12 months free cashflow is down slightly versus last quarter, but still basically

the most they've been earning, uh, in their history. Yep. And it's been a huge inflection. They had the recovery from the E. coli outbreak and then 2020, they had to have a lot of expenses. And now last year, huge inflection in cash generation. And prior to the E. coli incident, they had really, really strong margins for a restaurant. They're slightly lower, uh, than, than they were generating, uh, prior to that, because they made those necessary investments. And I think there's probably necessary costs that they were excluding prior, um, that, aren't going to hurt margins, but it helps the brand long-term. Yeah. All right, Brad, let's hit balance sheet and liquidity.

Yeah. So 615 million in cash and equivalents on the balance sheet versus about 815 million just last quarter. They have $18,000 in traditional debt, and then they have a $500,000 revolving credit line. But really the liabilities come from 3.3 billion in long-term lease liabilities. It does have another $240 million in investments. It was extremely vague what that actually refers to. So I'm not really sure how liquid or how current those investments actually are. So not positive if you can lump that into cash and cash equivalents. So just to be safe, let's not. It has $4 billion in retained earnings as it really has successfully financed its growth internally without really having to rely on more expensive capital raises very frequently. And then

And yeah, I think that's a good place to leave off there. Yeah, they have a fairly conservative balance sheet. And yeah, like you said, really haven't had to raise that outside capital. Yeah, compared to a lot of restaurants that try to go quickly, they have to go the opposite model. All right, I'll hit valuation. Pretty simple one here. This is based off a stock price of $1,266.

So if it changes before you listen, just make these adjustments. And actually, if you're listening to this, you will get the newsletter associated with this that'll have the dynamic valuation that'll change as the stock price changes. All right. Market cap, $35.4 billion. Enterprise value is slightly lower at $34.2 billion. However, I'm not including that $3.3 billion in lease liabilities that Brad mentioned. Do what you want with that. you can subtract it out or add it back or not. We're not sticklers on either or. Enterprise values to operating income, which is just enterprise value divided by the trailing operating income is 42.5. I'm using the 2021 numbers here just because I like to frame these

sort of restaurant businesses as kind of on an annual basis because if you're going to go into the quarterly one, there's a little bit of seasonality and they're fairly predictable on what they're trying to do to open stores, all that good stuff. And then on the same 2021 numbers, EV to free cashflow, which is enterprise value divided by free cashflow is 40.7. So as Brad mentioned, whether using cashflow or operating earnings, we're right around that 40 times number. And then no major concerns on stock options or SVC. Brad mentioned that they do give out some, but there's not a huge ballooning number of potentially dilutive securities that's going to really hurt shareholders. And they'd be able to have buybacks that's slightly reduced

shares outstanding, but at these prices, it's not going to be meaningful unless we get a huge stock drop. All right. Anecdotal evidence, Brad, what do you got for us? Yeah. I eat there more than any other restaurant. um all right we'll we'll take it one step further give us what your thoughts on the business but also what is your order all right so i'm walking up to the to the register or to the to the the nice uh employee smiling back at me and a little bit of white rice not a lot of white rice burrito bowl burrito bowl no beans a lot of mixed veggies um double chicken guacamole ate mild salsa so the pico de gallo uh and then lettuce on top all right but you have to get but

guac has to be a side of guac because otherwise they give you like half of the portion on top so guac has to go on the side that's good that's good yeah good strategy there um yeah because they have to fill up that little container right exactly what uh any complaints with the business or do you like what's it's been brown before um that has happened um so yeah okay all right ryan i i love chipotle i eat there on a regular basis uh if i'm the thing i like about them just compared to other fast food restaurants is i don't feel like crap after like i don't you know it feels it is fresh it is fresh they are solid and it's relatively healthy um and my order uh i'm a burrito bowl guy myself uh i kind of mix it up he doesn't do the same stuff all birds

blue lemon burrito bowls i mean you guys gotta live get these like get that tortilla i'll mix it up on occasion and add a little tortilla um but i would say my typical order if i'm really try and sometimes i just try to get as much as i can like food wise so i'll ask for extra rice i'll ask for extra beans and then they get the gist hungry and so they give me a generous scoop of chicken um and then mixed veggies i like the the corn they have really fresh corn salsa um which is a big advantage over qdoba which is sort of their uh largest competitor i forgot yeah i should have mentioned that Qdoba sorry uh and they are I think that's about it but I'll mix it up on occasion uh I have been getting this is my anecdotal um a little bit of shrinkflation

