Master Thesis. Strategic Analysis and Corporate Valuation of Chipotle Mexican Grill, Inc.

Transcription

1 Master Thesis Strategic Analysis and Corporate Valuation of Chipotle Mexican Grill, Inc. MSc in Finance and International Business Michael Christopher Fontenot, Exam Number: Thesis Adviser: Otto Friedrichsen Submission Deadline: 01/06/2014

2 Table of Contents ABSTRACT... 3 INTRODUCTION... 4 PROBLEM STATEMENTS... 5 METHODOLOGY... 6 DELIMITATIONS... 6 THESIS OUTLINE... 7 COMPANY PROFILE... 8 STRATEGIC ANALYSIS INTERNAL ANALYSIS MISSION, VISION, VALUES STRATEGY BUSINESS MODEL EXTERNAL ANALYSIS INDUSTRY ANALYSIS ENVIRONMENTAL ANALYSIS HISTORICAL FINANCIAL ANALYSIS VALUATION MODEL ESTIMATING THE COST OF CAPITAL MODEL ESTIMATES FORECAST ASSUMPTIONS Scenario Analysis SENSITIVITY ANALYSIS IMPLIED MULTIPLES ANALYSIS VALUATION OF SHOPHOUSE EXPANSION VALUE OF INTERNATIONAL EXPANSION VALUATION OF BREAKFAST MENU CONCLUSION REFERENCES... 58

3 ABSTRACT The overall objective of this thesis is to determine the fair market value of Chipotle Mexican Grill Inc. In this thesis, strategic and financial analyses are conducted to support forecast estimates used in the valuation. The primary valuation method used is the enterprise discounted cash flow model. Chipotle Mexican Grill (pronounced Chi- poat- lay) is a chain of fast- casual restaurants known for serving oversized burritos stuffed with fresh, high- quality ingredients. The company has grown rapidly after its IPO in In addition to the Chipotle brand chain of restaurants, the company has developed and opened several Asian inspired restaurants called ShopHouse Southeast Asian Kitchen. Chipotle is a U.S. based company with only 1% of its total restaurants being located outside of the United States. Chipotle is and always has been categorized as a high growth stock. As such, the fair market value of the company has been a highly debated topic. Adding to this debate is the question of how much value does the potential to increase the currently small number of ShopHouse and international locations add to the current value of the company. These are some of the questions this thesis set out to answer. In the end, a weighted average scenario analysis led to an estimated fair market value of $ In addition, an analysis of the companies various growth opportunities resulted in the conclusion that Chipotle does have the potential to add value over and above what is currently priced in by the market.

4 INTRODUCTION Chipotle Mexican Grill, Inc. owns and operates a chain of Mexican restaurants serving fast, fresh, high- quality food. The company has been very successful in creating a strong brand image. Chipotle s Food with Integrity philosophy of using locally sourced meats and produce raised in a sustainable and environmentally responsible way differentiates the Chipotle brand from its competitors. The company often receives additional media attention for their unconventional marketing practices, innovative social media campaigns and extensive efforts to implement and promote socially responsible business practices. The first Chipotle restaurant opened in Denver, Colorado in 1993 and with the help of a large investment from McDonalds grew from 16 restaurants in 1998 to over 500 by In 2006 Chipotle went public and began trading under the symbol CMG on the New York Stock Exchange. Now a component of the S&P 500, the stock price has experienced exceptional growth from a first day closing price of $44.00 in January of 2006 to an all- time high of $ in March of As of December 31 st 2013, Chipotle Mexican Grill has grown to 1572 restaurants in the United States, 7 in Canada, 6 in London, England, 2 in Paris, France and 1 in Frankfurt, Germany. In 2011, CMG opened the first of 6 Asian inspired restaurants called ShopHouse Southeast Asian Kitchen. Following the same philosophy and business model, ShopHouse was created to see if Chipotle could replicate its success by extending its model to different cuisines.

5 PROBLEM STATEMENTS The overall purpose of this thesis is to determine the fair market value of Chipotle Mexican Grill Inc. (CMG). A fundamental component in determining fair value is an accurate assessment of future growth potential. Of particular relevance to the future growth of CMG is the ability to increase unit growth. As such, opportunities for unit expansion will be a primary focus point in this valuation. In addition to analyzing the opportunities for continued domestic revenue growth and expansion of the Chipotle Mexican Grill chain of restaurants, the following sub- questions will be addressed. 1) How much does the potential for international expansion of Chipotle Mexican Grill add to the value of CMG? 2) How much does the potential domestic expansion of ShopHouse add to the value of CMG? 3) How much additional value could be created by extending current opening hours to include a breakfast menu? 4) Is management s idealistic philosophy of Food with Integrity and extensive efforts to implement and promote socially responsible practices an asset and key driver to continued growth or is it a liability and threat to future growth and shareholder value?

