The Burrito Battle

David Einhorn, iconic hedge fund manager of Greenlight Capital, spoke at the Value Investing Congress on Tuesday October 2, where he outlined his bearish case for Chipotle Mexican Grill (CMG) saying that the fast food chain is overvalued. Chipotle, he asserts, is vulnerable to competition from Taco Bells recently launched Cantina menu. This presentation caused Chipotle stock to plunge more than six percent on Tuesday. Taco Bell (YUM) launched its Cantina menu in July and was a thinly veiled attempt at Chipotle-styled fast food. The menu features both burritos and bowls in chicken, steak, or veggie combined with fresh salsa, guacamole, and roasted corn salsa on a bed of cilantro and lime rice. Sound familiar? To help put to rest some of the natural skepticism of Taco Bell providing anything gourmet, the menu launch was accompanied with a guarantee that if customers dont like it, Taco Bell would replace their meal with something they do. In Chipotles last earnings release on July 19 it missed analysts growth estimates though it was able to beat the guidance it gave. Chipotles phenomenal growth seems to have slowed and this realization caused a huge drop in stock valuation, falling more than 20 percent in a single day. So with the uncertainty in the strength of Chipotles sales, Einhorns words took quite a hit to investor confidence.
1

Looking at both the quantitative and qualitative differences between Chipotle and Taco Bells new Cantina menu, we dont feel it is a real threat to Chipotle. We at Davian Capital Advisors ordered a burrito from each restaurant to perform a comparable analysis. The burritos were ordered with similar ingredients:
Chipotle Barbacoa Burrito Black Beans White Rice Mild Tomato Hot Salsa Corn Salsa Guacamole ($1.80 Charge) Lettuce $8.45 Cantina Steak Burrito Black Beans White Rice Pico de Gallo Salsa Roasted Corn Salsa Guacamole Lettuce $4.99

We weighed both burritos to get a per ounce price and to the surprise of many, Chipotle is cheaper on a price per ounce basis! Value conscious consumers get a better deal at Chipotle ($0.316/ounce) than at Taco Bell ($0.336/ounce), not even considering the premium that should be factored in for the difference in food quality. Chipotle sources vegetarian-fed, antibiotic free, naturally-raised meats, purchases organic ingredients when possible, and has made notable strides in sourcing locally. This all equals fresher, high quality, better tasting food. Not quite the same story with Taco Bell. We broke out the price per ounce as well as the nutritional facts for both burritos per ounce just to demonstrate the true value of Taco Bell. Based on our analysis,
2

a Chipotle burrito has more fiber, about the same protein but lower fat, cholesterol, sodium, and calories per ounce.

Chipotle Barbacoa Burrito

Item Cost Weight (oz) Calories Total Fat (g) Calories from Fat Saturated Fat (g) Cholesterol (mg) Sodium (mg) Total Carbs (g) Sugar (g) Fiber (g) Protein (g) Total Burrito $8.45 26.75 1005 36 325 8 60 3160 127 15 26 48 Cost Per item $0.32 $0.01 $0.24 $0.03 $1.06 $0.14 $0.00 $0.07 $0.56 $0.33 $0.18 37.57 1.346 12.15 0.299 2.243 118.131 4.748 0.561 0.972 1.794 Item Per Oz 0.316

Taco Bell Steak Cantina Burrito

Item Cost Weight (oz) Calories Total Fat (g) Calories from Fat Saturated Fat (g) Cholesterol (mg) Sodium (mg) Total Carbs (g) Sugar (g) Fiber (g) Protein (g) Total Burrito $4.99 14.85 750 28 250 6 45 2040 76 7 12 28 Cost Per item $0.34 $0.01 $0.18 $0.02 $0.83 $0.11 $0.00 $0.07 $0.71 $0.42 $0.18 50.505 1.886 16.835 0.404 3.03 137.374 5.118 0.471 0.808 1.886 Item Per Oz 0.336

Like stated above, we made a concerted effort to order identical items. However, at Chipotle we could have added additional items free of charge to further increase the value: brown rice, pinto beans, fajita vegetables, cheese, sour cream and a larger choice of salsas. That certainly would have lowered Chipotles price per ounce. Chipotle operates in the fast-casual dining segment. According to Scarborough Research, which measures consumer shopping patterns and media habits, the largest segment of fast-casual consumers are married Caucasians ages 35 to 54 and have no kids, a group commonly called DINKs (dual income, no kids); 38 percent own a home worth $100,00-$199,00. Rodger Roeser, Vice President for Justice & Young Advertising and Public Relation who researches target audiences for clients, said this segment wants quick, healthful food and a restaurant that is a good place to meet with other DINKs. The core consumers for Taco Bell are young adults looking for cheap late night food, fourth meal as Taco Bell calls it. Chipotle closes at 10pm; Taco Bell is open until 4am. The core demographics are completely different between the two
4

restaurants so we dont feel the Cantina menu will eat away at Chipotle sales. All the late night sales for the Cantina menu would not be eroding Chipotles sales since it isnt even open during those hours. If anything, Taco Bells new menu will be a threat to other fast food companies like McDonalds (MCD), Burger King (BKW), or Wendys (WEN). Those already looking for a cheap quick meal could be more inclined to give the perceived healthier Cantina menu a shot. For the purposes of discussion, lets assume the Cantina menu takes off and Chipotle loses sales to Taco Bell. Einhorn suggested Chipotle would lose five to ten percent of sales. We calculated what effect this would have on the fiscal year 2013 estimates assuming a ten percent loss:
Fiscal Year 2013 Revenue Estimate Less: 10% Sales Adjusted Revenue Estimate Historical Net Income Margin 2013 Net Income Estimate Shares Outstanding EPS Current Share Price (10/04/12) Forward P/E for 2013 Current P/E (10/04/12) $ $ $ $ 3,180,000,000.00 $ 318,000,000.00

$ 2,862,000,000.00 9.50% 271,890,000.00 31,100,000 8.74 294.01 33.63 35.26

The argument is if Chipotle misses its sales estimate due to Taco Bell, it will not be growing as fast as before and therefore such a high price to earnings multiple cannot be justified. We then did a scenario analysis using our adjusted EPS from above and more realistic price to earnings multiples to see what effect this would have on the stock price.
P/E Multiple 20 22 24 26 28 30 32 Adjusted Stock Price $ $ $ $ $ $ $ 174.85 192.33 209.82 227.30 244.79 262.27 279.76

If David Einhorn is correct in his prediction of Chipotle losing ten percent of sales, we can see this would in fact negatively affect the stock price. Based on our analysis of the demographics, value and quality of ingredients, we just do not see this as a serious threat. There are a few feasible ideas Chipotle can utilize to quell any sales erosion. First, it can launch a minimenu featuring a One Pound Burrito which could be sold at the same price point as Taco Bell and would actually improve Chipotles gross profit margin. Next, it could start late night pickup window orders on Fridays and Saturdays in key markets. Locations in large cities, near college campuses and other areas with active nightlife would thrive being open late. The dining room could be closed with only online or iPhone pick-up orders. The stores would not have to
6

have the entire kitchen open. All they need is a late night skeleton crew to fill the pick-up orders. Finally, Chipotle could launch the breakfast menu, to again, capture another part of the day it currently is not capturing. These are ideas we just casually kicked around; there are probably even better ones out there. In conclusion, the core consumers of Chipotle and Taco Bell are much different. Yes, there are some fringe customers who will enjoy the perceived value of a five dollar burrito but as we just demonstrated, Chipotle is still the best value. Based on this, we do not agree with Mr. Einhorn that the Cantina menu offered by Taco Bell will affect Chipotle sales.