Motley Fool Money - Chipotle's Pricing Power is Real

Episode Date: February 9, 2022

(1:00) Three months ago Chipotle's CFO made a bold proclamation regarding the company's pricing power. Chipotle's 4th-quarter results prove he was correct. But how much more can the company raise the price of their menu without lose customers? Jason Moser analyzes the restaurant landscape, including: - Yum Brands' eye-popping unit growth over the past year - How the economics of Yum's franchise model stack up against Chipotle's decision to own all of their locations - Whether Chipotle can get to 7,000 locations (15:00) Ron Gross discusses the business of acquisitions, including: - The different ways that companies fund buying another business - Horizontal vs. vertical acquisitions - Hostile takeovers - Whether investors should wait for an acquisition to close before selling their shares Looking for more information on restaurant stocks? Click here: https://www.fool.com/investing/stock-market/market-sectors/consumer-discretionary/restaurant-stocks/ Stocks: CMG, YUM, MSFT, ATVI, TTWO, ZNGA Host: Chris Hill Guests: Jason Moser, Ron Gross Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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which makes it so much easier to stay on track. And you can get unlimited expert help at no extra cost, even on nights and weekends during tax season. Visit turbotax.com to get matched with an expert today, only available with TurboTax full service experts. Warning, do not listen to this episode on an empty stomach. Motley Fool Money starts now. I'm Chris Hale, joined by Motley Fool Senior Analyst, Jason Moser. Thanks for being here. Hey, thanks for having me.

Ron Gross is going to be here later in the show to talk about acquisitions, what to do when one of the companies in your portfolio gets bought, which is a timely topic because I don't know if you've noticed, Jason. There have been some acquisitions lately. People have questions. The dozens of listeners have questions. There's some rumors. There's more than rumors, right? We're going to get to that later.

I want to talk with you about investing in restaurants. You tweeted something out three months ago, a quote from Jack Hartung, who's the CFO at Chipotle, three months ago on their call, basically Hartung saying, we've got pricing power better than pretty much anyone in our industry. Here we are three months later, Chipotle's fourth quarter report comes out. You look at it, and that was kind of of a bold call for a CFO. Generally, CFOs as a group are not, it's not in their interest to make statements like that. But when you look at the latest results from Chipotle, they've got pricing power and they are using it. It was a bold call. I agree. I think CFOs, for the most part, it's in their DNA to

probably be a little bit more soft-spoken and just let the numbers do the talking. But I mean, I like the confidence as well. And I think, you know, I think, you know, I'm a lot of Certainly, that quote from a quarter ago, this quarter's results back that up for the most part. I mean, when you look at the numbers, just a very impressive quarter all the way around. Total revenue for the company grew 22 percent to $2 billion. Comps up 15.2 percent. This was the line item here that kind of caught my attention.

It's just because when you think about it a little bit bigger picture, right? Digital sales. We talked a lot about digital sales with Chipotle. and how successful they've been with their app. Digital sales grew 3.8% for the quarter, accounted for 41.6% of all sales. But the interesting thing to me is you go back just a quarter ago, digital sales grew 8.6%. If you go back a year ago, they grew 174%. So it's not entirely surprising, but I think the translation there, I mean, you can read a few things into that,

But I think the ultimately, the translation is we're seeing in many, many places, people are simply moving forward with their lives, right? This isn't 2020 anymore. People are going to restaurants. People are going to movies. They're going to do things. Offices are open, right? The world has gotten back to normal, to a degree.

At least now, it's not fully back, right? The impacts of the last couple of years, we'll see some ebbs and flows in the near term. But generally speaking, I think all of these investments, that are the next time. They've made their digital business continue to pay off, but it's really nice to see, too, that traffic in the stores continues to grow as well. And just to put a number on how many people love their Chipotle today, Chris. They now have more than 26.5 million members in their rewards program a year ago. That was at 19.5 million.

So really, a lot of success in that lever alone. It gives them a ton of data. And back to that pricing power points. you were making earlier, it lets them make informed and really thoughtful decisions on how they're going to push those prices up if and when they need to do it. Yeah, I was doing an interview earlier in the week on one of our affiliate radio stations and got a question about inflation and sort of how much, you know, how much does that factor into your decision making? And part of my answer was to talk about pricing power. Because

the businesses that have, the consumer-facing businesses that have pricing power are going to be able to exercise it. Brian Nicol, the CEO at Chipotle, talked yesterday about how they're getting no resistance. That was the phrase used. They're getting no resistance from their customers when they're raising prices. Obviously, you can't just go jacking up the prices, you know, to whatever degree you like. You have to be very thoughtful about it. But they're doing that. I want to touch on the digital orders for a second, because one of the things, things that we want to see when we're looking at restaurants is what are their growth projections, and part of that obviously is new locations. Chipotle talked about their growth

plans, and part of it that struck me was 80 percent of new locations that they've got planned. And they've got somewhere in the neighborhood of, I think it's 230 to 250 new locations planned for this year. 80 percent of them are going to go. going to have those Chipote lanes, the pickup for digital orders only. So even though, as you say, they talked about their staffing, getting back to pre-pandemic levels, people are getting on with their lives, they are planning for digital orders to continue to be a robust part of their future. Absolutely. I mean, when it represents closing in on half of the revenue that you're bringing in, you better depend on it.