6 METHODOLOGY In an attempt to find answers to the previously mentioned problem statements, a combination of strategic and financial analysis will be performed. An internal company analysis and external industry and environmental analysis will be conducted in order to gain incite into the factors influencing Chipotles future growth potential. This will be concluded in the form of a summary SWOT analysis outlining key factors influencing the company s profitability and capacity to increase unit growth without destroying shareholder value. In addition, a historical financial analysis will be performed in order to evaluate the company s ability to combine unit growth with growth in revenues and return on invested capital. Information from both the strategic and historical financial analysis will be used to estimate and then forecast future unit and revenue growth. These estimates will provide the basis for answering the proposed problem statements. The enterprise discounted cash flow model will then be used to value the company based on multiple scenarios including those related to answering the problem statements. Finally, a sensitivity analysis and implied multiples analysis will be performed in order to evaluate the inputs and assumptions used in the valuations. DELIMITATIONS Although financial statements for the year ending 2005 and Q were available prior to the completion of this thesis, the historical financial analysis will be based primarily on information from the financial statements for the years ending In addition, Chipotle has recently announced their investment in a pizza restaurant company called Pizzeria Locale. As the percentage and dollar amount have not been disclosed and the company currently consists of only a single restaurant, no discussion or consideration of Pizzeria Locale will be included in this thesis. Furthermore, it should be noted that the excel spreadsheet and model used to value employee stock options is not of the author s own design.

7 THESIS OUTLINE Chapter 1: This chapter consists of: A brief introduction highlighting areas of interest behind the motivations for this thesis; A description of the problem statements to be investigated and answered by this thesis; A brief description of the methodology and models used to provide answers to the problem statements; A description of certain delimitations associated with the thesis; A company profile providing relevant background information considered to be both helpful and necessary for a complete understanding of the strategic and financial analysis. Chapter 2:This chapter includes the strategic analysis of Chipotle Mexican Grill. The analysis is divided into three parts: An internal company analysis, an external industry and environmental analysis, and a summary SWOT analysis. Chapter 3:This chapter includes a historical financial analysis of the company highlighting relevant accounting issues, and the historical developments in revenue growth and return on invested capital. Chapter 4:This chapter includes a discussion and description of the valuation methods used to answer the problem statements and a discussion of the estimation models, methods, and results used in the final valuation. Chapter 5:This chapter describes the estimates and assumptions used in forecasting the financial statements and associated free cash flows used for answering the problem statements and final valuation. Chapter 6: This chapter includes the final valuation of Chipotle Mexican Grill using a weighted average of three possible yet hypothetical scenarios. Chapter 7:This chapter includes a sensitivity analysis of the estimates used in the valuation model and an implied multiples analysis as a test of plausibility. Chapter 8:This chapter includes answers to all four problem statements and final conclusions.

8 COMPANY PROFILE After graduating from the Culinary Institute of America, founder Steve Ells went to work as a sous chief in an upscale San Francisco restaurant. With a dream of opening his own fine dining restaurant, Chipotle was originally conceived as a way for Steve to generate enough cash to realize that dream. The Chipotle Mexican Grill concept was inspired by the local taquerias (traditional street vendors who make and sell fresh, authentic Mexican tacos and burritos) he frequented while living in California. Combining his appreciation for fresh ingredients with his training in classic cooking methods, Ells set out to create a better burrito. In 1993, with a loan from his father, Steve opened the first Chipotle Mexican Grill in Denver, Colorado. The restaurant proved to be a success. (chipotle.com) A Few Things, Thousands of Ways Chipotle restaurants serve only a few things: burritos, burrito bowls, tacos and salads. Customers can choose from four different types of meat, two types of beans and a variety of extras such as salsas, guacamole, cheese and lettuce. (CMG AR 2014) Customers order and choose ingredients via an interactive assembly line format. The order process consists of choosing one of four main menu items, then personally selecting the individual ingredients to be included.

9 Food with Integrity From the beginning, the importance of using fresh ingredients has been the cornerstone and hallmark of the Chipotle brand and the quality of food that it served. However, overtime their belief that freshness equals quality was challenged. In 1999 Steve Ells visited one of their pork suppliers. After seeing the conditions and learning more about how these animals were being raised, Steve decided he wanted to do things differently. From that point in time, Chipotle has been increasingly active and committed to raising the standards that define quality ingredients (chipotle.com). Their Food With Integrity philosophy outlines their focus and commitment to not only using the highest quality ingredients possible but also doing so with respect for the animals, the people and the environment that produces them. This includes extensive efforts to remove all genetically modified organisms (GMO S) from their menu items, serve meat and dairy products free of growth hormones and antibiotics, and the use of local and or organic produce whenever possible. Today Chipotle serves more naturally raised meat and local produce than any other restaurant company in the United States.(chipotle.com). Changing the way people think about and eat fast food Over recent years, the Chipotle story has evolved from Big Burritos to Big Agriculture. Their efforts to educate the public and influence industry standards in the areas of sustainable agriculture and responsible food production have become a large part of the Chipotle brand image. In 2011, Chipotle produced and released a short animated film called Back to the Start showing the journey of a small pig farmer as he transforms his small family farm into an industrialized animal factory. The story then proceeds to show the farmer struggling with the morality of what he has created and eventually tearing it all down and going back to more natural farming methods: back to the start. Then in September of 2013 Chipotle released another original animated film called The Scarecrow about a scarecrow working for a huge industrialized food production factory. The story shows a behind the scenes look into the dark side of industry practices such as animal confinement and antibiotic/hormone injections. In February 2014, Chipotle released a four part original comedy series called Farmed and