where they have raised prices but they've given me a bit of a lousy scoop on some of my ingredients well this is why you gotta I don't know if they're shrinkflationing the burrito uh tortilla a you know diameter but the burrito can help with that because i got it filled up if it's not you know a little wrinkled thing yeah the the other and this is like more sort of more real anecdotal evidence is sometimes recently and the more packed chipotles i've been in they are spending so much time and labor resources optimizing for the digital orders that the wait has been longer for the in-person. Beautiful. That's great. I haven't done in-person in years. Okay. Well, an increasing percentage since COVID are in-person.

We did that in Omaha. So my concern is that you may be frustrating the larger percentage of your customer base trying to optimize for online orders. That's true. Which still, I think last quarter, about 60% were in-person orders as opposed to online. So at its peak, it was 46%. Well, it was 60% one quarter during COVID, but annually the peak has been 46% online orders. The majority of your customers are still coming in person. I think guaranteeing a good experience for them is pretty important. Yeah, that makes sense. All right. Well, my order, I don't eat meat, so we're not going to have a meat here. I do the veggie burrito. If you do that, the positive is that it's free guacamole. So I guess that's the upside since

a little bit cheaper you don't have the meat there but what i go burrito brown rice black beans fajita veggies i don't even know it's saved in the mobile app so guacamole i guess because you get that for free um there's some of the salsas the pico de gallo and some of the salsa yeah we can talk about rewards too i've used that before um yeah i go like i don't know once or twice a month and i only use the mobile app so i don't really have any experience in store anymore but i mean i do prioritize that you are right uh the mobile app is all right i have this might sound weird when i say this the mobile app is bad but also good because the app itself doesn't work that well however i can get to my order in four clicks so it's pretty efficient if it actually

works but sometimes i have to reload it like half the time it's the screen like not breaks but it's like off and then I have to reload the app. However, it's really, really good at just saying, all right, click this reorder. Boom. Pay stores already there. So in that regard, it's good. Are they the most successful restaurant digital wise? I have no idea. I don't shop at many restaurants, so I would have no good information. What'd you say, Brad? I think Domino's probably is the bellwether.

Starbucks or McDonald's. McDonald's would definitely be ahead too. Okay. I mean, they're top five. I just, I follow Olo, and they don't even consider Chipotle to be a target customer because they think that the largest 10 in that cohort are the only ones capable of building internally, and they lump Chipotle into that bucket. Right, right. Yeah, those McDonald's, Starbucks, Chipotle, probably out of reach. None of the food? Okay.

I said in preparation for the show that – well, I just tweeted it, so maybe listeners don't know. but I said the food quality may be going down just because of supply chain stuff. Um, I think the food is good. Like we just mentioned, especially compared to other quick service restaurants, fresh, um, quality ingredients. Then he used that weird preservative stuff that say like McDonald's or Burger King might use. However, given that it's like this quick assembly line thing,

sometimes I find the way they prepare it is not good. And this might be picky, but I would ask that the rice isn't cold. I would ask that the burrito isn't like Brian Nichol if you're listening look look the the right having cold lukewarm rice is not great I mean if it's just not warm it's not good I would ask for the ingredients to be spread around the the burrito evenly that may be I'm not I think I need to get back to I know I know this is important but there's other stuff but that's just like it is important for their pricing power okay all right I'm not I'm not joking it's probably one of most important things we talked about. Yeah. I mean, definitely the product is the number one,

an excellent product is the number one way to keep your cost of sales down. Yeah. And hopefully as they don't get this recycling of laborers with COVID and they get, you know, people that are in the stores that have more experience, this quality will maybe recover. All right. Future growth opportunities, Brad. Honestly, like tossing the burrito toppings inside of the burrito does sound really good to me. Like, like kind of like a salad that you're to spread out everything so we'll we'll throw that in as a bonus future growth opportunity but um there's and you guys took the two uh the two most interesting ones i think but there is still really just boringly put long runway for store growth i mean you saw seven percent plus um your

