I am excited to launched a Youtube channel extending the information and ideas from theValueSurfer website. The first “How to” video series will be for beginners who are starting to think about investing in stocks and want to learn the ABCs. The first video is now available here How to Invest in Stocks? Step 1 – Opening a Brokerage Account Online Please watch and subscribe for more upcoming videos. Thank you!!
Approximately a year ago in August 2013 I wrote an article about the veterinary care company then called VCA Antech (WOOF) outlining the opportunities and risks facing it. Since June 2014 the company is known as VCA Inc. in an effort at rebranding. It operates over 600 veterinary hospitals as well as a network of laboratories in the United States and Canada. In this article today I will refresh that analysis and attempt to re-evaluate the company based on updated information.
Recent Financial Performance
The company released its second quarter financial results last month. It reports its financials in three major segments; Animal Hospital, Laboratory and All Other. It beat consensus estimates on earnings with an EPS growth of over 10% in Q2 2014 versus prior year. Revenue missed analyst expectations but still expanded by 5.2% over the previous year.
The last time I reviewed VCA Inc., I was concerned about the lack of revenue growth in their largest segment, that is, Animal Hospital, which accounts for about 76% of total revenue. For the six months ended June 30th 2014 revenue in this segment expanded by 4.6% year-over-year. In Q2 the same figure was 5.9% out of which 2.2% was organic growth whereas the rest came from acquisitions. While this growth is not impressive, it is a good start to improving the top line. Another positive development was expansion in gross margins both at a total and same store level. Management has indicated that there is still room for margin expansion in the future. The company has also continued with acquisitions, adding 6 new hospitals so far with more in the pipeline for the remainder of the year.
Revenue growth in the Laboratory segment was 3.3% over prior year for the six months ended June 30th, 2014. Separately organic revenue growth in the second quarter over previous year in labs was over 5%. This category reported improved profitability as well with expanded gross margins. While the number of requisitions was down, it was the smallest decline in recent history. Also the company added 2 new labs to its network.
The All Other segment reported an approximate 7% decline in revenue year over year but it was due to a onetime hit from the destruction of the Sound Eklin facility in Carlsbad from wildfire.
Price and Valuation
Since I wrote about WOOF one year ago its price has risen approximately 42% from $27.29 to $38.98. For reference the S&P 500 has risen 21.7% in the same referenced period. The following chart shows the movements in the closing share price of the company along with the highest and lowest closing price in this approximately one year period.
Interestingly when I wrote my last article about VCA Inc., its trailing twelve month (ttm) P/E ratio was very high at over 50, even though the forward P/E was expected to be at a much more reasonable level around 16. With improved earnings performance in past quarters the company is trading today at about half of that ttm P/E of about 24 which is closer to historical levels.
Universal Appeal: As I outlined in my last article, there is a high proportion of pet owning households in the United States. Estimates range between 70–83 million pet dogs and 74-95 million pet cats. I think that the universal appeal of pets to different demographic groups is likely to continue whether the population has a mix of the elderly with companion animals, families with children and family pets, or young, single professionals in apartments with smaller pets.
Pet Care Expenditure: Additionally the general sensibility in the United States of treating pets as members of the household also increases the likelihood that pet owners will continue to spend money on the health and well-being of their animals. In my last article I quoted the American Pet Products Association (APPA) which forecasted total expenditure on pets in the United States would be upwards of $55 billion in 2013, that is an increase of 4% over 2012. Actual figures for 2013 available now on the website show that $55.72 billion was actually spent on pets in the United States. The current forecast for 2014 is $58.51 billion with $15.25 billion being on Vet Care. This implies acceleration in total expenditure growth to 5% in 2013-2014 compared with 4.5% in 2012-2013. In fact expenditure on Vet Care is expected to grow slightly faster at 6.1% between 2013 and 2014.
