Most analysts look at company-wide financials and industry trends when looking for value on the market, but unit economic analysis is a powerful tool for predicting a company’s growth potential, and Morgan Stanley’s latest North American Insight newsletter is a hands-on guide to doing unit economic analysis on your own.
High return unit economics
The report focuses on retail stores because they combine high return unit economics with the potential for rapid unit expansion. When both cylinders are firing overall growth can beat the market year after year. Looking back, Target Corporation (NYSE:TGT), Costco Wholesale Corporation (NASDAQ:COST), Starbucks Corporation (NASDAQ:SBUX) and others have managed to succeed on both fronts and their investors have been amply rewarded.
Healthy dividends vs explosive growth
But once a company has saturated the market growth becomes more difficult. There are plenty of mature, profitable retail chains that pay healthy dividends to investors, but they just can’t provide the explosive growth of a well-managed chain getting off the ground. “The trick is to isolate the growth stories that have both compelling unit economics and the unit expansion potential to pay off in the long run, even if current valuations are high,” says the report.
Retail stores under consideration
To cut down on the number of retail stores under consideration, Morgan Stanley (NYSE:MS)’s team of analysts (John Glass, Kimberly C Greenberger, David Gober, and Jay Sole) looked for retail chains that could expand their number of stores by at least 25 percent in the next year and that had fully capitalized unit level returns over 15 percent.
This left three companies in the ‘sweet spot’ of high unit economics and high unit expansion: Chipotle Mexican Grill, Inc. (NYSE:CMG), Michael Kors Holdings Ltd (NYSE:KORS), and Lululemon Athletica inc. (NASDAQ:LULU) (TSE:LLL).
Drilling down, compare the economics of a single, typical Chipotle Mexican Grill, Inc. (NYSE:CMG) store, disaggregated from the company as a whole.
The volume of sales is lower than other restaurants (though it’s actually quite good for fast food), but the store space is smaller and costs less to lease, the cost of goods is less than industry average, and the cash-on-cash return is 18 percentage points better than average.
Chipotle Mexican Grill, Inc. (NYSE:CMG) is able to achieve all this with a clever business model. For instance, the cost of its ingredients is higher than the industry average, but the service model means that essentially all food goes toward throughout and there is very little waste. A simple aesthetic has proven to be popular with customers and has the benefit of reducing costs. The combination of strong margins and fast expansion is exactly what investors should be looking for.
At its core this type of analysis is a simple relation (average per-unit profit times the number of units gives you total profits), but it lets investors focus on the details that differentiate a wildly successful difference retail chain and one that continues expanding until the day it declares bankruptcy.