you better count on it because it's been a wonderful lever that didn't exist really a decade ago when we loved Chipotle, even back then, right? This is a little bit of a different story, but I mean, it is fascinating to look at the growth opportunity on the store side of things. I mean, the company today, they have just under 3,000 restaurants. Previously, we'd heard them talk before about this opportunity of 5,000 to 6,000 stores, potentially here in North America. Now, with the end, At the advent of the Chapult Lane, this is opening up the playing field for them a bit, right? You referred to that greater than 80 percent of new restaurants having a Chipotle Lane.

And what it's doing, it's opening them up to, I think, an entirely new potential market. And they mentioned it the call, small towns. And I think up to this point, they've really focused on getting real estate and prime locations, heavily trafficked areas where they can justify the economics of the real estate itself. Chipotle, obviously, carries a much smaller footprint, and therefore, it's easier to justify the economics of opening those up, even if it's, even if it's just a standalone sort of Chipotle store. And so, I mean, I think, golly, Chris, you know, a couple of months, I'm going to fly

down to Mulchree, Georgia, I'm going to go see my mom and dad, and who knows? Maybe, I mean, that's a small town. Maybe one day we'll see a Chipotle there. That would be awesome. I know they want one. My mom and dad liked Chipotle, and they're just, they're kind of bummed. I don't have one. But I think that's really the interesting thing to think about there, because now, and this was something they'd noted to the call. I think you've got to take note of here

as they've up that market opportunity. They're talking about now the potential for 7,000 stores in North America all in. And it's neat to think about how this story has evolved, because it wasn't all that long ago when we were kicking that 7,000 number around, but in a different context, right? We were talking about Chipotle and them taking it. that platform that they've developed and coming up with different concepts, whether it was burgers or whether it was high food or pizza. And we know how that worked out, right? I mean, those have become ultimately. That's how it worked out. It didn't work out. Yes. I was going to, yeah, yeah, exactly. So it didn't work out. And I think that's where

you need to keep those types of estimates, those types of forecasts, those types of goals. You've got to keep that, you got to keep that, take it with a little bit of a grain of salt. I would say a smart investor will look at that 7,000 number and discount it back a little bit. Let's think maybe 7,000 is an aspirational goal. What if they don't get there? What if they get to 6? How does that change the potential of this investment? But even at 6, you can see they're essentially doubling their store count from today.

And if they're targeting that new unit growth rate of 8 to 10 percent per year, as they stated in the call, well, that gives them a pretty long, runway ahead to continue opening up stores, growing that loyalty program. And ultimately, over time, because you have that bigger store base, because you own all of those stores, the economics continue to work better and better for you as you continue to scale up. So there's a lot of potential for this business still. I know folks look at that stock price today, $15, $1,600, and think, wow, that's expensive. Remember, the stock price is just a, it's a function of really ultimately how many shares are outstanding. This is a business still with a lot of opportunity in front of it.

And I think investors should be very encouraged. There is a way for them to open more locations more quickly, because when you look at Young Brands, parent company of KFC Taco Bell and Pizza Hut, they just closed their fiscal year. They opened nearly 4,200 locations in their fiscal year. But of course, they'd have to go the franchise route to do that. clear that Chipotle doesn't want to do that. No, they don't. And I understand.

I don't think it's really right or wrong. I think it's just a matter of the business strategy that they opt for. But you can see certainly how that plays out. I mean, you get yum with something like 50,000 total stores around the world all in with your pizza huts and KFCs and Taco Bells and whatnot versus Chipotle's. what, 3,000, right? The funny part is, Chipotle chalked up about $7.5 billion in revenue over the last 12 months, and the Yumb Brands was closer to 6.5 billion, I believe. And again, that's not to say that Chipotle is a better business, but that's just, that marks the difference

in the model, right? Because a franchise, you're essentially, with a franchise, you're essentially introducing another business partner into the mix, right? So it adds some risk, it adds, it relinquishes some control to a degree, but on the flip side, it can also help spur growth. But I mean, you look at, you look at how the numbers play out for these two businesses. Chipotle, they're bringing in a net margin, 8.7 percent on 7.5 billion dollars in sales. Yum brands, you're talking about something closer to the neighborhood there, what I say, six and a half, six and a half billion dollars in sales, but a business that's bringing in net margins closer to the 24 percent range, right? And so it's just a matter in the difference of the