Pet Insurance: According to statistics provided by the North American Pet Health Insurance Association (NAPHIA) the pet insurance industry has been growing over 13% annually since 2009 and the North American market is estimated to be about $595 million. It estimates that there are over I million insured pets in North America which suggests that there is still room for a lot of expansion in this field which would benefit a company like VCA , Inc.
VCA Inc. has an expanding network of hospitals and labs that position it to take advantage of these industry trends. Management plans to continue to use capital for a combination of share buybacks as well as acquisitions. Also since I reviewed it last the company has kept up its good margin performance while slowly improving its revenue growth. There has been a focus on increasing overall wellness visits that generate higher priced orders and reducing lower priced orders. The company has also continued to introduce new programs such as CareClub for wellness and Cattitude for care of pet cats. It recently acquired pet daycare and overnight board franchise Camp BowWow. Although there is still more to be desired on that the revenue growth front, but there has been an effort to improve it. Overall, I think that WOOF could be a good addition to a long term investment portfolio.
What do Costco and Carrie Bradshaw have in common? Fendi.
High end designer merchandise has been popping up in the unlikeliest of places. In the past one had to go treasure hunting in discount retailers such as TJ Maxx and Ross for a great luxury find that did not break the bank. These would mainly be discounted items from previous seasons. But now you can find high end merchandise alongside your groceries and cleaning supplies. Target has been collaborating with designers such as Isaac Mizrahi, Prabal Gurung and Missoni. Similarly you can run into Prada and Fendi at Costco. Kohl’s has been selling Vera Wang and Juicy Couture for a while. But is this really a good strategy for these brands? Or is luxury for less, less luxury?
What Works? A sales platform like Costco for instance, gives a designer brand exposure to the company’s 71.2 million cardholders. The average household income of a Costco customer is approximately $96000. For Target customers the median household income is $64,000. Some of these people may not have purchased a full priced high end item from a designer or department store, but may be willing to try it at a lower price point during their usual shopping trip at a mass retailer. So these stores are a gateway to a large, untapped market of higher volumes (although usually lower price points) for the luxury brand. Also for some shoppers exposure to an accessible version of a luxury brand may be the initial hook that pulls them into the world of high end merchandise.
What Hurts? There are two ways in which the move to reach the masses could backfire for some makers of luxury merchandise and lead to a dilution of their brand. Firstly, if they produce lower quality versions (to match the lower price) of their full line merchandise specifically for sale at mass retailers it could hurt the overall reputation of the brand and actually lead customers away.
Secondly, for many people buying a high end item is not just about paying a higher price for great quality. It is also about acquiring a status symbol. If Prada was sold at the same store as peanut butter, that may dampen the “posh factor” for some loyal customers of the brand.
Is it worth it? Among many other factors the success of this strategy depends upon the price and income elasticity of the product being sold. And that depends on the type of product in question.
Luxury goods like high end designer merchandise are defined as products whose demand increases more than proportionately as income increases. But their relationship to movements in price can be interesting.
Usually luxury goods are price elastic, so a change in price leads to a more than proportionate change in demand for the product. Price elasticity can be defined as the percentage change in the volume of a good demanded with a one percentage change in its price, everything else equal. Let’s assume that a luxury handbag is highly price elastic. So for example, a one percentage price cut leads to a ten percentage increase in its sales. In such a case selling more handbags for a reduced price may lead to higher total revenue for the seller. Taking their merchandise to the mass market at a lower price point may be a good bet.
Alternatively, if sales of an item do not respond as greatly to price changes, then selling fewer but more expensive units would generate greater revenue and could be the better way to go. This price indifference could occur in instances where there is a great degree of brand loyalty, or the price of the item is a tiny proportion of the buyer’s budget.
This is just a small piece of a much larger cost benefit analysis that any luxury brand would need to do before making the decision. In the meantime, there are more options in the market for shoppers!
 The source for this figure is a 2012 article in the Washington Post. See here http://www.washingtonpost.com/business/capitalbusiness/costco-drives-deeper-into-washington-area/2012/01/19/gIQAASr6IQ_story.html.
