Chipotle (CMG) Corporate Finance Analysis

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1 Josh Willner MBA Finance Dr. Hutton Summer 2015 Chipotle (CMG) Corporate Finance Analysis Please see attached Excel documents for further analysis of self-made screen shots. 1. Corporate Governance Analysis Is this a company where there is a separation between management and ownership? If so, how responsive is management to stockholders? Who is on the board? Are the directors mostly independent? What are the other potential conflicts of interest that you see in this firm? How does this firm interact with financial markets? How do markets get information on the firm? How does this firm view its social obligations and manage its image in society? Of the eleven members on Chipotle s Board of Directors, four are insiders. This leads me to believe that the separation between management and ownership is noticeable. Mr. Ells, founder and Co-CEO, assumes the role as Chairman of the Board. The other insiders consist of C-Suite executives such as the General Counsel, CFO, Creative Directors and Development Officer. The fact that the original founder of the company serves as Chairman also leads me to believe that shareholder and board decision-making can only accomplish so much in terms of change. A good amount of individuals on the board are now retired. Additionally, the remaining independent directors bring experience from many diverse sectors such as pharmaceutical, cybersecurity, and a good amount of restaurant experience. Two to three individuals who have worked at McDonalds now sit on the board. Elon Musk s brother, Kimbal, serves on the board and is said to bring a strong entrepreneurial influence. All in All, Chipotle s board seems fairly independent; however, reality could tell a different story. You cannot portray a full history of people and their relationships without knowing them. Chipotle is a company that is steeped in Corporate Social Responsibility as a part of its business model. Subsequently, the firm s CSR efforts play a large role in signaling to the marketplace the quality of their offerings as well as the sustainability of their business model. A recent example can be drawn when Chipotle found that one of its pork suppliers was not treating animals to their strict standards. Chipotle communicated to the marketplace that this was not going to be supported, had a slight pork shortage, and found a new supplier. Even though there was a product shortage in their restaurants, consumers and the market took goodwill from this and may have valued the firm more highly due to the nature of their standards. 2. Stockholder Analysis What is the breakdown of stockholders in your firm - insiders, individuals and institutional? Who has the incentive to monitor managers? Who is the marginal investor in this stock? Major investors in Chipotle are institutional investors such as banks and large funds. Fidelity, JP Morgan Chase amongst other indexes and funds are the major elements of shareholder power. These institutions own the biggest blocks of equity. The top individual stockholders in this firm are Board of Director s members. Some of the independent directors on the board have an incentive to monitor managers and steer them in a certain direction if it means serious value creation for them personally. Large financial institutions and mutual funds also 1

2 have the incentive to monitor managers, but the role that a single firm plays in their earnings may be little. The marginal investor of CMG is any one of the large institutional equity holders. 3. Risk and Return What is the risk profile of your company? How much overall risk is there in this firm? Where is this risk coming from (market, firm, industry or currency)? How is the risk profile changing? What return would you have earned investing in this company s stock in the last 1-3 years? Would you have under or out-performed the market? How much of the performance can be attributed to management? How risky is this company s equity? What is its cost of equity? How risky is this company s debt? What is its cost of debt? What is this company s current cost of capital? This firm is not a hugely risky one. It has large market capitalization and a good amount of liquidity. Chipotle is subjected mainly to risk that centers on market-based fluctuations. Consumer tastes and socioeconomic variables play into demand for Chipotle s food. With an average ticket of around nine to eleven dollars, consumer spending for fast casual food is on the rise. Playing off of a health factor, Chipotle has been able to capitalize off a trend away from traditionally over-processed fast food. With healthy ingredients, sourcing and preparation, Chipotle s business model is seemingly not subject to stagnation in future growth or popularity. Threats to the business are present in similar fast casual restaurants. Dining has seen a drift away from drive-thru fast food to pick & choose fast casual restaurants such as Moes, Newks and Baja Fresh. Chipotle conducts business mainly in the USA, with just 17 of their roughly 1700 stores lying outside the U.S. (As of 2014). They are not subject to huge swings in currency value risk. More so, they are subject to the socioeconomics and demography of their markets. Chipotle has seen a great appreciation in the market value of their equity in the past three years. The stock price is up nearly 100% since three years ago with an increase of value around $362 per share. Further appreciation is expected if the firm makes a move to conduct a stock split. If you were an investor in this security, you would have improved your position over the market (S&P 500) by over 52% in a three-year period. Please see below for a visual representation of this performance. Currently trading around $730 per share, this stock is priced out of many institutional investors and funds due to price limit stipulations. If Chipotle were to split 2:1, the firm and shareholders would be better positioned to accumulate additional value in continued growth and appreciation. Below you will find a conservative estimate on a yearly return for Chipotle. This annual return estimate will be used in later section(s) to determine appropriate capital structure for the firm. 2