store growth on a pretty large base of of stores already so they're still very much so full speed ahead there's some international expansion in the roadmap for sure um yeah i think there it's very simple there is a lot more there are a lot more chipotle's to be opened here's the yeah so my i think domestically here in the u.s there's definitely room to expand store count but they don't have a huge footprint internationally and i don't have a gauge on whether or not this would do well in other countries latin america maybe not a lot of america no but i mean europe yeah you only have canada easy i mean canada for canadian listeners you're basically part of the according to the 10k which they might may have added some of the most recent quarter i think

out of their 3 000 stores like 44 when we're international so yeah they're not focusing on that at all right now and they believe they can get to 7 000 in north america i don't i think that probably considers canada as well so that'd be more than doubling their current store count so they think there's plenty of room i think that's possible like that's probably possible given how big you know a subway and mcdonald's is i mean domino's for reference has more than 6,000 locations in the US. I would say they're pretty close to being able

to probably have the same store count. It's not going to come as fast because it's not a franchise model, but I would imagine that they have room for that kind of growth. Yeah, I guess that makes sense. I think that makes sense. All right, Ryan. Yeah,

Chipotle Lanes is my future growth opportunity. 82% of their new store openings this quarter had a Chipotle Lane in them. They target around 80% of the new stores, or at least that was their guidance for the next year. Per the last conference call, they said, or the CEO said,

Chipotle lines also continue to outperform non-Chipotle locations due to the convenience, which is encouraging since digital order pickup is our highest margin transaction. Yeah, Brad. Boom, I'm helping margins so much. Sorry, Brad. So I'm just wondering why it's not 100%

or some of their stores, just the footprint doesn't work out for drive-through lanes? I imagine, yeah, like super dense cities, you might not be able to. The one I go to, there's no way they could put a drive-thru in, so. Makes sense. They are also, you know, adding or reconstructing some of their existing stores to add Chipotle as well. But, yes, it boosts their highest margin transaction, and I also think it helps with increasing transaction volume purely because it's more accessible, more convenient. if you're in a hurry you can get it done quickly as as opposed to if you had to go in store you

might not be able to get it um so are people unaware that you can click take less than a minute on the mobile app and walk in and out in 10 seconds in the store i'm not like is this still a mystery to people i think it is because they said like walking in true that might be a possibility uh yeah that is possible but they are here's the that was kind of my thing is uh mcdonald's tried to push them towards drive-thrus, they said no initially. Granted, that was when Steve Ells was still sort of running the company or his co-CEO. Now, this is a big growth opportunity for them. They talk about how it's helping boost margins and transactions, and this should hopefully, or I think it would, increase the average unit volume at each Chipotle location.

Yeah, that's true. And that is super, super important for margins. What is Chippy? Yeah, so I was going to say my future growth opportunity is Chippy. That's my fake one. That is their autonomous chip making robot that they're experimenting with. So, uh, this is kind of a joke, uh, but they do have some R and D going into replacing, uh, some of the media, like the tough employee tasks or the really boring employee tasks, which would be making chips or, um, I don't know, slicing veggies maybe would be more harder, but making chips seems pretty easy.

Uh, I mean, relatively for robot to do, uh, so they're experiencing that, but again, that's time for my real future growth opportunity they have also i know they had extra depreciation this quarter or increased depreciation because they are working on revamping some of the tech in their stores to for like mobile tap payments uh they had to depreciate some of their old equipment so i think you're right they are trying to make it more advanced and a more seamless process yeah by using technology they've been saying it on the conference call they said that some uh investment conference i don't know if chippy will be successful but yeah labor's huge they have over 100 000 employees now my real one is uh and you guys personally might be against

this but i think they should get more customers using digital ordering because it is the highest margin according to management around half of customers right now are in store only but the pot but if they can get those to switch over to at least being a hybrid digital or in-store uh if If you use digital ordering, you spend more, you also hop onto the rewards program, most likely, and they have 28 million members right now, so they could probably get that to 50 million over time. Lastly, digital orders, because they're a lot quicker, you hop and hop out and just pick up your order.

You don't have to do the transactions in the store. That can really drive AUV growth, which is average unit volume growth, and that is the key to margin expansion. So I think it's really important, even if it, and the downside is sacrificing some of that in-store, um, customer experience, but I think it's important if they, if they want to drive margin expansion. Yeah. All right. Highlights, low lights, Brad, I know you've been looking at this. I saw you tweeted.