The over sized shopping carts and super sized merchandise of Costco (COST) is familiar to most Americans and even some customers overseas. As a members only warehouse it provides a diverse selection of merchandise to its customers at a discounted price. While the loaded shopping carts and long checkout lines at the warehouses suggest that people have bought into Costco’s idea of quality at a reasonable price, but does the bargain end inside the store? Or are the company’s shares a good value for money for the long term investor? The following is my view of Costco’s growth potential and valuation.
Business Model: The Company operates over 550 warehouses in the United States and Canada. It also has a smaller, but growing, footprint in the United Kingdom, Mexico, Japan, Korea, Taiwan, Australia and Spain. While targeted towards small business owners, the warehouses also meet the needs of households with their selection of groceries, home supplies, furniture, furnishings, pharmacy and even gasoline. The business is built on the principle of providing cost savings to customers by sourcing merchandise directly from manufacturers and shortening the distribution channel. In addition the warehouses have shorter hours, minimal aesthetic displays and limited number of active SKUs to reduce labor costs and increase efficiencies.
Growth: Costco’s two main sources of revenue are sales and membership fees. Since 2009 both have expanded over 10% annually on a compounded annual growth rate basis. Food and sundries (such as candy, alcohol, cleaning supplies, etc.) contribute the largest share in revenue. The company operates with tight margins and needs to maintain its fast inventory turnover along with growing its membership base. Its in-house brand, Kirkland Signature, generates a higher margin and could be a useful income source if it continues to grow as a proportion of sales.
When it comes to sales it is important for the company to grow organically, as well as add new warehouse locations. Same store sales of the company were in negative territory in the aftermath of the financial crisis in 2009, but have recovered admirably since. In comparison to its major direct competitor Walmart’s Sam’s Club, Costco’s comparable store sales performance has been stronger.
Change in Comparable Store Sales*
|* Sam’s Club and Costco fiscal years are different.|
The company has also been expanding through new stores both domestically (an average of 11 new stores per year in the United States since 2009) as well as internationally. In fact by the end of this month, the company expects to open 3 new warehouses. There is more room for growth in the international markets where the company’s presence is still not as large. Same store sales performance of warehouses overseas has been at par with the United States in the last couple of years, but international markets are more profitable than the domestic market. So there are opportunities to grow both sales and margins in those markets as well.
Treasure Hunt: An approximation of revenue per square foot also shows that Costco’s generates over $1100 per square foot racing ahead of Sam’s Club over $674 figure. The company has been maintaining this strong performance through large sales volumes and quick inventory turnover supported by its limited yet high quality and fast moving selection of merchandise. Since the company is on the lookout for the best deals, it does not consistently carry the same products that it may have sold before. Anecdotally, while this can be frustrating for some shoppers it also leads many to stock up whenever their favorite product is being sold in the stores. Additionally there can be an element of curiosity pulling people into the stores to discover what new product lines are being sold each time. Similarly the practice of moving products around within the warehouse also may help with putting customers face to face with new items they may not have bought otherwise.
Keeping it Simple: Another point in favor of Costco is that management understands its market and target customer. The focus is on offering low prices without compromising quality and so it has stayed true to simple warehouse style stocking of items and shorter hours that save on labor costs.
In terms of e commerce, there has not been an overly zealous approach in that area. Online sales are only 3% of total revenue and could be a potential growth area in the future. While management is cognizant of future opportunities/challenges in the ecommerce channel, I think it has wisely kept its focus on the warehouses which are the core of the business at present. Similarly marketing via its newsletter Costco Connection and other activities is limited but targeted.
Employee Satisfaction: One of the business ethics that Costco follows is that a happy employee leads to a happy customer. It is well known that the company pays an average of $21 per hour to its employees, much higher than its direct competitor Walmart. The company also does well in offering career growth opportunities to its employees since it follows a model of promoting people within the organization, from warehouses to corporate offices. Unsurprisingly, employee turnover rate is low and sales per employee are strong.