models. And I know at one point, very early on in its inception, Chipotle and its relationship through McDonald's, there was a franchise dynamic to it. They got out of that real quick, because they think they felt like the strategy was, grow it slow, methodically, be very thoughtful about the offering. They were kind of all in on the one concept at the time. And that's worked out very well. And I know I've referred to this before on our shows. And I know you remember very well because we had, it was Jerry, Jerry Murrell, right, of five guys. The founder of five guys who came and spoke to us one day at Fool HQ years ago. And I think there was a question that was asked of him at the time. if you could go back and change something, what would you change?

And he was very quick to say, you know what? I would go back and buy back every single one of those stores. And it wasn't really because he hated the franchise model. It's just because he felt like owning those stores was a superior option. He felt like he was leaving money on the table. He was leaving control on the table. And I thought that was just interesting to glean from a founder of what is clearly a very successful restaurant company today. Shares of Yum, you know, not terrible, up 90% over the past five years, although you compare

that to Chipotle up 280% over the same five-year period. So, as you said, it's not to say one is better than the other, but when you look at the economics, the sort of what is the version of both of these approaches to restaurants, and what is the best version of that? The best version of the We Own Everything model, seems to be working out better. Yeah, I tend to agree. I mean, I do own shares personally in Chipotle. I have for a long time.

I don't own shares in Yom. Part of that just is reflective of my personal preference, honestly. I mean, I just, I never go to YM Brands' properties, but I frequent Chip with Chipotle a lot, and I just think it's a quality offering at a reasonable price. And as long as management is able to continue controlling the quality of quality. of that offering while remaining thoughtful about the prices, the value proposition that it's offering customers, I don't see why they shouldn't continue to succeed. I think the biggest question marks for Chipotle today, and I would encourage investors to think about these questions, because as good

as this quarter was and as well as the stock is done, you have to at least ask yourself a question, okay, if they're so confident about pricing power right now, what flips that on its head? How far can they go with that? Because you just can't go on with that forever, right? I mean, at some point or another, you do start to hit a ceiling there. And what does that potentially look like? And then just the growth targets. I mean, 7,000 is a great number to hear. I love it.

I'm not modeling for 7,000 though, Chris. And I think any investor worth his or her salt would probably ratchet back that forecast a little bit and try to see how does this investment look if you target 5,500 stores or 6,000 stores, at least get that insight there to be able to understand if you'd be able to understand if you few different scenarios. But on the whole, I think this is a business doing a lot of things well, and it sounds like that's poised to continue. Jason Moser, thanks for being here. Thank you.

So Microsoft is buying Activision Blizzard. Take2 Interactive is buying Zinga. If January is any indication, then 2022 is shaping up to be a big year for acquisitions, and probably not just in the gaming industry. So how does it affect you if a company in your portfolio gets bought by another company. We're here to talk through some of the nuts and bolts, is Motley Fool Senior analyst. Ron Gross. Thanks for being here. Always a pleasure, Chris.

How are you? I'm doing well. I want to get to a couple of things. Let's start with how the execution takes place. They can buy with cash, they can buy with stock, they can buy with a mix. Does one of those tell you more about the acquisition than the other, or is it all the same? Well, sometimes a company would like to use all cash, perhaps, but just they don't have that kind of capital, that cash on the balance sheet.

There is the potential to use debt to do that, but very often the capital just is not available. And that's one reason you might turn to stock instead of cash. When you use cash to buy a business, the acquiring company is then taking 100 percent of of the risk going forward, that acquisition makes sense, that the synergies, whether they be cost synergies or process energies, are realized that the growth, perhaps, that they're looking for will be realized. And so, because the other shareholders, they're out. You paid them cash. They're gone. Buy. Now, if you stock, both parties are absorbing some of the risk that this will or will not work out by the synergies being realized. If you are

on the side of the acquiring company and you are a shareholder, you have to evaluate whether you're happy or not with A, the purchase price, because, yes, you will likely be taken out at a premium to where the stock was trading at the time of the announcement. But perhaps you thought the stock was worth more than that, or would be worth more than that, because you're a long-term shareholder, and you're going to own this company for five, 10 years. And the acquiring company, in your opinion, is getting off cheap, perhaps. Then if it's stock, you have to say to yourself, huh, well, I bought this company that I own because I believe in the management team, and I believe in the company, and I believe in the end-user markets