It was on your watch list. So I'm assuming you have some highlights here, but what are, what do you like and dislike? Yeah. I mean, the food is really good. um i i eat there a lot um and and i i just simply put the food is really good and i i i enjoy it um they also i think so we we've talked about lululemon and then other companies like a revolve group or something like that that really caters to um more affluent crowds and i know it's it's a 12 burrito but that is more expensive than a big mac and it is more expensive than um a whopper

or whatever you want to have for lunch so i i do think the relative affluence that they cater to makes them a little bit more insulated and gives them more pricing power, which we saw this past quarter with a 4% price hike across their entire suite of ingredients items. Plus short inflations. Nice short inflation. Yeah, they don't talk about that in the conference call. Yeah. And I think, so I alluded to this a little bit at the very beginning, but commodity prices are starting to give back a lot of the gains that we've seen over the last several months. And it's

how much of these price increases are permanent and sticky while their margins continue to go up with input costs going down. So that's a very interesting recipe, pun intended, for some better unit economics going forward. And just to throw in as a bonus, I love that the CFO has been there for 20 years to kind of steer them through that journey and through that ideal path that I'm kind of seeing. In terms of low lights, so taste change, it's not a fashion brand. So it's not an LA gear or, or a Nike or, or a revolver or a Lululemon where things go in and out of style because it's, it's taste. What, what do, what do I like to eat? But at the same time, um, taste do change. Uh, I mean, the, the most popular brands from a hundred years ago in terms of food and

restaurant chains, or maybe let's say 50 years ago are not really the same as today. You do have the exceptions with McDonald's and in and out and, and just really iconic brands that that stood the test of time, but that's not really a guarantee. It's not a guarantee. So remember Subway, Subway or Panera has had a lot of troubles over the last few years. And I mean, the chef who founded the company was, he was a chef. He was very obsessed and fixated and determined to keep the food quality consistent. And they didn't really release any new menu items for a very long time because of that. And then Brian Nickel took over and just totally changed the game and, and, and brought them back to that invoke company that they'd been for a

long time. And I think I'm, I'm, I'm turning my low light into a highlight because Brian Nichol, I do have a lot of respect for him, but it, you, they have to keep pivoting and bobbing and weaving and shaking and releasing delicious queso to, to stay, to stay relevant and to stay popular and to stay on that path to ubiquity, which I think is what they really want. All right. Good points. Ryan? Highlights.

I know it's qualitative, but yeah, I do like the food. Customers know what they're getting. It's high quality ingredients. It's healthy, quick service, and it's at a reasonable price. I think they could probably charge me 20% more. It feels like they are perpetually about 20% under what they could charge me. And that's for anyone that might be questioning that just look at other lunch item concepts. So like I know Brad said $12, that might be the double chicken order. Uh, but, but their basic

is still on average, you know, there's a lot of people that might be listening to this in New York city or San Francisco or Toronto on maybe they're not even in Toronto, but, uh, they're below like $10 and a lot of other options for lunch might be, you know, in that 12 to $15 range right now. Do we need a readable index to match our Big Mac index? Well, I was just trying to, yeah, like people, there's been a lot of short reports out there that they have no pricing power and that they're already pretty in price, but compared to like a sweet green, I mean, it's much, much cheaper. Yeah, I agree.

They also have a really good history of cashflow, even in tough times. I believe they even generated positive margins. Actually, don't quote me on that, but I thought I heard someone mentioned they generated positive margins around the E. coli crisis. And the other thing, if you're really interested in this business, I recommend reading Jake Taylor's book, The Rebel Allocator. He basically talks about, he goes through sort of an illustration of the little iterations and time it takes to build a business like this and how difficult it can be and how you can provide a little extra value to your customers and they're going to stick around. And I just think it's a really good book to kind of – and it feels like it's based on Chipotle, even though it probably isn't. Lowlights for me, though, they are seeing supply chain pressures across the board right now.

Beef costs, freight costs, wages are going up, construction shortages for new buildings. All these are going to put pressure on margins. I have a hard – I do not know whether or not those will stay elevated over time. I do think they have pricing power, so hopefully they can pass through those costs. And then I worry that, and this might be overblown, but I've had my anecdotal evidence I think matters here where if they optimize too much for online orders because they are the higher margin transaction, they maybe mortgage their brand or risk the way their in-person customers view the brand if it degrades the in-store experience. So let me ask you this. What's keeping you from doing the mobile app? Because it's quicker and you get the digital rewards, which can be quite, you know, they get a free burrito.