Brand Value: A harder to monetize yet important metric is what I like to call “brand value”. In this case I looked at the loyalty that the Costco brand enjoys reflected in its total membership renewal rate which has continued to strengthen, reaching above 90% for U.S. and Canada and above 87% internationally in the last quarter. Among business members the renewal rate is even higher, that is, above 94%. This implies that the company has a stable, growing base of customers that are loyal to the brand as long as it maintains its product quality and pricing.
Valuation: The shares of the company were trading at $118.64 at the time of writing. This price is above the company’s 100, 50 and 20 day moving averages and just below its resistance ceiling calculated with recent price data. Additionally the peak closing price in the last three months was $119.59, close to the current level at which the stock is trading.
The current price puts the trailing twelve months price to earnings ratio at 26.55, which at first glance is not inexpensive in my book. Alternatively, the forward P/E is estimated to be around 23.04, which is more reasonable. Also the trailing 12 month price to sales ratio for Costco is 0.48 which is lower than that of its direct competitors.
Another good forward looking measure to consider would be the price to earnings growth or PEG ratio. Given that the company has seen EPS growth of 9.88% per year compounded annually for the last 5 years we can make some assumptions about future growth. Assuming this growth will continue in the near future and adjusting for dividend yield (since that is another consideration for investors besides earnings growth) the result is a PEG ratio of approximately 2.4. This is on the higher side compared to its direct competitors in the industry.
A point to note is that the company has been continuously adding new warehouses domestically and internationally. Since profitability is higher overseas and major U.S. competitors have a limited presence there, it is a possibility that earnings growth may improve in those markets. Also if the company can continue to increase sales of its higher margin Kirkland Signature brand then that would be another impetus for better earnings.
Overall: Costco is an example of a company that has proven to be a sound business idea combined with good execution. It has potential to expand its footprint in the United States and overseas and I would look for a price level near the 100-day moving average ($115 – $116) to pick up some stock in the company.
The price of Walgreens (WAG) shares plummeted after the company announced that it had no plans to shift its headquarters overseas as part of its acquisition of Allianz Boots and take advantage of the “inversion loophole”. The company’s management cited reasons like the burden of IRS scrutiny as well as public and media backlash as drivers of the decision. The move may be considered patriotic by some, but did not get the stamp of approval from disappointed shareholders. Wall Street expectation was that Walgreens would follow the footsteps of several other corporations that have acquired companies located in countries with lower corporate tax rates primarily for the benefit of slashing their U.S. tax burden. But Walgreens was not alone in forgoing the overseas tax advantage and retaining its headquarters in the homeland. Agricultural giant Archer Daniels Midland (ADM) also decided to move its headquarters to the Chicago area despite rumors of a possible move overseas associated with its recent purchase of Swiss food ingredient producer Wild Flavors.
While these companies refrained from this lucrative but ethically ambiguous option, there are many others who have leveraged it. A recent article in the Wall Street Journal reports that this has been the chief motivation for approximately 66% of international deals announced this year. Corporations such as pharmaceutical company AbbVie have initiated mergers with foreign counterparts in the recent past that could result in large tax dollar savings. So I have been wondering if this was a smart move or a missed opportunity for Walgreens.
Anyone reading the news will see that this topic is heating up in Washington. President Obama has expressed his resolve to tackle this loophole and prevent U.S. companies from “gaming the system”. Although any substantial executive action may be easier said than done in the near term, the issue is definitely on the radar. So for a business that is estimated to earn a sizeable chunk of its revenue from Medicare and Medicaid program prescription sales, picking a fight with Washington may not be the greatest idea. Since Walgreens is such a universally recognizable brand, there is greater awareness and somewhat higher exposure to backlash from the government and general public compared to other companies that may not have as much direct consumer recognition. So in the case of a possible inversion investigation, large PR costs would likely be piled on top of legal costs.
Additionally inversion deals could lead to greater burden of corporate gains tax on shareholders even without selling any shares when they receive shares of the new corporation. There are ways to mitigate this impact, but it is another case in point that this route may not be an obvious win for shareholders as it appears to be initially.