10 Dangerous based on big agriculture and the evil practices used by large corporations in the factory farming and food processing industries. STRATEGIC ANALYSIS The purpose of this strategic analysis is to provide insight and understanding into the issues affecting the past, current and future business activities of the company. These insights will then be considered when analyzing past financial performance and in forecasting future scenarios for the company. INTERNAL ANALYSIS The internal analyses will begin by looking at the companies goals and objectives as expressed through its mission, vision and values statements and the strategies by which they hope to obtain them. Then an analysis of the business model will be performed in order to identify and evaluate the resources, capabilities, structure and systems used by the company to implement those strategies. MISSION, VISION, VALUES Analyzing a companies Mission, Vision, and Value statements is an important first step in strategic analysis. The mission statement describes their purpose for being in business today. The vision statement announces their ambitions for the future. The value statement declares their organizational beliefs and standards of behavior (Grant, R. M. (2010)). The following statements were taken from Chipotle s 2012 annual report. Mission: Serving high quality food while still charging reasonable prices. Vision: " Our vision is to change the way people think about and eat fast food. Values: " We believe that purchasing fresh ingredients and preparing them by hand are not enough, so we spend time on farms and in the field to understand where our food comes from and how it is raised." "We focus on recruiting and retaining top performing people to ensure that the restaurant experience we provide is exceptional; on building

11 restaurants that are operationally efficient and aesthetically pleasing; and on doing all of this with increasing awareness and respect for the environment, animals and people who grow or raise the food." Chipotles statements of mission, vision and value, as stated in their annual reports from 2006 to 2013, have been both clear and consistent over time. Any variations between years have been to further enhance efforts associated with the previous year statements. According to Grant, R. M. (2010). clear, consistent long- term goals are the first element in successful strategies. Corporate statements of mission, vision and value are sometimes viewed by people, inside and outside of a company, as being just words. However, looking at a companies actual business practices and resource expenditures can help to determine the validity and authenticity of these statements. A clear connection between Chipotles vision statement and a commitment of resources can be seen in its cause marketing campaigns Back to the Start, The Scarecrow, and the new Farmed and Dangerous series. STRATEGY Porter s generic strategies for competitive advantage will serve as a starting point to frame the discussion of Chipotles overall competitive strategy. Porter describes two primary strategies that companies can use to create competitive advantage in an industry or market. These include cost leadership and differentiation. (Grant, R. M. (2010)) Using Porters model, Chipotle clearly falls into the category of differentiation. The fast food industry as represented by large chains like McDonalds has widely been associated with and characterized by serving less than high quality food. Although it is quite clear that millions of people enjoy eating at these chains, it is likely that few if any would describe the food as high quality. The use of microwaves and warming lamps to prepare and serve highly processed, pre- cooked food is in many ways symbolic of the industry. Unlike most large fast food chains, Chipotle in- store employees actually

12 prepare and cook the food in the restaurant. Employees do not just reheat and assemble frozen, pre- cut, pre- cooked food; they chop the fresh raw vegetables with knives, cook raw fresh meat on grills in open kitchens where customers see the food being cooked. Chipotles differentiation is based on offering a higher quality of food with a higher perceived value compared to others in the industry. This quality is based on the use of high- quality ingredients and classic cooking methods. In addition, the use of an open kitchen floor plan and unique interior design further add to the feeling that this is a different kind of fast food restaurant. BUSINESS MODEL Analysis of CMGs business model will be based on the 9 building blocks of the Business Model Canvas as outlined in the book Business Model Generation. The 9 areas for analysis include: Customer Segments, Value Propositions, Channels, Customer Relationships, Revenue Streams, Key Resources, Key Activities, Key Partnerships and Cost Structure (Osterwalder, A., & Pigneur, Y. (2010)). The individual analysis of these components and how they work together as a whole, allows for an in depth understanding of the company's operations and the ability to quantify the degree of importance of each component area as they relate to the companies key value drivers and costs. This ability to understand the interaction of the individual parts and how they affect the whole is extremely helpful when determining the validity, power and significance of current and future strengths and weaknesses. This is not only key to understanding the impact of new news and events on the value of the company but in understanding exactly how and where it affects the company.