I get one like once every few months. I can manage how much I get. Are you sure though? Yeah. Like if I see it and they give me extra rice, I don't think it's enough rice. I can say I'd like more rice. They'll add more rice. On a digital order, you can't do that.

Well, if you realize that. There's a reason that 60% still order. It's not that they don't have phones. I think that they like managing I think that's why the assembly line model works is you see the progression of your food being made and you can kind of tweak it how you want that's fair

what about you highlights lowlights let's see anything different no I mean okay I guess you know we all talked about it's an understandable concept that should work well in many regions I think it can work in a lot of regions around the globe I don't see any reason why it can't

work in Canada or Western europe um depending on supply chain supply chain in europe could be a lot tougher for avocados but i'm not exactly sure and yeah i mean a highlight is that the unit growth should be steady for the next 10 plus years which is not a lot of companies can say um and then another highlight is they've gone through the e coli scare and i think that really like they really executed well coming out of that which is a testament to the management team it's a testament to the quality of the product and the concept um for example subway had i mean it's been multiple things but they had that big news thing with that you know the the guy that used to be in the commercials turned out to be

kind of a criminal and a and a creep uh and that kind of like i don't know if subway could have recovered from something like this if you guys understand what i mean just because chipotle had had a better quality brand. Um, and it is, uh, they really revamped that, especially among young people, like I mentioned. And then lastly, they've been able to have consistent operating margins, even while significantly bumping their employee salaries and having the fresh ingredients. So they're, they're hurt even more than I I'd say versus someone like, especially at Domino's where they don't really have the fresh requirement. If you guys get what I mean, they're there, They have way tougher, I don't know, operating environment, especially when things are kind of going haywire like they have been the last month or so, or not month, year or so.

And that can be, I don't know, it's just a testament to the quality of the product. Low light, we talked about supply chain, so I don't want to mention that again. But the labor side, they have over 100K employees. They treat them well. But if wage inflation continues, this could really hurt their ability to get back to that 15% plus operating margins that they were at, I believe, in like 2015. And they probably surround their goal over time. I saw the one by where I live that they're advertising $17.50 an hour on the storefront with 401k. All these great benefits, which is great for the employees, but I wonder how much of an impact that is having.

All right, let's wrap things up. What do we got? Bull case first. Brad, what's your bull case for Chipotle? Yeah. And I think this is a very high likelihood bull case. So Brian Nichols staying really is my bull case. But the company can continue to successfully morph their store portfolio into a fully omni-channel operation while keeping that brick and mortar experience excellent, which is very important. And I sort of agree with Brett. The 46 or 7 or 8 percent of whatever it is, a percent of sales that are digital should be a lot higher in a perfect world because that expands the margins. And it's all in all, generally speaking, more convenient for people and better experience. But at the same time, with restaurants especially, got to balance the inside the four walls experience with all their digital channels.

So it's a very delicate balancing act. And I think Brian Nicol and that CFO has been there for 20 years steering the ship makes me pretty confident that they can that they can balance it pretty well. Bear case. And again, Brian Nicol taking over has made this far less likely running more of a corporation and and yeah, a corporation rather than a kitchen. I want to say, because the founder was phenomenal at building menu items, but maybe not the best operator. So for how that manifests, it's food safety issues like E. coli and norovirus that we talked about before. And when you're selling food, the stakes for cleanliness and sanitation are even higher, arguably, than anything else you're not ingesting, not arguably, objectively. So again, less likely with the standard operating procedures that have been put in place to kind of mitigate the risk of this, but it's still possible. And it's not something you can

rule out and say is unheard of because we're only seven years removed from it happening to this company. Yeah. I agree. My bull case, I'm just going to put some numbers on it so listeners can try to follow along and see where we get to in terms of stock upside. If they double their total store count over the next seven years, which would mean 6,000 locations, roughly, we kind of talked about that. And their per restaurant revenue doubles over that same time period. So a double in both. And they get to free cashflow margins at about 15%, which I think CapEx over time should decrease as a percentage of revenue. Let's assume they weren't trying to do international expansion. Ideally, CapEx declines as a percentage of revenue because you start to hit maturity.