The debate over whether it is justified for companies to evaluate the option of inversion deals or not, and what would be the optimal way to dissuade them from it, is not likely to be resolved easily. In the case of Walgreens, while the initial shareholder response to the decision was negative as manifest in its stock price decline, for the long term investor the focus should remain on fundamentals and growth.
Walmart recently announced that it was partnering with Wild Oats to sell organic foods in their stores at prices 25% below other organic food brands. If successful this could be a game changer in the organic foods world, typically understood to be a niche market for a premium paying customer. In this regard Walmart has a potential goldmine of untapped customers who shop on a budget and have been keeping away from organic foods due to the cost factor.
The opportunity that lies open before Walmart is a market that currently makes up about 4% of total grocery sales in the United States and is expected to grow to 5% by 2019. The largest components of these sales are produce and dairy. In the case of dairy, the share of organic to total milk sales ratio in the United States has grown from 1.92 in 2006 to 4.38 by 2013. Interestingly during this period, except for the year 2009, there has been a decline each year in total milk sales while sales of organic milk have been increasing. Since around that time consumers were feeling the direct hit of the Great Recession on their personal finances, it may be possible that it led to a cutback in the purchase of higher priced organic milk. However the fact that every other year the consumption of organic dairy has increasing might suggest that the status of organic foods as “luxury” grocery may be changing. And Walmart could benefit by taking it even further in affordability to a growing number of customers who are willing to try it. In fact Walmart’s own survey indicates that 91% of their customers would be willing to buy organic foods if they were available at more reasonable prices.
But the question is whether the reduction of this price premium by Walmart will pose a threat to the Natural foods stores that have so far been out of reach for a majority of customers. The typical customer who shops at such stores is already willingly paying a higher price not only for their grocery, but also for the ambiance, the healthy cuisine in-store restaurants, and so on. So natural food stores can probably keep this group of customers even if Walmart offers a more competitive price. However, it is the potential “converts” who are not buying organic foods at present but would try it at a more reasonable price that could open up a still largely untapped market with great growth potential.
Ceco Environmental (CECE) is a global air pollution control company that I have evaluated in the past as a potential investment opportunity. In its recent released Q4 2013 earnings report the company beat expectations with an EPS of $0.26, but missed revenue expectations. This was despite the fact that its revenue expanded over 100 percent year over year, mainly on account of acquisitions, and gross profit was up 50% from last year. But to me the highlights of earnings release were in the following three themes that indicate the future direction of the company.
Acquire and Integrate: In my last article on Ceco I had written in detail about the business and management’s strategy relating to acquisitions. Total revenue in 2013 was $197 million compared with $135 million primarily due to the acquisition of new businesses. In order for an acquisition to be successful it is crucial for the integration of the new asset with the existing operations to be seamless. In this regard the company has been successful so far in smoothly integrating the recent acquired MetPro and realizing $9 million of synergies from it. Management has consolidated 3 manufacturing facilities and office buildings, selling the Met Pro facility and moving ahead on the path of realizing synergistic value from the integration. Recent acquisitions have opened up new revenue sources, contributed to an increase in bookings as well as more recurring business opportunities. Another example of the effective management of the integration process has been that operating margins improved with MetPro under the Ceco umbrella, and the company was also able to achieve 19% SGA including MetPro, despite it having run on higher SGA before.
Grow Overseas: The Company currently has about $3 billion of installed capacity worldwide and there is an opportunity to grow recurring revenue from this source since currently it counts for only about a third of the business. It is looking to expand operations in China both as a market and manufacturing source. In fact, it was indicated that there could be a potential acquisition as part of a manufacturing expansion initiative in China in the near future. While the company has operations in countries like India, China, Canada and Latin America, a large proportion of the business is still in the United States. So there is still room for expansion of its business internationally. Moreover in developing countries environmental/pollution control regulations and laws are likely to grow and create opportunities for the company.
