Guzman y Gomez (ASX: GYG) shares surged after their trading debut on the ASX on the 20th of June. Prior to the listing Morningstar Director of Equity Research Johannes Faul and Equity Analyst Lochlan Halloway issued a pre-IPO report setting a fair value for the shares at $15. This is well below the offering price of $22. It is even further below the roughly $30 the shares trade at after two days.

The obvious question is if Johannes and Lochlan were wrong in their assessment of the value of the burrito business. In fact, I received an email complaint about our valuation approximately four hours after trading started on the 20th.

If we had issued a pre-IPO report predicting the price of Guzman at 2pm on the IPO day we were emphatically wrong. But of course, that is not the purpose of our equity research. We are long-term investors at Morningstar. Focusing on the long-term is not a gimmick to explain away any deviation from our view. It is common sense.

Investing is the opposite of life. I am reasonably certain what I will do tomorrow. Anything could happen, but chances are tomorrow will go mostly as planned. I have less of an idea of what I will be doing on tomorrow’s date 1 year from now. I have no clue what I will be doing on the same date in 10 years.

When we turn to investing the opposite is true. I have no idea what any share I own will do tomorrow. Any number of factors could influence how a share performs on a given day. Most of those factors have nothing to do with the company that I partially own. Some of those factors have nothing at all to do with the share market.

Most of the data and news that captures the attention of investors will recede into irrelevance with time. And not just over the long-term but in the next day or two. The relevance of other pieces of data or news will only be appreciated in retrospect. The explanations of why the market or a particular share went up or down in a single day is just a guess. We can’t know what motivated each buyer and seller.

Over the long-term what will impact share prices is how a company performs. Simple as that. It is not easy to predict how a company will perform over the long-term. But it is impossible to know what will happen with a share price tomorrow. I choose to focus on how a company will perform over the long-term because I would rather spend my time on something challenging than something impossible. That is why our approach at Morningstar is common sense.

When hype meets reality

Our analysts spend time building a discounted cash flow model for each share they cover. This involves understanding the competitive dynamics in an industry, the economics of the business they are assessing and future trends that will influence demand for goods and services.

Johannes and Lochlan spent a significant amount of time putting together their pre-IPO report on Guzman. I’m going to take a different approach. I am just going to do a sense check of what Guzman trading at $30 means. Is this hype or is this a situation that is likely to be profitable for investors?

The Guzman IPO was a big deal. It is rare to have a company go public that is as well known as Guzman. Many Australians have heard of Guzman and many have tried their food. This isn’t some obscure business software company or small miner. This familiarity with Guzman undoubtably played a role in the media and investor fixation on the IPO.

I understand the hype. I like Guzman. And I go to Guzman. In fact, I had Guzman for dinner last night. Do I think Guzman compares to the burrito offerings in the US? Not even close. There are many things I love about Australia. The quality of the Mexican food is not one of them.

In the land of the blind, a one-eyed man is king. And Guzman has a chance of being the quasi-Mexican food king in Australia. Is my opinion about the realitve merits of Guzman’s food relevant? It isn’t. But neither are the opinions from people who know Guzman and are contributing to the hype.

The problem with hype is that it can cause us to lose sight of reality. And in this case I think that the hype is problematic for long-term investors. Returns come from three places. Changes in valuation levels, earnings growth, and dividends. We can eliminate dividends for Guzman. With ambitious growth plans it is unlikely Guzman will pay a dividend any time soon.

Valuation levels are a good place to start. Our analysts expect Guzman to earn $0.03 a share in 2024. The shares are currently trading at around $30 a share. That is a price to earnings ratio of approximately 1000. Obviously, this is off the charts. In comparison this makes Nvidia at 80 times earnings look like a share Ben Graham would be salivating over.

But it is also not completely unreasonable for an IPO. More than 83% of IPOs are unprofitable according to research by University of Florida professor Jay Ritter. At least Guzman is profitable.