13 Key Activities The key activities describe the most important things a company must do to make its business model work. They are required to create and offer a value proposition, reach markets, maintain customer relationships and earn revenues. ( Osterwalder, A., & Pigneur, Y. (2010). Chipotles key activities include: marketing, customer relations, supply chain management, employee acquisition and training, and new store location and expansion. These key activities will be the focus of discussion that follows. Customer Segments Customer segmentation involves analyzing the "mass market" customer base and then grouping customers with similar characteristics into individual segments. Identifying common characteristics and the creation of customer segments allows companies to maximize the effectiveness of their business activities and the utilization of their resources. Chipotles customers are derived from the "mass market' of consumers who choose to frequent a restaurant for their lunch and/or dinner needs. As such, the overall demographic of their customers encompasses a wide range of characteristics. Upon entering a Chipotle restaurant, it is not atypical to observe customers that vary widely in age, perceived level of education and social class/status, ethnicity and gender. As for customer segments, Chipotle does not publicly define a "specific" group or demographic. However, analyzing and reverse engineering their value proposition and associated business model components clearly points to a well known demographic. A comparison of Chipotles value proposition and business model with the dominant character traits, values, and behaviors that define "Millennials" (aka. "Generation Y ) shows a high degree of correlation. In fact the similarities are so significant that an analysis of Chipotles strategy and business model would be incomplete without providing some additional information regarding this demographic. Some of the findings from a recent

14 study by Fromm (2013) on Millennials that are relevant include: Millennials include some of the earliest adopters of new technologies and emerging social tools? Millennials are interested in participating in brand marketing. Millennials strive for a healthy lifestyle. Millennials seek peer affirmation. Millennials are hooked on social media. Millennials believe in cause marketing. Millennials ask the question, is your brand authentic and transparent or just using a cause to sell them something in a disingenuous way? This final statement is particularly important as many consumers are becoming increasingly aware of the fact that companies often make only superficial adjustments to products in an effort to keep up with changing consumer trends. Value Propositions A company's value proposition constitutes the sum total of all products, services and experiences that create a real or perceived value for customers. It comprises those elements that differentiate its products and services from competitors. A company's value proposition may be quantitative and or qualitative in nature. (Osterwalder, A., & Pigneur, Y. (2010)). Chipotles primary value propositions come from their customizable menu choices, the quality of their ingredients, relative price for value, service efficiency, and dining experience. These are often articulated through company slogans: " A Few Things, Thousands of Ways"

15 " Serving high quality food while still charging reasonable prices" "Food Served Fast So That Customers Can Enjoy It Slowly" Channels Channels describe how and where a company communicates and delivers their value proposition and products to customers. More specifically, channels are the places and avenues companies use to create awareness of their brand/product/service, enable customers to purchase products and services, and ultimately deliver the overall experience of the value proposition to the customer. (Osterwalder, A., & Pigneur, Y. (2010).) Restaurants Chipotles restaurants play a primary role in delivering the companies value propositions and the customer experience they define. Serving their focused menu in an assembly line format allows them to efficiently serve customers in a timely manner while the open kitchen format allows customers to see all ingredients being freshly prepared and cooked. The interior design of their restaurants is based on the same philosophy as their food, using a few simple ingredients to create something special. Their restaurants follow a functional, modern and simplistic design that is both consistent and unique. The overall affect creates a place that feels trendy and modern with a distinct sense of style and personality. The combination of quality food, service, and design provide the overall experience. Company Website The design and format of their online order process is easy and intuitive almost exactly replicating the in- store order process. Chipotles is notorious for having lines so long that they go out the door during peak lunch times. Online ordering helps to reduce these lines while increasing the number of sales during peak hours. When customers arrive to

16 pick up their orders, there are a number of parking spaces reserved specifically for customers who have ordered online and this further enhance the speed and experience of the process. In addition to enabling customers to order food and purchase products, the site offers a variety fun formats designed to further educate and create awareness on topics that define and differentiate the Chipotle brand. Social and Online Media Chipotle has fully embraced the use of social media as a platform to further create brand awareness and the Food With Integrity philosophy that define it. Using social and online media platforms such as Facebook, Twitter, YouTube, etc., Chipotle focuses on real interaction and getting to know/ having a relationship with customers. These will be discussed further in the customer relationships section of this analysis. Marketing Chipotle is well known for its unconventional and innovative marketing campaigns. In particular, their cause marketing campaigns in recent years have been the subject of much debate. The defining characteristic of their marketing efforts is that they are all designed to give people something to both think and talk about. They believe in and focus on word- of- mouth marketing and promotion. Creating unique marketing pieces gives people something to talk about and more importantly something to share with others. Chipotle has been very successful at creating headline grabbing, buzz worthy attention not only through purposeful marketing campaigns, but also from first and or best in class business activities and initiatives. Community Events Over the years, Chipotle has used various local community contests and events to