OneCeco Initiative: Most of the revenue growth reported in the quarter was from acquisitions and organic growth was not robust during the period. But one of the company’s initiatives highlighted in the earnings call could also be instrumental in moving the dial on this. The OneCeco sales initiative is a tool to consolidate all air pollution control products and technologies and use this powerhouse to gain more market share and grow margins. The company is tracking its sales performance closely under this OneCeco “segment” and management expects that only 50% of the gains from this initiative have been realized yet. The initiative has already resulted in the creation of over 150 new RFQs and led to over a dozen new air pollution control projects. I think this could be an astute way to blend, bundle and leverage economies of scale for the benefit of Ceco as well as its customers.
Blucora (BCOR) has been in the news for all the wrong reasons lately. First, the company was hit with accusations of possible policy violations which resulted in the stock tanking. A couple of days later the company released their fourth quarter earnings beating both revenue and EPS expectations, but lowered guidance for the next quarter. Management revealed that Google, their largest search partner and contributor of the lion’s share of their search revenue, had renewed their partnership but only partially.
The last time I wrote about the company in October 2013, I had analyzed its growth potential based on recent performance and acquisitions. In the same article I noted concerns regarding its relative inexperience in the mobile space and heavy dependence on Google, but overall it still appeared to be a good growth opportunity. Recently, in the light of events mentioned above I decided to take a more cautious “hold” approach towards the company. This was because these events brought into sharper focus for me the importance of the following –
- Blucora’s dependence on Google
- Need for better information on the company’s future strategy
Dependence on Google
While I have no way of knowing about the accuracy of any of the accusations raised against the Company, it does make one thing very clear. Even the suggestion of a doubt on the future of the Blucora-Google partnership can wreak havoc on the stock. For context, the Search segment of the company’s business is about 75% of their revenue and Google alone accounts for nearly 85-90% of it. So at least at present, Blucora’s success is closely intertwined with its relationship to the search giant.
It helps that the company announced in its earnings call last week that Google had renewed its partnership with them until 2017 in the desktop search area. However the renewal did not extend to the mobile and tablet space. The immediate implication is the financial headwind, reflected in lowered guidance. The long run implication is the possibility of a further break in the alliance with Google in the future. Since the Android OS has the largest market share in the mobile market globally, it also implies that Google is the search engine of choice in that medium. So the end of Blucora’s mobile/tablet agreement with Google is a blow to the company.
But to put this into perspective, mobile is a relatively small driver of the company’s search revenue at present. Management stated that about 85% of the search traffic from Google comes over desktop, which is still covered under their renewed agreement. Alternatively, on the mobile front the company has other liaisons like Yahoo that will continue to power their searches. Also the mobile/tablet market still has a lot of unchartered territory; so the company could potentially carve a niche for itself in that space. Management mentioned plans during the recent earnings call to explore search and non-search solutions like text, video, etc. But there is still not enough clarity around the company’s plans for mobile growth. In my last article as well I had concerns about the Search segment’s lagged development in this field. But with this latest development with the Google partnership, this issue has become more relevant.
Needed Clarity on Long Term Strategy
In the recent past the company has made a move to diversify its revenue streams through the acquisitions of the DDIY tax business TaxAct and the ecommerce business Monoprice. Both segments have been performing fairly well, although ecommerce sales were softer than expected in the fourth quarter. Overall the ecommerce segment generated revenue of $39.7 million in the fourth quarter with order growth of about 10%. TaxAct revenue grew at about 75% year over year while recording a loss, in line with expectations, due to seasonality in the tax business. It is expected to track guidance in the 2014 tax season.
At present these two acquired segments combined comprise only about 25% of the company’s total revenue. They are also very different from the company’s core search business. But while they may not be obvious synergistic acquisitions, they may turn out to be useful diversification tools that the company needs. One advantage is that they open up the growing DDIY tax and ecommerce market to the company that could potentially grow into a larger proportion of sales in the future. In fact, if the company has more future acquisitions planned that are executed and integrated successfully, then this may be a way to reduce the heavy dependence on search and Google. But again, the long term strategy on acquisitions and vision of what the company wants to evolve into, is not very clear at the moment.