3 The company s cost of capital would be its current cost of equity due to the capital structure of pure equity. This cost of capital is estimated to be 6.69 as you can see below. 3

4 According to the 2014 Chipotle 10K, performance goals for management are in place. These goals may include EBITDA and Stock Price incentives. Exact compensation metrics for these goals are unclear as they are based on internal metrics and methodologies. 4. Measuring Investment Returns Is there a typical project for this firm? If yes, what does it look like in terms of life (long term or short term), investment needs and cash flow patterns? How good are the projects that the company has on its books currently? Are the projects in the future likely to look like the projects in the past? Why or why not? The typical project for Chipotle is the introduction of a new location. These projects are usually long term in nature due to contractual lease agreements extending years. Smaller projects such as R&D and sourcing initiatives may be sought, but the frequency of such ad-hoc projects is minimal. Financially, Chipotle is a very conservative firm that sticks to what they know best. The firm may need working capital upfront for long-term projects; however, the firm possesses a healthy amount of liquid cash from net income every year. The same projects are likely to continue as the firm grows and pursues additional locations both domestic and abroad. A radical change to Chipotle s business model would need to arise for the projects to differ. Same store growth has been a historically good metric for Chipotle. The first quarter of 2015 showed a 10.4% increase. Returns on invested projects remain healthy. 5. Capital Structure Choices What are the different kinds or types of financing that this company has used to raise funds? Where do they fall in the continuum between debt and equity? How large, in qualitative or quantitative terms, are the advantages to this company from using debt? How large, in qualitative or quantitative terms, are the disadvantages to this company from using debt? From the qualitative trade off, does this firm look like it has too much or too little debt? Chipotle has historically financed with pure equity and has not made any recent moves to transition to include debt as an option. One could make an argument that Chipotle s capital structure is too reliant on equity markets. As I introduce below, Chipotle s Cost of Capital can be decreased by a move to debt; however, this would then cause the company the burden of interest payments. Debt, however, does bring advantages of tax incentives for the firm. Interest payments would then be tax deductible, saving the firm a great deal of cash in the long run. The influence of the historical downsides of equity financing is not as apparent in Chipotle s corporate dynamics as other firms. Shareholder control over corporate decision-making isn t as much of an issue for this firm. Please follow below as I explain a quantitative rationale for the introduction of debt to lower Chipotle s cost of capital. 6. Optimal Capital Structure Based upon the cost of capital approach, what is the optimal debt ratio for your firm? Bringing in reasonable constraints into the decision process, what would your recommended debt ratio be for this firm? Does your firm have too much or too little debt relative to the sector? Relative to the market? Assuming the cost of equity remains constant, any incremental debt will lower the firm s WACC. As such, the company still needs to remain prudent in terms of its interest coverage. Chipotle s EBITDA in 2014 was Million. Assuming a 2.5 times coverage ratio, they can conservatively take on 7.7 billion dollars in debt at 4.25% (~100 basis points/30 year treasury note for Single A Credit Borrowers). I utilized the 30 Year, long-term, treasury rate due to the extended nature of Chipotle s projects. This calculation also relies on the main assumption that 4

5 CMG is a Single A credit holder. Credit worthiness is not readily available due to the fact that the firm has never engaged in debt financing. If the firm decided to engage in debt financing to the maximum extent reasonable, their debt to equity ratio would be around 25/75 (assuming the market cap remains around 22.6 Billion). Below is my quantitative methodology for maximum allowable debt for the firm. Maximum Interest Expense & Debt Amount: Chipotle EBITDA: 710,800 (operating income) + 110,474 (D&A) = 821,274 Million ,274 / 2.5 (assumed interest coverage ratio) = 328 million (maximum interest expense possible) / (Treasury rate) = 7.7 Billion maximum allowable debt If CMG were to take on the 7.7 billion dollars in maximum allowable debt financing its WACC would be considerably lower compared to a capital structure of 100% equity. As you can see below, CMG s cost of equity under full equity financing stands at 6.69 whereas a blended WACC with debt stands at This blended WACC represents the optimal cost of capital for the firm to maintain an assumed 2.5 times interest coverage ratio. It is important to note that the firm s cost of capital would continue to decline as the percentage of debt in the capital structure increases; however, Chipotle s ability to cover the incremental interest expense is hindered, given the previous year s EBITDA generation. The following spreadsheet exhibits a calculated Chipotle WACC assuming they begin to finance to the maximum allowable debt amount. It is important to note that the market return annually was estimated at 8% (S&P 500). The fast casual restaurant industry is historically financed through mostly equity with very few firms opting to utilize debt. Below you will find Lease-to-debt output from the Capital Structure Excel sheet you sent out 5