17 further create and expand awareness of their brand and cause. Some of the most popular events include Chipotles Cultivate Food, Ideas and Music Festivals and the Boorito Halloween contests. Chipotles Cultivate Food, Ideas and Music Festivals: These events give our customers an opportunity to experience Chipotle in a new way and to learn something about issues in food, develop a deeper appreciation for farmers and food artisans who are changing food culture for the better, and enjoy some great music. (chipotle.com) Customer Relationships The customer relationships component of the business model describes the type and purpose of the relationships a company aims to create with its customers. It describes how and why they interact with customers. The type of relationships can range from highly personal to highly automated. Defining the purpose of the relationships is an important aspect in choosing what type of relationships a company should focus on. What are they trying to accomplish with the relationship? Is the goal to create new customers; retain current customers or increase revenues from existing customers? (Osterwalder, A., & Pigneur, Y. (2010).) At Chipotle, two primary types of customer relationships stand out. The first can be seen in their stores. Their assembly line order process involves a real time, one on one dialog between the customer and the person assembling their food. This interaction and ability to ask questions, etc. creates a more connected and personal experience. The second type of relationship can be observed through their active participation in social media and community events. This type of relationship involves creating a sense of community. Creating a sense of we, a sense of belonging to a group of like- minded individuals based on shared values. The combination of Cause Marketing and community events provides opportunities to connect with new customers and strengthens relationships with current customers. Key Partnerships

18 Chipotles key partnerships include: their regional distributers of food, beverage, materials, network of farmers, real estate brokers, and landlords. These partnerships are all considered vital to the past and future success of the company. However, the companies network of local farmers is especially important as their value proposition is directly related to the quality and the integrity of their ingredients. Furthermore, in the case of Chipotle, these partners are not easily replaced. In fact, finding enough suppliers who can meet Chipotles quality requirements has been a big challenge for the company. In recent years, the supply of these quality ingredients has not been able to keep up with demand. For example, on a number of occasions, Chipotle has disclosed that they have been forced to use ingredients that do not meet the standards they have promised their customers. Key Resources Human Resources Executive Management: Steve Ells: the founder, chairman and co- chief executive officer is a key resource for the company. Steve was recently named the second most powerful person leading and shaping change in the restaurant industry by Nation's Restaurant News. (2014 NRN Power List). His authentic story and commitment to changing the industry based on the "Food With Integrity" philosophy is an integral component of the past, present and future success of the company. Corporate employees: their experience and capabilities have allowed Chipotle to grow successfully at a rapid pace. Customer relations, marketing, supply chain management, human resources, etc. Their experience and expertise are a key asset and determining factor in Chipotles ability to successfully expand operations. In- Store employees: These include managers and crewmembers. This is an area where Chipotle really stands apart from others in the industry. Executive management has described this group as the most important in the company. Their Restarantor

19 program is designed to create an incentive program that is not often found in hourly employment positions. Furthermore, when they hire a person for a dishwasher position, they do it based on whether or not that person shows the quality and characteristics to eventually become a top performing restaurant manager. Financial Resources Chipotles has maintained a strong balance sheet with sizeable assets and zero bank debt. Furthermore, as a publicly traded company, Chipotles financial resources include the ability to issue new equity and or debt if needed. Further discussion of Chipotles financial resources is provided in the financial analysis. Physical Resources Chipotle leases almost all of their store locations. However, the large number of nationwide restaurant locations and the lease agreements governing them is their most valuable physical resource. Intellectual/Intangible Resources Chipotles intellectual resources consist of various trademarks related to their company slogans and other name rights. Chipotle, Chipotle Mexican Grill, Unburritable, Food With Integrity, Fresh Is Not Enough, Anymore, The Gourmet Restaurant Where You Eat With Your Hands, Responsibly Raised, ShopHouse and a number of related designs and logos are U.S. registered trademarks of Chipotle. We also believe that the design of our restaurants is our proprietary trade dress (CMG AR 2012). Without question, the most valuable intangible resource the company has is its brand name and the reputation of integrity associated with it.

20 Revenue Streams The revenue streams component categorizes the methods by which a company receives revenues from its customers. (Osterwalder, A., & Pigneur, Y. (2010).) Chipotles does not offer franchise or license agreements at this time or in the foreseeable future (CMG AR 2012). Their main revenue stream comes from the sale of their menu items. These revenues are generated primarily from in- store food sales. Chipotle has recently added catering services to their offerings allowing them to deliver the same in- store menu items in a new way. However, catering is a very small percentage of revenues at this time. In addition to in- store and catering food sales, Chipotle also generates revenues from the sale of gift cards and a small number of miscellaneous branded merchandise such as shirts and water bottles. Cost Structure The cost structure describes key costs associated with delivering the company s value proposition. For restaurants the most important costs are food costs, labor costs and occupancy costs. The importance of these costs has much to do with the structure of the industry. Food and labor costs make up the majority of the costs of goods sold and the nature of the business requires large capital investments in fixed assets in the form of new stores. A single restaurant can only serve so many customers. As customer demand increases companies must open additional stores, hire additional employees to run those stores, and purchase additional inventories to be sold. In other words, the industry is not set up to have significant increasing returns to scale. The importance of food, labor, and occupancy costs will be discussed further and in more detail in both the external strategic analysis and financial analysis that follow.

