Wednesday, February 22, 2012

Could This Stock be the Next McDonald's?

Long-term investors in McDonald's (NYSE: MCD) have much to celebrate. The stock delivered returns of 20% a year for the past five years, 15.3% for the past 10 years and 11.4% for the past 15 years.

But the Golden Arches could finally be ready to downshift, perhaps just for a while or maybe even permanently. For a firm the size of McDonald's, which now has a market capitalization of more than $100 billion, further growth can be increasingly hard to achieve. While analysts say sales should be alright for now, rising about 8% a year for the next three to five years (just like they did for the prior 10 years), the bottom line could become an issue.

This is because McDonald's has some hefty spending in store. In 2012 alone, for example, the company is planning capital expenditures of $2.9 billion, a 35% increase from 2011. The money will go for projects like technology upgrades, remodeling at 2,400 restaurants, 1,300 new restaurants and marketing for the Summer Olympics.

Having to spend more to achieve the same level of sales growth is often an obstacle for huge companies. In the case of McDonald's, analysts expect the coming surge in spending to slow drastically yearly earnings per share (EPS) growth drastically from 18% during the past five years to 9% for the next three to five years. Annual dividend growth may decelerate even faster, from nearly 30% for the past five years to 9.5% for the next three to five years, analysts say.

Investors who buy McDonald's now could be disappointed. The stock may continue to do OK, but nothing like the performance of the past 15 years.

The trouble is, stocks such as McDonald's, which perform well through all sorts of economic conditions for many years, are rare. So what's an investor to do?

The only thing they can: Buy the "next McDonald's."

I believe the Mexican fast-food chain Chipotle Mexican Grill Inc. (NYSE: CMG), could be it -- in its own way, of course.

Surely, there are never any guarantees, but I can imagine Chipotle becoming the next McDonald's. No other fast-food chain is better positioned to capitalize on the growing demand for healthier, more wholesome fast foods. Past sales and estimates of future revenue suggest consumers will be willing to pay a bit more for this.

Shares of Chipotle have performed more than twice as well as McDonald's, returning 43.5% a year since the IPO five years ago, compared with 20% per year for McDonald's during the same period. In that time, the combined value of all outstanding shares of Chipotle more than doubled, from $4.8 billion to nearly $11.5 billion. The number of restaurants in the chain more than doubled, too, from about 560 to 1,230.

This is fast expansion, to be sure, and Chipotle is already pretty big. But the company is still only a ninth of McDonald's size and more of a mid-cap company by Wall Street standards. Plus, it has a formula for success that's especially relevant today, so future growth potential is vast and, well, McDonald's-like.

Customer loyalty will obviously be a key catalyst, and Chipotle's got plenty. Current sales of about $2.3 billion a year have grown nicely despite rising commodity costs that have brought the typical customer bill up to $10-$12 from around $8.50 in 2007. Indeed, sales rose 19.5% annually during that five-year period, and analysts expect them to keep growing at a 15.5% rate for the next three to five years.

A crucial intangible is the formula for success I mentioned earlier, and I think analyst R.J. Hottovy of Morningstar describes it best: "Chipotle is at the forefront of a restaurant industry movement toward naturally raised proteins, pasture-raised dairy products and organic produce." Although fresh ingredients such as these are more costly, they're a key source of differentiation from other restaurant chains, he adds. The company aims to apply this formula to new ventures such as ShopHouse Southeast Asian Kitchen -- the Asian version of Chipotle -- the first of which opened Sept. 15, 2011, and has so far received positive reviews.

Earnings per share (EPS), which climbed 22.5% a year for the past five years, are projected to rise at a 20% rate for the next three to five years. This would bring EPS to about $11.80 by 2015 from $6.85 now. Lower costs should help in achieving this sort of EPS growth. Avocado prices in particular soared in 2011 due to a shortage in California, however, analysts expect prices to decrease significantly as more avocados are imported from Chile and Mexico.

Risks to Consider: Competition will be intense as fast-food rivals upgrade their menus and decor to better mimic Chipotle's formula for success. Higher commodity prices could hinder results in any given quarter.

Action to Take --> While I think Chipotle could very well become the "next McDonald's," I don't suggest investing in Chipotle right now, though. The stock has run up a lot recently and, at almost $380 a share, is trading at 55 times 2011 earnings and 47 times the $8.10 a share in earnings analysts have forecasted for 2012. A share price in the $285 range would be a much more reasonable entry point. At that price, the price-to-earnings (P/E) ratio would be in line with the five-year average P/E ratio of about 42. So keep an eye on the stock, wait for this sort of correction, and then consider jumping in.

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