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Gad: Chipotle Is the Future

Restaurant chain Chipotle (CMG - Get Report) will report its third-quarter results Thursday. Analysts expect revenue of $702 million and earnings per share of $2.30. Around the same time three months ago, before Chipotle reported second-quarter results, shares were trading for $400. After a quarterly report that caused concern among analysts, shares plunged 25% over the next several days to $300. Today they sit relatively unchanged at $290. Shares didn't drop nearly 30% because of the numbers -- both sales and earnings grew significantly and it's common for a restaurant's margins to fluctuate from quarter to quarter.

The shares fell because they were trading for more than 50x earnings. At some point, anything less than a home run was going to put a crack in an already excessive valuation. So now, the shares are trading at 35x trailing earning and 26x forward earnings estimates. When Chipotle reports later this week, the numbers will probably reflect continued food cost inflation pressure. Margin pressure, absent a strong future earnings forecast, could slice the share price further. If so, the price decline may present an opportunity to own one of the most compelling investment opportunities this decade.

To understand Chipotle's potential future value is to understand that Chipotle has what is known as a first mover advantage in the growing desire for people to consume fast food that tastes great but is good for you, and good for the local economy. Ironically, the biggest evidence of this consumer desire comes from fast food chain McDonald's (MCD), which has more than 33,000 worldwide locations serving nearly 70 million, or 1% of the world's population, annually. Several years ago, McDonald's decided to give both its stores and menu a facelift. Beautiful stores certainly make a great first impression, but it was the menu change that drove consumer traffic. McDonald's began offering more salads, better quality coffee, kids meals with fruit, smoothies, all white meat chicken nuggets, and Angus beef burgers. In addition, McDonald's focused ad spending on communicating this better menu to consumers. Sales and profit grew consistently. In the past decade, McDonald's shares have climbed from $16 to nearly $100.

So, here sits Chipotle today with approximately 1,500 stores offering quick service, high-quality burritos, tacos, and salads for less than $8 (if you think that's a high price point a black Angus burger value meal at McDonald's will cost you nearly the same). On average, Chipotle invests $800,000 to open a new store. Average 12 months sales per store is around $2 million, while cash flow is around $550,000 per store. Do the math: that's an average return on investment of more than 60%. Chipotle is opening more than 125 stores a year, and with only 1,500 locations, the growth curve is still in its infancy.

How strong is the demand for Chipotle's food? You tell me. I was traveling through Atlanta and stopped in for dinner around 7 p.m. Ten minutes later, the line was 40 to 50 people deep. But I observed something even more telling: as customers would walk in and see the longer line, instead of walking out, they would eagerly walk to the back of the line and wait. We both know that in most cases people leave in frustration at the sight of long lines. More so, the consumer base is diverse. The food, along with its nutrition, is spreading like wildfire, and that is pulling in diners from all areas. Folks that would typically pay $4 for a fast food meal are trickling in willing to pay a little more for the food. And the loyalty created by Chipotle creates pricing power. After a gradual menu price increase about a year ago, customer traffic is still growing. And the industry is now paying attention. None other than Yum! Brands' (YUM) Taco Bell, long a restaurant that was the butt end of jokes relating to its food quality, has now developed a Cantina menu with the tag line that it's so fresh you won't believe its Taco Bell.

I am looking forward to dissecting the earnings release, but more importantly, hoping for another big share pullback. Chipotle holds significant growth potential for years to come. But you can't invest in that growth at just any price. But in this instance, paying a fair price for a great company is a far superior investment decision than trying to pay a great price for a fair company.
At the time of publication, Gad had no positions in the stocks mentioned.

Sham Gad is the managing partner of Gad Capital Management, a value-focused investment firm based in Athens, Ga. Gad has written extensively for The Motley Fool and was a securities analyst for UAS Asset Management, a small value investment fund in New York City, in 2007. From 2002-2005, Gad managed assets for the Gad Investment Group.

Additionally, Gad has just released a new book, The Business of Value Investing: Six Essential Elements to Buying Companies Like Warren Buffett. He earned his BBA and MBA at the University of Georgia. Gad appreciates your feedback; click here to send him an email.

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