21 EXTERNAL ANALYSIS As a starting point for industry analysis it is important to discuss the definition of the industry to be analyzed. The restaurant industry can be segmented into two main sectors: limited- service restaurants and full- service restaurants. However, the industry is more commonly segmented into three basic categories: fast food, casual dinning, and fine dining. Fast food restaurants also known as limited- service restaurants (LSR) or quick- service restaurants (QSR) are characterized by lower priced menu items, where speed of services is a priority, and where customers must pay for their food before they sit down to eat. McDonalds would be the classic example of a fast food restaurant. Compared to LSR s, casual dinning restaurants are characterized by moderately higher prices, a broader menu selection, a more casual atmosphere, a higher perceived quality of food, and the addition of waiter and waitresses providing table service. Examples would include the Chilies chain of restaurants in the United States and Jensens Bofhus in Denmark. In comparison to casual- dinning restaurants, higher prices, higher food quality, and overall higher levels of service characterize fine dinning restaurants. Recently, a newer segment labeled Fast Casual or Quick Casual restaurants has received much attention. It is important to understand that this is not technically a separate segment but the description of a group of restaurants in the traditional LSR- fast food segment. It could be considered a sub- segment of the fast food segment. At the most basic level, they are still limited service restaurants where you pay before you eat. The name Fast Casual is derived from the fact that these restaurants seem to combine the characteristics associated with fast food and casual dinning restaurants. Most notably, this segment has embraced certain practices that are atypical of the traditional fast food industry. These restaurants offer menus consisting of freshly prepared food and quality ingredients in a comfortable upscale atmosphere. In addition, many of these restaurants show a noticeable appreciation and tendency towards social and environmentally responsible business practices.

22 Over the last few years, this segment has experienced rapid growth in market share. As a result, the large national fast food and casual dining chains that have dominated the restaurant industry in years past, have been looking at the success of fast casual restaurants and adapting their business models, restaurant design, product offerings, and marketing efforts to compete against this new sub- segment. These activities may potentially create wide spread change in the structure of an industry that has been relatively consistent for decades. Although technically a segment of the overall restaurant industry, for the purpose of this thesis, the industry to be discussed and analyzed will be the fast food industry. This is defined as consisting of traditional fast food and fast casual segments collectively. INDUSTRY ANALYSIS The purpose of the competitive industry analysis is to evaluate how the dynamics of competition and the companies involved effect industry attractiveness and profitability. For this, Michael Porters Five Forces framework will be used. The theory assumes that the intensity level of the competitive environment in the industry is dictated by five competing forces which together act to determine the attractiveness and profitability of an industry. The five forces include: the degree of rivalry among existing competitors, the threat of new entrants, the threat of substitutes, the bargaining power of buyers, and the bargaining power of suppliers. (Grant, R. M. (2010). ) From a purely financial perspective, industry attractiveness in terms of profitability can be measured by analyzing the weighted average cost of capital (WACC) and return on invested capital (ROIC) for the industry. Using Bloomberg and taking a market capital weighted average of individual company ROIC s and WACC s, a level of industry profitability can be calculated and analyzed. The results of this exercise show a market cap weighted average ROIC and WACC of 20.23% and 7.99% for companies in the fast food industry. Based on those numbers, this is clearly a profitable industry to be in and one could make the assumption that this would attract attention and increase the threat of new entrants in the future. These numbers alone however do not explain where the

23 source of profitability is coming from or the factors contributing to the industries ability to achieve this level of return. Therefore, it is necessary to look deeper into the industries individual competitive parts as suggested by Porter. Rivalry between Established Competitors: Over the years, the dominant fast food chains have waged war on each other through various marketing campaigns and promotional offers in an attempt to win customers. A review of the television commercials for McDonalds, Burger King and Wendy s hamburger chains over the past twenty years provide clear evidence of intense rivalry. However, an argument could be made that the level of rivalry between the established national chains has been lower than perceived. This can be seen in the fact that industry wide menu prices are continuing to increase. Theoretically, the presence of intense rivalry and competition should result in a decline of overall industry prices. A possible explanation is that companies have been competing based on non- price related factors. Instead of engaging in price wars, companies have been competing based on differentiation factors and new product offers. Chipotle is a perfect example of a company competing based on pure differentiation. Where as other companies focus on promoting limited time offers on new menu items to lure customers to their stores. Recent examples of this are Taco Bell s Doritos taco and Wendy s pretzel bun burger. These non- price related competitive strategies have clearly dominated the marketing and advertising campaigns used by industry leaders in recent years. However, the dominance of non- price related competitive strategies might soon change. With the success of the fast casual concept and an attractive overall industry spread, the future may bring many new entrants into the industry. As more restaurants with new, yet similar, concepts enter the industry, the levels of differentiation may be unrecognized by consumers resulting in increased price competition over time. Threat of New Entrants: The threat of new entrants has been relatively low. Although it may be fairly easy for an individual to by into a national franchise, the creation of a new national chain is quite a