At present Google is certainly the mammoth in the search landscape. So in the near future at least, the success of Blucora’s search segment is tied closely to its partnership with Google. Currently I am comfortable with a more cautious approach of having a neutral position towards the company. I would like to wait and watch how it operates in the mobile world without Google, and get more information on what plans it has in the future of building a business that is not overwhelmingly dependent upon one partner.
- Case-Shiller home price index December data is scheduled for release on Tuesday. Although lagged by nearly two months, a noticeable slowdown would support other housing indicators.
- Consumer Confidence February results are also expected to release on Tuesday. Consensus expectations point toward an index value around 80 on par with January. Continued sluggishness in the job market could push the consumer confidence numbers to come in below expectations.
- New home sales January results are expected to release, and expectations are for slightly lower numbers compared with December. With the decline in existing home sales, new home sales could come in below expectations as winter weather and low inventory more than likely hampered sales in January.
- Weekly Jobless numbers will be released which will provide further insight into February’s employment picture.
- Durable goods orders for January could shed some additional insight on the state of the economy. After a noticeable 4.3% decline in December, orders are expected to decline a further 2.5% in January.
- Markets will be closely watching Janet Yellen’s testimony at the Senate for any additional insights into the Fed’s monetary policy.
- Q4 GDP revision release and expectations are for a downward revision of 2.4% compared to an initial release of 3.2%.
- Chicago PMI for February is expected to come in at 56.0, down from 59.6 recoded in January.
- The release of January pending home sales should provide some insight into home sales in February. The 8.7% decline observed in December brought the index to the lowest level observed since Oct-2011.
As a frequent customer of Chipotle Mexican Grill (CMG) I have been happy with the quality of food, promptness of service and reasonableness of price that I have experienced. Given that its revenue has expanded in the last five years at a compounded annual growth rate of almost 21%, there are many others that share that feeling. The company has risen as a leader in the “fast casual” industry, intelligently filling the gap that existed between less healthy fast food options and healthier but more expensive sit down restaurants. My own experience as a customer and Chipotle’s incredible growth story has prompted me to don my investor hat and try to evaluate if buying the company’s stock would be as satisfying as buying its delicious food.
1. Simple Concepts: Chipotle has built a business and a reputation by focusing on a few basic ingredients and serving dishes that are based on permutations and combinations of those. This makes it easier for the company to focus on improving the quality of these ingredients. It has done so by moving towards more organic, sustainably grown or raised, non GMO, lower carb raw materials.
In terms of service as well, having few simple ingredients is very helpful in keeping speed and service levels high in their assembly line style setup of made to order meals.
Every so often the company does expand its offerings to cater to a wider range of customer tastes and preferences. Some examples are sofritas or tofu for vegetarians or salad and burrito bowls for the carb conscious. But overall it has stayed true to using a few building blocks to build many different structures.
2. Strong Financials: Chipotle has been continuing along a path of robust financial growth for the last several years. After the company reported its solid Q4 2013 performance recently the stock soared 12% at opening the next day. The fourth quarter was another strong quarter for the company with revenue growth of nearly 21% and comparable restaurant sales growth of approximately 9% on a year ago basis. Operating margins for restaurants increased by a 100 basis points year over year, while earnings per share increased nearly 30% over prior year to $2.53 in the fourth quarter.
Historically, between 2009 and 2013 the company’s revenue grew at a compounded annual growth rate of nearly 21% and diluted earnings per share grew at about 28% over the same period. The company ended the year 2013 with over $323 million in cash and cash equivalents and 185 more restaurants under its belt. Another attractive factor is that it has virtually no long term debt and total cash per share of $18.64. While the company does not pay cash dividends, reinvestment of cash into the business can compensate the stock holders by providing future returns.
