Decoded’s Take
- Chipotle owns and operates all of its restaurants and is largest US non-franchised restaurant chain by number of locations. It is the 2nd largest restaurant stock listed in the US and the 4th largest by revenue.
- Each location costs around ~$1.2M to open and generates ~$2.8M in annual revenue and ~$600k in annual pre-tax earnings (20.6%). A fully ramped store therefore represents an impressive ~50% annual pre-tax return.
- Chipotle is so profitable that cash from operations funds all of its growth (read: no debt) and has bought back $1.73B worth of shares since 2021 (ending Q3 2023) all while growing almost 2x in the 5 years from 2017 to 2022.
- Chipotle is the only restaurant chain in the US (that I could find) committed to using only “53 fresh ingredients” without any artificial extracts, flavorings, or additives which dramatically increases its operational complexity but also raises its competitive moat.
The Business
Chipotle is a restaurant chain selling Mexican-style burritos, burrito bowls, and tacos. It owns and operates over 3,200 restaurants, the majority of which is in the United States. Internationally, Chipotle has 34 locations in Canada, 15 in the UK, 6 in France, and 2 in Germany.
Unlike most other major restaurant chains (just about every other one out there), Chipotle does not franchise. Well, at least it didn’t until now. That growth strategy is changing slightly as they announced in July of 2023 its first ever franchise deal with the Alshaya Group to open restaurants in Dubai and Kuwait. It still does not have any intention to franchise in the US, Canada, and Western Europe due to, and I quote from a company representative, “very strong returns and a balance sheet with zero debt, which gives us the ability to fund our own growth.”
As of this writing, the chain does not have a presence in Mexico. 🙃 But that’s not entirely surprising. There’s no Domino’s in Italy and no Panda Express in China, either.
Part of the chain’s success stems from its simple and streamlined entree menu: burrito, burrito bowl, tacos, or salad (they are experimenting with lifestyle bowls and quesadillas but we’ll ignore them for now). Customers can pick from 6 different types of meat (or veggie), 2 types of rice (or none), 2 types of beans (or none), and 10 types of toppings. Oh, and you can buy chips and a drink. That’s it. Even though the number of unique combinations can be mindboggling (depending how you calculate it’s something like tens or hundreds of thousands), the number of components prepared by the kitchen is extremely limited:
- 2 types of wrapping (burrito or taco)
- 6 types of meat
- 2 types of rice
- 2 types of beans
- 10 types of toppings
- Chips
Which in total comes out to 23. 53 fresh ingredients to make 23 components which enables (theoretically) millions of different orders.
Excuse me while I go order myself a burrito.
The Numbers
Chipotle has a very healthy balance sheet. It has no interest-bearing debt and the last time that it raised any capital at all (that I could find) was during its IPO in 2006 where it raised $173.33M. It has made a positive net profit in every single year since 2004, including in 2016 when it suffered from the famous Chipotle E Coli outbreak (though this was a close one, only $23M in net profit while the year before they made $476M). Even with this black swan event, Chipotle had enough cash to buy back $838M worth of shares AND open 243 new stores that year, all without any additional financing.
It’s just damn good business.
Using full year 2022 data, we can roughly understand its unit economics as follows. Each Chipotle location brings in, on average, $2.8M in annual revenue. Costs are broken down into:
- Food, beverage, and packaging: 30.1%
- Labor: 25.5%
- Occupancy: 5.3%
- Other operating costs (marketing & promotion, delivery expense, credit card processing fees, utilities, tech costs, maintenance): 15.2%
- Depreciation and amortization: 3.3%
A location’s avg annual EBITDA, therefore, is 23.9% ($669,200). EBT is 20.6% ($576,800).
Chipotle ended 2022 with 3,187 total locations. Full year revenue was $8.6B. Restaurant-level pre-tax earnings was $1.8B. Now, let’s account for corporate costs:
- General and administrative: 6.5%
- Pre-opening costs: 0.2%
- Impairment, closure, asset disposal: 0.2%
To arrive at a final corporate pre-tax income of $1.2B. After paying income taxes, all this results in a corporate net profit of $0.9B on $8.6B of total revenue, or 10.4%.
Because Chipotle owns and operates its own restaurants, that 10.4% net income percentage can’t compare with McDonald’s (26.65%) or, as we learned in Ep 1, Marriott (44.03%), but it is very respectable for the restaurant industry. In fact, they are so confident and happy about their business that they’ve chosen not to franchise, which is the classic way for companies to shift operational complexities and risk onto franchisees and generate fatter profit margins.
Each Chipotle location costs roughly $1.2M in build-out and equipment costs, and can take up to 24 months to fully ramp (though I expect many locations, esp ones that open to much fanfare in smaller towns, ramp much much faster). Even so, returns on investment are highly attractive, with each store making roughly $600k in pre-tax earnings per year (~50% annual return on invested capital). Further, as inflation continues to devalue the dollar, that return will only increase YoY. Avg restaurant sales in 2012 was $2.1B. In the latest Q3 2023 report, that has already increased to $3B, a 3.6% compounded annual increase.
Chipotle has never paid a shareholder dividend, instead choosing to reward shareholders through share buybacks. It has bought back shares every single quarter over the last 10 years with the exception of the last 3 quarters of 2020 when the world was highly uncertain and cash was king. It’s bought back $1.73B worth of shares since 2021 (ending Q3 2023) all while growing almost 2x in the 5 years from 2017 to 2022.