Um, so if they do all that double store count, double AUV, and they reach 15% free cashflow margins, that would be just under $5 billion in free cashflow 4.8. Um, if investors value those cashflows at 20 times, that would be a $96 billion market cap. That's 171% higher than today's market cap. So a little under a triple for the stock over seven years. Do you think that's aggressive on the restaurant per restaurant, I think that might be on the per restaurant doubling. They're going to get 5 million

AUV. I think their goal was slightly over 3 million. It's both lanes, man. Do you really think it's 7 million? Last year, it was teens AUV increases. That was an easy comp. 9% this year after. That's another. Q1 was also

an easy comp. They were up 20% last year. And then up 10% this year. I think they've shown an ability to increase comp store sales. Do you think they're going to double AUV to 5 million? I think it's possible. You really? It's not.

How? I think if Portillo's can generate seven and a half. No, come on. On a per store basis. I think you're under, first of all, price increases on the burritos. That's number one. Then any efficiencies. I think to half of that, let's say inflation persists.

Yeah. I think they can get there. Sure. If inflation, that is fair. If inflation, I just think I put 50% initially And that seems This is the bull case

I'm trying to put an optimistic I don't think An optimistic scenario I just don't know if doubling I don't think it's that reasonable But I do think it's possible It's possible if inflation stays high, I guess Seems

It seems very 8% a year for the next 7 years I think it would be higher than that I guess it'd be 10% probably. God, that seems, I mean, how are they going to double like the throughput with their existing kitchens? Yeah, the Chipotle's could, but with their existing restaurants, it just seems like they would have, it just seems very, very difficult. Yeah, it might be a little rosy. But either way, I mean, even if it's slightly lower, I mean, that's a lot of cashflow.

Yeah, you're still getting at least more than a double in the stock. Let's say it's 50% increase over the next seven years. You're getting more than a double in the stock. And would you have 15% margins? Yeah. But 15% margins is fairly optimistic as well. Yeah. All right.

Did you want to do bear case? Why don't we do – Okay, yeah. Maybe they're closer to store maturity in the U.S. than I thought. Maybe .mos is not a very good comparison. And then if same restaurant revenue growth slows to mid to low single digits, so like Brett just mentioned, maybe throughput on the burritos is already pretty close to capacity and the Chipotle's aren't that much of an improver in that. Um, so if that happens or if store maturity is too close or they're too close to store maturity already and the restaurant level cost pressures stick around, or if the company

is just valued at a lower multiple in whatever, five to seven years, which is very possible. I think 10, 15 times for a restaurant is, is realistic. Maybe not for a premium operator like Chipotle, but now 40 times, I mean, it's not going to be, uh, it's not going to be 40. We know that. If any of those four risks come to fruition, there's a good chance this is a single-digit return. Yeah, quite low. All right.

I mean, my bull case is I really think the key is margin expansion. A unit growth, yeah, there is that risk. I guess it's hard to know. There is that risk that they're reaching saturation and it's below 7K, but I would trust my instincts less than the data they are provided that they know where they can work. that would not seem like the biggest risk to me. Yeah. Yeah. Um, I think that is, you know, union growth, especially whether only at 3000 right now is fairly easy to forecast and returns, I believe will be dictated by whether they can get consolidated operating margins to go much higher than 11%. And then if we go one level deeper, what dictates operating margin is how

much sales volume volume you get on your fixed costs, which is just labor leases, et cetera, for a restaurant. So the most important metric is growth in AUV, which is average unit volume, like we were discussing, or comp sales growth. I just think that has to be consistently at 3% to 5% minimum for this to work on a margin and operating leverage. Yeah, just to have solid operating leverage, which is the key, and they should convert a lot of that to free cash flow over time. Of course, it would also be nice if the valuation would come down in buybacks, which they do fairly consistently with their excess cash, could help juice earnings per share growth and free cash flow per share growth by 2% to 3% a year, because right now it's very

negligible. And then my bear case is, I'm going to keep it simple. If margins do not expand, I think shareholders will almost assuredly do poorly over the next 5% to 10% years if margins stick at 11%. It's just not, the numbers don't work. And the multiple will compress. most i think we could say most likely yes anything can happen but i mean betting on staying at 40x i uh this isn't 2020 all right more or less interested brad yeah more interested um in in much more interested uh it's on the watch list with uh shopify google and disney now um so So those those four. Sorry, what? So that's a short watch list. Yeah, I know. I like to keep the watch list really short just to stay laser focused.

