CMG reported their most recent quarterly earnings a few weeks ago. I wanted to update my last post on CMG with some additional thoughts regarding their numbers.
CMG’s operating history shows one of two things. Either CMG has created a superior model in what has typically been a fairly poor place to operate a business (the food industry) or CMG enjoyed a long, but temporary, tailwind in the fast casual food space. The length of CMG’s run may have led some to believe that CMG had cracked the code on the food space in a way that allowed it to earn outsized margins compared to the industry and competitive environment. These outsized margins also allowed CMG to earn approximately 70% cash on cash returns in the first year of opening each new location. I am not sure there is a black and white answer to the either/or question I proposed, but CMG’s recent operating margins seem to indicate that its success was temporary, albeit lengthy. I believe the “fast casual and healthy” competitive environment has significantly shifted over the past 5 years with an increasing number of players entering CMG’s space. Although no single competitor may operate at the scale or success of CMG, each location is effectively competing in their own individual markets against local options for CMG’s customers. In other words, CMG is not only competing with Panera Bread, but each local company, some with as few as 5-10 locations. I do not think the e. coli incident dramatically re-shaped the competitive environment, but instead accelerated what had already begun to occur—Chipotle was no longer the only fast casual healthy option. The e. coli incident merely gave these customers a reason to try other options and, at least so far, it appears that those customers are happy with their other options. These customers may still come back to CMG to add variety to their dining, but the crowds necessary for the outstanding historical results do not appear to be coming back.
Earlier this year, CMG had outlined its plans to open approximately 200 locations each year for the next five years. On its last conference call, CMG scaled back this number to approximately 150 (give or take a few) over the next 5 years. If we assume that CMG opens 150 new stores over the next four years, each with an AUV around 1.5m, the SSS metric will decline a little over 1% during that period, assuming flat sales at currently opened stores. I have no idea what the current stores will do, but I do think CMG’s new stores are going to operate at a much lower AUV than their past locations. Management has indicated that its cash on cash returns are approximately 20% in the first year of a new location’s opening compared to its historical 70% cash on cash returns, given the lower AUV and lower profitability of the new locations. The lower AUV is simply a function of opening stores in less dense areas or cannibalization among its existing store base.
This drag on same store sales growth impacts the top line at CMG. However, I am realizing that even my lowered operating margins of 17.5% (versus historical 22.5%) may have been too optimistic. CMG’s run rate for the past 9 months has been 11.5% operating margins, which leads me to believe that even 17.5% may never be possible again.
This isn’t to say that CMG could not be an excellent investment at a specific price. However, I think it is more realistic to estimate the margins and potential AUV numbers for the 2021 CMG in a way that reflects CMG’s business in the food space. Instead of 17.5% margins, I think 13% margins appear more realistic, given that CMG is only back to 11.5% operating margins two years after the e. coli incident.
With flat same store sales, 13% operating margins, 150 new locations per year and cash build over time, I estimate the value of CMG with a P/E of 15 in 2021 around $315. Perhaps, CMG trades at 20x P/E and the valuation is $400, the valuation gap between those two obviously creates a large difference. My thought on a lower valuation reflects the idea that CMG will be seen as more vulnerable to competition in the space instead of historically where CMG has been valued as an exception to the food industry and given a higher multiple.
At today’s stock price, I estimate a CAGR of between 8-14% from here until 2021, using negative 1% to positive 1% SSS and operating margins between 13-14%, accounting for cash build over time. Although these returns represent respectable numbers over the next four years, the more I thought about CMG, the more I have come to the conclusion that CMG still operates in a very competitive industry without any significant advantages. The main advantage CMG enjoyed over the past 15 years was its first mover advantage in the “healthy” fast casual space. I believe this key advantage has either slipped away entirely or is almost gone. Given the risks of another health incident or recession, I do not feel the upside is worth it at current prices.
Matt Brice is a portfolio manager at The Sova Group, LLC and can be reached at firstname.lastname@example.org