and the opportunity. I'm not sure I want to be a shareholder of this new company that's giving me stock. And so you have to make that determination, too, about whether you're actually happy about becoming a shareholder in a new company that perhaps you never intended to be in the first place. Of course, there can be a combination of cash and stock. We saw that with Take 2, Quaring Zinga, where it was part cash and part stock, which you'll see quite often. Companies nowadays have so much cash on the balance sheet, especially the mega big boys we talk

about, whether it's Apple, Amazon, Facebook, Microsoft, that cash is not a problem. almost do any acquisition they want. And that's across a wide range of companies. Balance sheets are full. So cash becomes an even bigger option during these types of times where they have the capital to do it, and they don't need to go the route of stocks. We talked earlier in the week about Peloton and the reports of, you know, whether it's Amazon or Nike or whoever may be acquiring them. Part of that story involves activists, investors in a previous life. You yourself were an activist investor, which leads me to this. Some of these acquisitions are not friendly. Some of them are very much partnerships in the making,

and others are hostile takeovers. If you are looking at your portfolio and you find out that one of your companies is involved in, whether it's friendly or hostile, does one indicate more red flags than the other? You know, it's certainly cleaner when it's friendly because the management teams get together. The board of directors is there. They negotiate a price. They're able to share information so they can see what kind of synergies can be realized or what incremental growth can be realized.

There's a meeting of the minds, and it's much, much cleaner. When you get an unsolicited offer, let's use the friendly term, unsolicited, you don't get a lot of those things. You see that going on with coals right now. Acacia research, which is backed by old friends of mine from Starboard Value, really strong activists, are going to offer or offered to pay, I think, $64 for coal. But that was not solicited. That came from an activist.

And typically, when it comes from an activist, it is either unsolicited or potentially hostile. And then it becomes this whole battle. The acquiring company goes really right to the shareholders rather than through the board of directors to try to make this argument that, yes, you should tender your shares, what we're offering you make sense. It just gets messier. And sometimes they happen, quite frankly, sometimes they don't. Whereas in a typical friendly acquisition or merger, it's more likely to actually close unless there's something going on like antitrust or something with the Justice Department, like we're seeing now people potentially with the

Microsoft Activision deal, people wondering, well, these big mega tech companies are under lots of scrutiny from a monopolistic perspective, and the government doesn't want them to have too much power. And so even though that's a friendly deal, there's a risk that perhaps it wouldn't get done. I want to come back to Microsoft and Activision Blizzard in a minute. But first, in terms of the types of acquisitions, because here's one more way for investors to look at this, there are horizontal and there are vertical. Is there one you'd rather see than the other?

Not necessarily. I think it depends on the individual circumstance. Just today, we see Frontier and Spirit airlines getting together in a merger. Merger is really there are two companies when they're combining. The word merger is more appropriate versus when one company absorbs an entire other company, then the word acquisition is more appropriate. So this is kind of a merger, and it's horizontal because it's two competing companies that are combining to become one bigger company.

In fact, they'll be quite large, certainly top 10, maybe top 5, top 6 airlines out there. So that makes sense. The Microsoft Activision acquisition, that's more vertical because they're not necessarily competing. Microsoft has their Xbox platform, and Activision creates games, and this is a marriage made in heaven theoretically, because now Microsoft can bring that in. and just increase their whole consumer side of their business. That's an example of something that's more vertical. They're buying Activision Blizzard at $95 a share, and I get that the deal is not expected

to close until 2023. But as of this conversation right now, shares of Activision Blizzard are around $80 a share, leading a lot of shareholders to ask, okay, what do I do here? Do I wait until this deal actually closes? because $15 a share, that's a decent amount of money. Do I just sell now and take the 80? How should people think about something like that? Yeah, each circumstance is different. Specific to this one, you laid out the numbers, there's a 20% upside on the table if you hold and the deal gets done.

So what the markets are telling you, because that's a pretty big difference there, it's not usually that big. What the markets are telling you is that there is actually a bigger risk than normal that the Justice Department is going to put a stop to this acquisition. Now, I personally don't think that's going to happen, and I do think it's going to go through. So investors actually have an arbitrage opportunity to come in right now if they don't own the company, if they don't own Activision at all, buy it here, hold on and make a quick 20 percent, assuming it goes through. And you will for sure see institutional investors and arbitrage yours come in and do that. The risk is that if it doesn't

go through. Then you're going to see Activision go back to where it was before the announcement, which was in the 60s. And so you have an upside, downside, risk-reward conversation with yourself to figure out if that makes sense. In this particular example, I think the risk does make sense because the reward of 20 percent is pretty significant. Ron Gross. Thanks for being here. Thanks, Chris. That's all for today, but coming up tomorrow, we'll take a closer look at what a new customer is worth to a business and how much companies are willing to pay to get one. As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have

formal recommendations for or against, so don't buy or sell stocks based solely on what you're here. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.