What matters for an IPO like Guzman is earnings growth. And Guzman has ambitious growth plans to expand from 183 stores in Australia to over 1000. Our pre-IPO report stats our belief that Guzman can open 40 new stores a year so this is a plan that would take over 20 years to accomplish. This assumes that Guzman can find enough areas where a profitable store can be opened.

Guzman also wants to expand to the US and Asia. It is hard for me to judge the prospects for Guzman in Asia. I have serious doubts about the prospects for an Australian ‘Mexican’ chain in the US market with a 19% Hispanic population and a saturated competitive environment. Perhaps you disagree but without meaningful expansion globally it makes it hard to see achieve the growth that justifies the valuation. How much growth is needed is the question we need to answer.

A common sense approach to Guzman

While my opinion on the relative merits of different burritos is irrelevant I think my ability to use a calculator is useful. Guzman will not be trading at 1000 times earnings forever. This doesn’t spell doom for the company. If earnings grow faster than the drop in valuation the share price will still rise. We can calculate the amount of earnings growth needed to counteract the inevitable fall in valuation.

To get to a price to earnings in line with McDonalds current ratio of 21 in a decade would require earnings to grow to $1.43. That would require earnings growth of 54% annually over a decade.

If you think a PE ratio of 21 is too low how about 50? That is roughly in-line with Domino’s current valuation. That would require earnings to rise to $0.60 in a decade. Earnings would have to grow 39% a year. This is similar to the earning growth forecast by Johannes and Lachlan in their pre-IPO report. This is plausible.

The problem is that in both the McDonald's and Domino's scenarios I’ve assumed the shares are still trading at $30 in a decade. This is not an ideal situation for investors.

If we assume 8% annual returns Guzman’s share price would be roughly $60 in a decade. In that case earnings growth would have to be higher. The McDonald’s scenario of 21 times earnings would require 66% annual growth in earnings. The Domino’s scenario of 50 times earnings means 51% annual earnings growth.

When considering that level of earnings growth it is important to consider what type of business Guzman is in. This isn’t a scalable tech company where the same software can be sold to more and more customers. Growing earnings means opening new locations. This takes time and it takes money.

We can once again do some back of the envelop math. To earn an 8% annual return and trade at 50 times earnings means growing earning from $0.03 a share to $1.20 in a decade. Earnings would have to be 40 times higher than they are now. With 183 current stores on a store-by-store basis this would mean 7,320 Guzman locations in a decade.

But we do need assume Guzman will increase margins and more of each burrito sold will flow to the bottom line as the company grows. In our pre-IPO report Johannes and Lachlan assumed margins would more than double. If margins double that means 3,660 stores. If margins triple it is 2,440 stores.

To me the math just doesn’t add up. To get to an 8% annual return from a share price of $30 requires 51% annual earnings growth and a tripling of margins. It means opening somewhere around 225 more stores each year for a decade. Given Guzman’s own projections 1,257 of those stores will have to be overseas. Our analysts think they can open 40 stores a year. They would have to be very wrong.

Opening the stores will cost money. Johannes and Lachlan estimate that approximately 40% of Guzman stores will be corporate owned. In the scenario I just mapped out it would mean Guzman would need a little more than $2 billion to open just under 1,000 corporate stores. The company took in about $200 million for expansion from the IPO. That money needs to come from somewhere.

All this to match an 8% return that historically has been achievable with an index fund.

Final thoughts

Nothing that I did should be confused with a rigorous analysis of a company. I didn’t forecast revenue and earnings. I didn’t put any thought into how many stores could be opened and the drivers of demand and profitability. I did not arrive at an estimate of the fair value for Guzman. I didn’t even put too much thought into what valuation level the company should trade at other than comparing it to peers. All I did was use the work done by Johannes and Lachlan to sense check if a $30 price is reasonable. To me it isn’t.

Over the short-term hype may rule markets. Over the long-term common sense has a way of imposing itself on that hype. I don’t know what Guzman’s future holds. I will keep eating their burritos until our shores are graced by Chipotle. But the shares will come nowhere close to my portfolio unless the price drops significantly.

I would love to hear your thoughts. Email me at [email protected] 

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