24 large endeavor. It requires significant financial resources and industry specific knowledge to enter the industry at a relevant scale. Again with the success of the fast casual concept and an attractive overall industry spread, the future may bring new entrants into the industry. In fact, this is already starting to happen. A number of national casual restaurant chains and fine dinning restaurants are creating fast casual spinoffs of their brands to compete in this segment of the industry. This threat of new entrants from established firms within the overall restaurant industry presents a significant threat. Unlike traditional new entrants, these companies have both access to the required capital and the knowledge required to expand rapidly on a national level. Competition from Substitutes: It is important to clarify what defines true competition from a substitute. The clarification between substitutions in buyer behavior versus the choice of a substitute industry product is required. For example, customers can choose to substitute their behavior of purchasing food for lunch with preparing food at home. This is different from deciding to substitute buying lunch from a fast food restaurant with buying lunch from a substitute establishment. Typical substitutes for fast food chains include: pre- packaged sandwiches and meals from the fresh section of grocery and convenience stores, food trucks and street vendors, local and family owned restaurant and shops, and larger casual- dining restaurants. While a number of casual dinning restaurants are creating new fast casual spinoffs as previously discussed, other large casual dinning chains are making adjustments to current menu items, prices and service models in an attempt to steal fast casual customers. Bargaining Power of Buyers: Buyer bargaining power is generally a function of supply and demand variables, their ability to buy a similar product at a similar price, and any associated switching costs. In the fast food industry, buyers/customers can in many cases buy a similar product at a similar price with zero switching costs. For example, customers can purchase a hamburger from McDonalds or Burger King and get relatively the same product at the

25 same price. Based on the previous example one could conclude that the bargaining power of buyers in the industry should be relatively high. On the other hand, the argument could be made that the bargaining power of buyers is ultimately based on their collective ability to place pricing pressure on the industry. As previously discussed, industry menu prices have consistently increased over the years implying that buyers have not influenced prices in their favor. Buyers in the fast food industry consist of individual consumers and although their combined size is very large, they do not make purchases collectively. This is unlikely to change. Bargaining Power of Suppliers: The bargaining power of suppliers is relatively high for the industry. Although one may think that large companies like McDonalds would have substantial bargaining power over their suppliers, the reality is somewhat more complicated. The issue is that there are very few suppliers that can handle the demand requirements of large national chains. In this case, there are many fewer suppliers than buyers leading to more supplier bargaining power. This is compounded by the fact that even the largest fast food chains represent a small % of overall sales for these suppliers. For example, 85% of all beef products in the U.S. are supplied by only four companies (Reding, N. (2014).) Considering the level of beef products served in the industry, this provides strong leverage for those suppliers. As large as McDonalds is, their total beef purchases still represent less than 2% of the total beef industry. (mcdonalds.com) Implications for Chipotle For chipotle, these developments could become a real problem in the future. As more and more comparable restaurant and options become available from new entrants, copy cat business models and established rivals adjusting their offering to be more similar to Chipotles value propositions. Taking away chipotles pricing power for differentiation will hurt their operating margins. Increasing industry demand for supply of the same quality of produce as Chipotle from an increasing number of competitors will increase their cost of goods sold further reducing operating margins. The result could be reduced

26 same store sales, reduced ability to charge a price premium for differentiation and increased costs of goods sold via food supplies. A large part of Chipotles efforts to promote changes in the food production industry is based on their belief that an increase in overall demand for sustainable higher quality food will ultimately lead to an increase in supply. Chipotles high standards mean that they have fewer suppliers to source ingredients from than many of their competitors. This puts Chipotle in a difficult situation. As Not only does it challenge their ability to grow their business from a supply restraint standpoint, but also it puts additional pressure on their profitability margins due to the ever- increasing bargaining power of their suppliers. ENVIRONMENTAL ANALYSIS Political/Legal The impact of ever changing political and legal issues on the fast food industry can be quite high. These issues are wide ranging and can have significant influence over industry profitability. While laws and regulations are designed to protect the welfare of consumers and employees, the compliance requirements generally result in an increase in costs for industry participants. The industry is subject to a variety of legal and regulatory issues including: local and federal labor laws affecting employee wages and benefits, environmental protection laws, consumer protection and food safety laws, and corporate tax laws. Two areas of interest that are set to impact the industry in the near term include the Affordable Care Act and the proposed increase in the federal minimum wage. In the United States, the majority of hourly employees in the fast food industry do not receive insurance benefits from their employers. The Affordable Care Act requires that by 2016 employers with full- time workers must provide affordable insurance to all employees working 30 or more hours per week. (nrn.com) For large employers like national fast food chains, this may amount to a significant increase in labor costs over the coming years.