6 7. Mechanics of Moving to the Optimal If your firm s actual debt ratio is different from its recommended debt ratio, how should they get from the actual to the optimal? In particular, should they do it gradually over time or should they do it right now? should they alter their existing mix (by buying back stock or retiring debt) or should they take new projects with debt or equity? What type of financing should this firm use? In particular, should it be short term or long term? what currency should it be in? what special features should the financing have? CMG is advised to proceed with bond issuing now ahead of expected interest rate hikes with heightened investor demand for better yielding corporate debt. In terms of mechanics, since CMG doesn t have an immediate need for radical change in structure, it makes most sense if they simply pursue future projects using the optimal capital structure detailed in the section above (~25% debt to total capitalization). This approach will gradually bring their total cost of capital downwards with a capital structure that is sustainable. This new debt should be in U.S. Dollars considering the firm conducts the majority of its business activities domestically. Additionally, the firm should be utilizing long-term debt due to the time nature of their projects, and possibly convertible debt. This convertible debt would make more sense for the firm if they feel converting it to equity would free up the company s financial obligations. 8. Dividend Policy How has this company returned cash to its owners? Has it paid dividends or bought back stock? How much cash has the firm accumulated over time? Given this firm s characteristics today, how would you recommend that they return cash to stockholders (assuming that they have excess cash)? Being a relatively young company (IPO 2006), Chipotle has not historically paid out a dividend to its investors. Given a healthy cash flow and growth in net income, many investors are beginning to show a motion towards calling for a dividend. In my opinion, Chipotle s free cash should continue to be used in growth projects and delivering value to shareholders mainly through price appreciation for the foreseeable future (~5 years). Given the fact that Chipotle has no real debt obligations besides its retail leasing, cash flows are ripe for a dividend in the 6

7 future. If dividend policy follows earnings success, Chipotle would certainly be attempting this value-sharing activity. Financial flexibility is key at this point in Chipotle s growth cycle. Thus, they are choosing to not partake Dividends as of yet. Given the fact that the major shareholders of Chipotle are institutional investors and certain types of large funds, they may not receive a large amount of value from dividends. This is due to a higher tax rate on dividends. They would not see as much of a return that would make a huge difference from these cash payments. They would certainly rather see price appreciation and growth. Established competitors within the industry do pay dividends; however, these firms are more mature in nature. 9. A Framework for Analyzing Dividends How much cash could this firm have returned to its stockholders over the last few years? How much did it actually return? Given this dividend policy and the current cash balance of this firm, would you push the firm to change its dividend policy (return more or less cash to its owners)? If Chipotle management decided to institute a dividend, they would be cutting into free cash to finance investment activities. Chipotle retained earnings has been averaging around billion dollars per quarter. This is in addition to a healthy annual EBITDA. Please see below as I have depicted Chipotle s FCFE for the year ended 2014 (numbers in millions). It would be solely up to management how much they would like to distribute to shareholders. I would not personally advise a dividend this early in the company s growth. Free cash should remain utilized in investment and growth activities only. 10. Valuation What growth pattern (Stable, 2-stage, 3-stage) would you pick for this firm? How long will high growth last? What is your estimate of value of equity in this firm (DCF and multiples)? How does this compare to the market value? What is the key variable (risk, growth, leverage, profit margins...) driving this value? If you were hired to enhance value at this firm, what would be the path you would choose? I anticipate a stable growth pattern for Chipotle. Given a recurring business model with little differentiation. Chipotle will achieve continue inorganic growth by saturation domestically. In additional to a stable growth, I believe Chipotle has staying power to continue such growth years into the future as it expands domestically. The key variable driving value for equity 7

8 holders as of now is growth. Future value will be derived from buybacks and anticipated dividends as the firm ages. I will recommend that the firm continue the course of action and strategy for the future and to deliver more value to its shareholders. Below you will find outputs from the Valuation Excel Sheet. 8

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