3. Room for Expansion: The Company has been growing its culinary empire in three main ways; new restaurant openings, organic growth and international growth. As of year ended 2013 it operated 1572 restaurants in 40 states in the U.S., 7 in Canada and 9 in Europe. So there is still plenty of room for both domestic and international expansion. An instance is that the first Chipotle location opened up in Reno only earlier this month.
Additionally expanding its frontier overseas could be instrumental for the company in maintaining the pace of growth that it needs to justify its price. In the last quarter of 2013 the company opened up a total of 56 new restaurants and plans to open a total of 185-190 locations in 2014. Included in this growth are the company’s ventures into Asian fast casual through its ShopHouse restaurants in the D.C. and L.A. areas, as well as, Pizza Locale, its experiment with pizza, in Denver. If it is successful in taking the ideas and culture that has helped make Chipotle a trailblazer in the industry and applying them to these new types of cuisines, then it could be a great way for the company to branch out and grow. It is also investing in a more enhanced marketing plan using digital media, food and music festivals to increase its reach to potential customers.
1. Valuation Multiple: The least attractive thing about Chipotle for me right now is its valuation. From a Price to Earnings perspective it is valued at over 50 times earnings. This puts immense pressure on the company to deliver stellar financial results quarter after quarter and maintain strong sales growth rates, which can be challenging. For instance, 2013 revenue growth over prior year was about 18%, which while strong, was a little below growth rates from the previous few years. If this does prove to be a trend of plateauing growth, and the company is not able to accelerate with help from expansion into new markets and cuisines, then a multiple of this level will become very hard to justify. Also with such rapid growth and lots of public exposure, the company has to not only perform well but beat a lot of high expectations continuously to maintain growth in its stock price, and justify the high valuation.
2. Comparable and New Restaurant Sales: Drilling down into comparable restaurant sales, the company gave guidance of low to mid-single digit growth in 2014 mainly because of tough 2013 comps. This organic growth is important for the company as there are higher margins associated with it. Also, as noted in their 10-K filing, in the past the stock price has slid down when the company experienced slowing comparable sales. While the company is skilled in maximizing efficiency and productivity from each of its restaurants through strategies like its assembly line setup, placement of best employees during peak hours, etc., there is a peak beyond which it is not possible to increase productivity. For example, the record so far has been 300 customers served at a location in one hour. While impressive, this is neither the average, nor easy to maintain and exceed.
As far as new restaurants are concerned, the company has a lot of opportunity to grow in domestic and international markets as I wrote above. This is also the main source of sales growth for the company. But the guidance for 2014 indicates between 180-195 planned restaurant openings in 2014. In the years 2013 and 2012 the number of new restaurants opened were 185 and 183 respectively. So the rate at which new restaurants are added has not been accelerating in the last few years.
Additionally, the company does not franchise. This helps with maintaining consistency of product and service but can be a limiting factor on growth.
3. Brand Dilution: The Company has undoubtedly done well so far, establishing itself in the fast casual healthy Mexican food business. By extension it should be able to apply the same panache to its new Asian and pizza ventures. But there are also chances that by wearing too many hats the company may not only fail to succeed in the new initiatives, but also lose focus on its core business and take a hit to its reputation.
Another issue for the company is upward price pressures on its food ingredients in 2013, that are expected to continue in 2014 as well. Pressures such as these pose a difficult situation for the company since its USP is selling healthy, high quality food at a reasonable price. The tradeoff between potentially raising menu prices versus abandoning some of the company’s organic, non GMO food initiatives could impact the image of the company.
Conclusion: Will Chipotle Mexican Foods stock keep going from strength to strength, or will it have a hard time justifying the high P/E multiple it is trading at presently, remains to be seen. Powered by continued financial strength and a business that has given new meaning to “fast food”, Chipotle stock has been soaring. Between its last closing price and the same day a year ago, it has grown over 76%. While there are many factors that could propel its growth in the future, I think that at the moment the valuation puts it out of my comfort zone. It may continue to perform well but I think it might be a challenge to keep growth continually at the same pace, or ahead, of expectations.