Who is Chipotle?
Chipotle Mexican Grill (CMG) first opened in Denver, Colorado and has been expanding across North America ever since. Since 1993, Chipotle has opened over 1,500 restaurants that use high quality raw ingredients, classic cooking methods, and design features in the restaurants that attempt to imitate high-class dining. Chipotle's wants to give customers high-quality meals for a competitive cost. The restaurant has quick service based on standardization and a simple menu, which helps eliminate customer uncertainly (ultimately making lines move faster). The way the food products are made are similar to Subway: assembly-line style.
Discounted-Cash Flow, Historical Operation Averages, and Current Problems
Discounted-Cash Flow (Part 1)
I employ the discounted free cash-flow valuation model that normalizes revenues, and uses the balance sheet growth as a proxy for capital expenditures. In the model, I will use averages and Wall Street estimates to forecast future expected earnings, but this is not the goal of the model. The goal is to determine the level of cash flow that will be available to shareholders under average conditions. Shown below, are the historical averages of Chipotle's cost structure line items and cash flow drivers:
*Note that I annualized the numbers (multiplied Q1 and Q2 by 2.05) taken from the 10-K statements for the first two quarters. I multiplied the quarters by 2.05 because Chipotle has slightly higher sales in Q3 and Q4 after looking at historical financials.
Historical Operation Averages
After analyzing the operating expenses, it can be seen that Chipotle has done a better job at labor costs year-over-year. Future problems that could affect the industry are an increase in the minimal wage and workers unionizing. More recently, fast food workers are protesting for an increase in the minimal wage and some state governments have responded (both NY and California are increasing MW).
Food, beverage and packaging costs are getting higher and higher every year, and this is worrisome. Chipotle believes that "food with integrity is our commitment to finding the very best ingredients raised with respect for the animals, the environment, and the farmers." Chipotle only sources its meat from sources that are never given antibiotics and are fed a vegetarian diet. Over 40% of Chipotle's beans are organically grown, and the restaurant supports local family farmers that meet its standards. While this is a positive for the environment and the organic, local farmers, this squeezes Chipotle's margins. At the same time, the balance sheet cash flow drivers have gotten better over the years as well. As technology has improved, Chipotle has lowered machinery costs. Change in working capital has also gotten better year-after-year.
Discounted-Cash Flow (Part 2)
Using a discount rate of 7.5%, and a terminal growth rate of 2.0%, this is the full discounted cash flow model using the assumptions based in the free cash flow projection.
After summing up the discounted free cash flow projections, I have the enterprise value (equity value + cash - long-term debt). In order to get the total equity value, I added back cash and subtracted long-term debt (zero) to get the total equity value. After dividing equity value by the number of diluted shares outstanding, I got the intrinsic value of the stock ($321). This is lower than what the stock is currently priced at ($442 as of 10/14/2013). Based on this model and these assumptions, Chipotle can be viewed as overvalued by investors. I decided to use 7.5% for my WACC (weighted average cost of capital) as the rate is slightly higher than the industry average of 7.2%.
Chipotle believes that its expansion is what is helping driving revenue growth, which the company has shown in the financials. Chipotle currently owns 1,502 restaurants of which 1,490 are in the U.S., 5 in Canada, six in London and one in Paris. While it is inevitable that eventually Chipotle's growth is going to slow down, I believe it will happen faster than most analysts would expect. A main reason companies like McDonald's (MCD), Wendy's (WEN), Burger King (BKW), and Taco Bell (YUM) can expand and continue to increase revenue is because they offer cheap options on their menu. I can walk into McDonald's and buy three McDoubles, a value fry and a small drink for $5, while at Chipotle, I need to spend at least $8 to get a decent meal (not including a drink or side). Opening a Chipotle in lower-income areas cannot provide the same returns as opening up a McDonald's in the same area. I normally spend about $12-$13 dollars at Chipotle, compared to when I go to another fast-food alternative for about $7-$8 dollars.
I believe that a major problem of Chipotle is that it is too simple, basic and easy to recreate. While I do enjoy eating Chipotle's burrito bowls, I find that a major problem is that there is not much variety at all. Its main competitor, Qdoba, offers more sauces and has stronger presence among vegetarians. As a consumer of both Qdoba and Chipotle, I'd rather go to Qdoba because while the taste is pretty similar, the menu has more options. Simplicity can also lead to quick market saturation. Frozen yogurt has become extremely popular in my home state of New Jersey. As more and more people realized how easy it was to start and operate a frozen yogurt store, every franchisee group began opening them. Initially, profits were great but recently, a majority of the stores were struggling to stay afloat. In my town, Chipotle has already had competition from Panchero's, Qdoba, Moe's Grill and other places with similar concepts. I believe that eventually the Mexican fast-food market will become saturated in the future and this will hurt Chipotle's earnings. Chipotle is just not unique, unlike some other fast-food restaurants (McDonald's, Burger King, Wendy's) that have a strong history. Although many may believe that the best way for Chipotle to continue its rapid growth is the expansion in emerging markets (China, India, and Europe), the company has announced that it doesn't have any definite plans for the future internationally. This shows that the only feasible area to expand in is primarily the United States.
A new concept Chipotle has adopted is ShopHouse serving Asian inspired cuisine. Chipotle's management claimed in their most recent 10-Q that it will open 165-180 restaurants (Chipotle's) in the rest of 2013, including up to four ShopHouse restaurants. While the ShopHouse concept will add onto the already established Chipotle name, ShopHouse is still an experiment that hasn't shown great returns. While Chinese/Asian fast-food is still on the rise, other restaurants like Panda Express, Chinese Gourmet Express and others already have head start in this part of the industry. After reading ratings from the few current locations, many consumers enjoyed ShopHouse but would rather eat from other authentic Chinese restaurants for the same price.
Stock Price and Additional Valuation Metrics
Looking at the graph below, Chipotle has increased 52.17% in the past year. My personal belief is that this is due to speculation because of the Chipotle hype.
When comparing the ratios above, the first three ratios show that Chipotle can be believed to be overvalued. First off, Chipotle has the highest EV/EBITDA ratio at 22.2 compared to its main competition with public companies. Its P/E ratio is also much higher than the industry average, and only comes close to Wendy's (35.2). When looking at price to free-cash flow, Chipotle again is ahead of the industry average, while only coming in second place to Wendy's (a company which I believe is also currently overvalued). All these three statistics show that Chipotle is overvalued when compared to the rest of the industry. I included operating margin just to show how well Chipotle managed its expenses compared to the rest of the industry.
After modeling a discounted cash flow, and using other valuation methods, I conclude that Chipotle is overvalued and I would not hold it in my portfolio. I believe that there are other companies in the fast-food restaurant sector that are currently undervalued, which I will go into in my future articles. While Chipotle is making the right steps for protecting the environment, supporting local farmers and providing healthier options, as an investor, I find other companies to have more risk-reward potential.