But I really like this company and think 15 percent top line compounding may be a little slower than that. But almost 15 percent top line compounding is reasonable. And I think margin expansion is more probable than not. So I agree with the bull cases or the bear cases that were just presented wholeheartedly that store count needs to kind of stay at that five, six, seven percent rate of growth going forward. And they need to keep getting more and more profit dollars out of their stores, which Chipotle is in digital and makes all the sense in the world that they will when when when spending starts to slow down a little bit. but that might take a while, but just a long way of saying more interested. It is expensive. It is on the watch list, but it's not in the portfolio at this moment because I don't see 40 times or 45 times earnings as, as sustainable,

even in the midterm or shortish term for, for a company like this. They will get a premium because it grows faster than, than most of its competitors. And, and, and yeah, I'm sorry for the, for the dog distraction, but yeah. Exactly. I think getting this closer to 30, 35 times earnings is where I'm looking, where I'm hoping and fully expecting that I could never, I mean, there's always a chance I never get it and never get an opportunity, but phenomenal company that I think is going to present a better opportunity in the future. All right. Yeah, good point. And I should mention they said their goal is to actually accelerate to 8% to 10% store count growth, but they're still working towards that goal. So that would be even better, and they can maybe grow faster. All right, Ryan? i'm on the fence i love the company but i always struggle i struggle with retail concepts or restaurant concepts um just kind of forecasting growth and

to me like basing basing a thesis around a brand like perception for that brand unless you're nike or apple or maybe even little lemon like unless you've been around for like 100 years well maybe 30 yeah 30 years successfully and like you're just a i think there's very few companies where i would invest and not have any concern about the brand yeah i mean disney nintendo also in that yeah the i just hate investing around like well it's a really good brand. Yeah. And I think the concern here is that if you were in 2005, maybe you would have looked at Subway if it was public and you would have said the exact same thing. Man, it's at 40 times earnings, but this is just a monster. Quiz note. Yeah. It's taking over. People love the

sub concept for lunch. Well, now people are eating burritos for lunch more at Chipotle. I know they haven't taken that entire market share, but it looks like they're on the path to do so. So that, I mean, who's to say it won't happen to Chipotle? Hard to envision, but it's always possible. I am more interested simply because if Chipotle is the next, say, McDonald's or Domino's, I guess would be another one. Yum Brands has those as well with Taco Bell in the United States. Then if it's trading at a reasonable price, which I guess reasonable is up to the... uh investor it it feels like one of the lower risk ways to get outside return outsized returns

if you can get it at the right price now today is not that price but man they execute well and yeah it's probably the one restaurant i would own unless obviously unless something trades at three times earnings but yeah if you have all restaurants at the exact same valuation This would probably be on the top of the list. I mean, obviously, it's not growing as fast as some other concepts, but. Yeah. Well, sweet green is growing fast, but. Right.

It's like one of the highest quality restaurant businesses I could think of. Yeah. Most likely margins should expand. I mean, they're on that way. And we've had a hiccup with just bad, you know, combination of labor, which they've been able to absorb, plus the supply chain stuff. And that should have been like Brad was talking about. All right, stock for not next week, but next month when, Brad, you are back on. It is your choice.

What do you got for us? Yeah, let's do Disney. Just added that to the watch list. So I want to use you guys to do some of my research for me again. I have a feeling you would say that. And it should be fun. They just, a lot of things going on. I'm sure we'll debate whether on the Marvel strategy and the Star Wars strategy.

But even more importantly, they just raised prices on ESPN+. Tons of stuff going on there with D2C, competition with Netflix. all that good stuff all right should we do a disclosure actually if you are listening to this you are on the premium feed so thank you for subscribing and you should be getting a free newsletter to your inbox if you are not getting the newsletter with the show notes charts all that good stuff um find us on twitter we'll have excuse me official mascot of chit chat money It is a great mascot. I don't know if no one's going to see this on video, but Brad has had his dog and he is multitasking with it throughout the show. But if you haven't gotten the newsletter, email us. Our email is in the show notes because it'll be very nice to have that. And it's part of the $5 a month you'll be paying. All right. That's going to do it for this episode. Remember, we are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital. Arch Capital clients may hold securities discussed in this podcast. Thank you all for listening. Tune in next week.

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