Understanding the health of the global consumer is essential to forecasting economic growth, considering that consumer spending contributes nearly 70% of US GDP. While the Artisan Partners Growth Team cannot precisely predict the onset of a recession, they are are less interested in businesses dependent on economic growth as the primary driver of their fundamental improvement. Instead, the team focus on identifying high-quality franchises exposed to secular trends and internal drivers resulting in multi-year profit cycles irrespective of fluctuations in the economic backdrop.
Within the domain of consumer spending, the team look for businesses that possess a powerful combination of a compelling value proposition, significant potential for increased market penetration via new store expansion and superior store-level economics return profiles as the recipe for success to creating economic value.
The Fast-Casual Restaurant Industry
Market penetration success stories are not uncommon within the consumer sector. In this context, this thought piece delves into the restaurant industry, which is inherently complex due to the nature of its offerings: perishable items consumed on demand necessitating precise inventory management, complex supply chains, and packaging solutions that preserve food quality for takeout and delivery. Therein lies the opportunity.
To be sure, there is no shortage of restaurants in the marketplace. The industry is intensely competitive. As analysts, the task is to scrutinize the unique value proposition of each company. What drives consumer preference? Is it solely the flavor, or does a narrative around quality ingredients appeal to health-conscious customers? Additionally, consideration is also given whether the pricing aligns with the consumer’s perceived value. A company that offers a widely appealing product at an attractive price can achieve substantial growth, especially given the frequency of meal consumption - breakfast, lunch and dinner, seven days a week, all year round.
Despite an intensely competitive landscape, fast-casual restaurants can be highly profitable. These businesses are increasingly benefiting from enhanced accessibility and convenience, a trend accelerated by the pandemic, with the advent of delivery services like DoorDash and Uber Eats.
In this analysis,the focus is on Chipotle and Wingstop. Each of these companies has cultivated a unique consumer value proposition and has significant runway remaining for high-return store expansion. However, each company utilizes a uniquely successful business model to create value.
Store Economics
A strong consumer value proposition is vital for driving robust consumer demand. However, the key to generating economic value lies in two essential areas: (1) deploying an operational model that not only satisfies consumer demand but does so with enough efficiency to produce appealing profits at the individual store level, and (2) formulating a store expansion strategy that optimizes capital efficiency. This means the cost of constructing or opening a new store should be at a level where the profit generated by each store, when compared to the build cost, results in an attractive return on the capital invested in opening that store. Thus, reinvesting cash flow from ongoing operations into new store openings becomes the most judicious allocation of resources.
Chipotle spent an average of $1.2M in development and construction costs per new restaurant in 2023 and expects these numbers to be consistent in 2024. Once a new store is fully operational, average unit revenues are expected to be ~$3M and operational costs per store average 76% of revenues (meaning operating margins are 24%). This revenue and operating margin profile implies $720K in expected annual operating income, a 60% cash-on-cash return and a payback period of ~20 months.
Wingstop targets an initial investment of $480K. Once a new store is fully operational, average unit revenues are expected to be $1.8M and the company targets a 70% cash-on-cash return and a payback period of less than 2 years, even after incorporating the 6% royalty fee and 5% advertising fee that franchisees pay.
These less than 2-year payback periods highlight the attractive economics of these business models. Both companies have created operations that have generated high returns and, importantly, are easily replicated, allowing for high-return market penetration potential. These high returns can create a self-funding flywheel where the highest and best use of capital from existing operations is investing in new stores.
Store Expansion Progress and Outlook
Given the demonstrated demand for each of these restaurant concepts and the attractive economics of launching new stores, these companies are expected to continue to march toward their market penetration aspirations. Using company reports, each is still relatively early in its expansion plan. Coincidentally, both companies are targeting a total addressable market size of 7,000 stores but are taking different paths to reach their targets. Taking a closer look at some of the details surrounding each company’s plans:
Chipotle is currently at ~3,400 stores, with the vast majority within the United States, and is targeting an annual unit growth rate of 8-10%. Importantly, the company continues to innovate as it grows with the recently launched Chipotlane, an efficient, drive-through operating model that should drive even higher cash-on-cash returns. In 2023, 238 of the 271 new restaurants included a Chipotlane. The company is also focused on expanding its presence outside of the US and will focus on accelerating growth in Canada and expanding at a measured pace in Europe.
Wingstop is currently at ~2,200 stores, and management believes there is a significant opportunity to continue to expand both domestically and internationally. Within the United States, 56% of stores are located in Texas, California, Illinois, and Florida. The company will focus on growing within these high-brand-awareness markets while attempting to broaden out to new markets through investments in advertising and promotional activity. At the end of 2023, Wingstop had 288 international locations. The company believes that the restaurant operating model translates well internationally based on the small real estate footprint, simplicity of operations, the universal and broad appeal of chicken and the ability to customize its wide variety of flavors to local tastes.
While it is an important part of the investment thesis, these footprint expansion plans need to be incorporated alongside a broader mosaic of fundamental factors. For instance, what is each company doing to drive same-store sales growth? With Chipotle, Chipotlane was mentioned earlier as one of the efforts management is taking to drive operational efficiencies during peak periods of demand. For context, the company is achieving low-20s transaction counts during peak 15-minute intervals, but management believes high-20s to low-30s is attainable. This would drive meaningful improvements in same-store sales.
Wingstop has been generating strong same-store sales momentum due to several factors, including menu innovation, national branding efforts, the integration of a second delivery provider (Uber Eats), and an ongoing value-based bundling strategy. Importantly, this same-store sales increase has been traffic-driven (rather than by rising prices), which stands in stark contrast to many of its competitors.
Investment Process Highlights
The Artisan Partners Growth Team seek to invest to invest in companies with franchise characteristics that are benefiting from an accelerating profit cycle and are trading at a discount to private market value.
Security Selection
The team seek to identify companies that are selling at attractive valuations and are benefiting from an accelerating profit cycle. They look for companies that are well positioned for long-term growth, driven by demand for their products and services, at an early enough stage in their profit cycle to benefit from the increased cash flows produced by the emerging profit cycle.
Capital Allocation
Based on fundamental analysis of a company’s profit cycle, the portfolio is divided into three parts.
GardenSM investments are small positions in the early part of their profit cycle that will warrant a more sizeable allocation once their profit cycle accelerates.
CropSM investments are positions that are being increased to a full weight because they are moving through the strongest part of their profit cycle.
HarvestSM investments are positions that are being reduced as they near the estimate of full valuation or their profit cycle begins to decelerate. The team believe that adhering to this process increases the likelihood of delivering upside participation with downside protection.
Broad Knowledge
Security selection and capital allocation is overlayed with the capability to invest opportunistically across the entire global equity spectrum. Having broad knowledge of the global economy helps ensure that the team is able to find growth wherever it occurs. This capability extends from the design of the team, which leverages the broad experience of the portfolio managers and the deep expertise of the analysts on the team.
Team Overview
The team believe that deep industry expertise, broad investment knowledge, a highly collaborative decision-making process and individual accountability are a powerful combination. Since the inception of the team in 1997, the team has been committed to building a team of growth investors that retains these attributes and is solely dedicated to the process and approach.
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