Analysis
There are very few restaurant chains that don’t rely on the franchise business model to expand. Franchising puts the risk of location performance and the operational complexity of running the restaurant on the franchisee, freeing up the corporate franchisor to focus on product development, marketing, and supply chain. It allows the franchisor to use franchisee capital to expand, instead of using its own balance sheet or taking on debt. And in bad years, the franchisor is shielded from the brunt of the impact from low sales by franchisees, resulting in a much more stable margin profile. Sometimes the franchisee can do a better job of managing the location than HQ as it is easier — and much more efficient — to manage one location than it is to manage thousands. Many times, businesses that adopt the franchise business model stand to generate much higher margins, such as McDonald’s (25% to 30%) and Yum! (20% to 25%), compared to Chipotle’s 10%.
After Chipotle, Chick-fil-A is probably the largest US restaurant chain (3,000+ locations) that does not rely on the traditional franchise model. While it does offer “franchise” opportunities, franchisees act more like managers rather than owners. The initial capital requirement for a franchisee is only $10,000 (while McDonald’s franchisees can expect to shell out between $1.3M to $2.3M) with Chick-fil-A investing in the land, real estate, and equipment and leasing it back to the franchisee. Chick-fil-A owns the location, and franchisees cannot sell or otherwise transfer the restaurant. Chick-fil-A franchisees can only open one restaurant and cannot own any other businesses. Franchisees must operate the restaurant personally — this is not a passive gig. Sound familiar? Yup, when you apply for a Chick-fil-A franchise, you’re applying for a job, not to own an asset.
After Chick-fil-A, the chains that don’t franchise get smaller. Panda Express (~2200), Sweetgreen (~1000), Cracker Barrel (~660), In-n-Out (~400), White Castle (~300). On this list, Panda Express cheats and offers “licenses” to operators with access to unique locations like casinos, airports, theme parks, universities, corporate campuses, stadiums, hospitals, food courts, military bases, and “non-traditional spaces.” For completeness, it’s worth noting that Starbucks (~36,000) has a model very similar to Panda Express: no franchises for core stores, licensing opportunities for partners with access to unique spaces. But I decided not to count Starbucks as a restaurant given the lack of a hot kitchen. All of the food sold at Starbucks locations is prepared centrally and distributed, much like a convenience store.
You might be wondering, what’s so good about franchises anyway? Chipotle, Chick-fil-A, Sweetgreen, these are great businesses. Yes, that’s true. But to truly hit scale, franchising is unavoidable. Just look at the number of locations franchised restaurants can hit: McDonald’s (~38,000), Subway (~37,000), KFC (~25,000), and Burger King (~19,000) — literally an order of magnitude more than their non-franchised competitors.
That said, the restaurants that decide against franchising typically do so in an effort to control the customer experience. After all, once a restaurant is owned by someone else, there’s just no guarantee as to how that person chooses to run the place. And the restaurants themselves tend to have strong, consistent performance, such that the company isn’t taking on substantial risk with each new location. They can fund the growth off their balance sheets, enjoy predictable payback periods and long-term returns on investment, and focus on operations rather than selling franchisees on their particular “opportunity.” At some point though, when chains like Chipotle and Chick-fil-A have saturated enough of the market, there will come a time when the management and board have to make a decision: slow down growth or change the model to shift more operational burden and risk to franchisees? Private companies like Chick-fil-A may choose to simply slow down growth, while public companies like Chipotle and Sweetgreen may not have that luxury given insatiable shareholder demand and be forced into the franchise model. Indeed, we already see Chipotle caving in at least in Middle Eastern markets.
In terms of future growth, Chipotle has announced that it has plans to open up to 7,000 locations in North America, roughly double its existing footprint. At least 80% of all new restaurants will have “Chipotlanes,” the restaurant’s drive-through format to pick up digital orders. Roughly 40% of all sales came via digital channels in 2022, and the company seems bullish on that remaining a large part of the business. Location-wise, it’ll increasingly look to small town America for growth opportunities, including in locations with as few as 10,000 residents. While the growth prospects are promising, Chipotle needs much more international growth in order to have a big enough addressable market to justify its high-flying 60x P/E ratio (the industry avg is closer to 20).
With regards to competition, the food and beverage market is unforgiving. Consumers are always demanding cheaper, faster, and more tasty meals. While Chipotle has found a sweet spot for itself in the fast-casual segment, you can bet that Panera, Sweetgreen, Shake Shack and others will continue to innovate on their menus and marketing to try to take market share. Further, the entire fast-casual segment will always face pressure from the ultra value fast-food market below it (McDonald’s and Chick-fil-A).
What makes Chipotle unique in the market today is that it is committed to using only 53 fresh ingredients to make its food. Compared with other chains, it does much less central processing, preferring to ship fresh ingredients to stores and prepare meal components every morning, fresh. While this significantly increases costs and operational complexity (and yes, food safety risks), it increases the desirability of its food and its pricing power. It also increases Chipotle’s competitive barrier, as most other chains cannot hope to transition to such a model due to its sheer complexity. As long as Chipotle maintains its commitment to making fresh food — and as long as that continues to give its food an edge over competitors’ — it should enjoy good returns on investment for a long time to come.
Until next time!
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