27 Changes in local and federal minimum wage requirements are another area poised to increase costs for the industry. The current federal minimum wage is $7.25 per hour. Last year, a bill backed by President Obama was proposed to increase the federal minimum wage to $10.10 per hour. If this were to take affect, the impact on labor cost would be substantial. Increasing by over 39%. In April of 2014 the senate blocked the proposed bill to increase the Federal minimum wage. (nrn.com)this has been followed by protests in 150 cities in the U.S. by workers in the fast food industry who are calling for minimum wages of $15 per hour.(nrn.com) Economic The overall economic environment plays a major role concerning the profitability of companies in the fast food industry. There is a long list of economic metrics and variables that can be considered important to industry profitability, many of which are interrelated and codependent. This analysis will break down the most important economic factors for the industry as they relate to consumer demand, costs of goods sold. Consumer Demand: In the fast food industry, sales are primarily the result of discretionary purchases. For the most part people do not need to buy fast food. Therefore, factors effecting changes in consumer discretionary income and spending are very important. Consumer spending on discretionary items is affected by many macroeconomic factors. The health of the overall economy influences unemployment rates, which in turn impacts disposable personal income, consumer confidence and ultimately discretionary spending. Cost of Goods Sold: For the restaurant industry, there are three primary costs associated with a company s cost of goods sold: Food Costs, Labor Costs, and Occupancy Costs. Food Costs, which are affected by fluctuations in commodity prices, are the least stable and most difficult to control costs for fast food companies. Many companies use hedging to try to reduce the uncertainty and volatility but beyond that they are mostly out of the companies control. Labor Costs: federal and local governments generally

28 determine labor costs as previously discussed. However, overall unemployment rates can also have an effect on the cost of labor. Occupancy Costs: Are a function of the cost and demand for commercial real estate. Typically these two variables are a function of long- term interest rates and the health of the overall economy. According to the CBO budget and economic outlook , disposable income and consumer spending on goods and services is expected to increase by 3% in 2014 and grow by nearly 3% per year on average through In addition, the agency reports that US real GDP is projected to grow by 3.1% in 2014, 3.4% in 2015 and 2016, 2.7% in 2017, and by an average of 2.2% (cbo.gov). Social Social factors including overall societal preferences, beliefs, aspirations, and concerns affect demand for products and services. Companies must be mindful of these factors when deciding on marketing and operating strategies. Social factor influences change over time and companies must continually adjust to these changes as they develop. For an industry dominated by large national chains, the time and costs of implementing nationwide changes to adjust for changing consumer preferences can be substantial. The fast food industry has long been demonized for contributing to the obesity problem in modern society. Over the last years, the trend towards a more healthy diet and lifestyle has been seen as a threat to many in the industry. In recent years, the industry has made adjustments to address these concerns by adding healthier options to their menus. Today, the trend in consumer preferences has developed beyond healthier choices. Consumers have demonstrated an increased preference towards food that is prepared fresh using quality ingredients. In addition, a trend towards social consciousness has developed where customers want to feel good about where their food comes from. (nrn.com) An ever- increasing number of consumers are becoming more aware and concerned about the effects of artificial additives used in food production. These trends will place high demands on many of the traditional fast food chains known for serving low quality, highly processed, pre- cooked food. For large companies, making

29 changes to meet changing consumer preference can take a long time to implement and leaving them at a competitive disadvantage. To highlight the previously mentioned issues, McDonalds will be used as an example once again. In January 2014 McDonalds acknowledged that the rise in social consciousness and growing consumer demand for responsibly raised proteins presents a big challenge for the company. They announced that they are now committed to the goal of offering, verified sustainable beef in their restaurants. However, due to their size and the complexity of their supply chain, they believe it will take them at least two years before they can begin serving verified sustainable beef to their customers.(mcdonalds.com) Technological Technology has played an important role in the historic development of the fast food industry. Most notably, developments in automated food production have allowed this industry to grow exponentially and take advantage of economies of scale. Today, technology advancements in point of sale systems, online and mobile payment methods, and social media are providing companies with new ways to increase sales and improve customer service. One of the key success factors in the industry is based on throughput. Throughput is a measurement of how many customers a restaurant can serve on an hourly basis. This is a critical metric considering that restaurant sales are highly influenced by peak hours. Peak hours are periods associated with a higher volume of customer sales and are typically broken down into breakfast, lunch, and dinner times. These hours make up a disproportionately large percentage of daily sales. A primary area of focus regarding the improvement and or increase in throughput statistics is at the point of sale. For many fast food restaurants, this point of sale is the order counter. The longer it takes for a customer to order and pay for their food the slower overall throughput. Advances in the technology of point of sales systems, online ordering, and mobile payments allow restaurants to serve more customers faster and improve the customer service experience. In addition, due to advancements in mobile payment technologies, these systems allow companies to track individual customer purchases and patterns of behavior. This is extremely valuable information that can be