Chipotle: Great Growth, Bad Price

| About: Chipotle Mexican (CMG)

There is a difference between growth at a reasonable price investing and growth at any price investing.

Right now, Chipotle Mexican Grill (NYSE:CMG) is trading at a price of $532 per share while creating $10.35 in profits for owners (due to a couple of one-time item charges, most stock screeners indicate that Chipotle's earnings base is a little bit lower, at $9.88 per share). Anyway, the current valuation of Chipotle works out to a P/E ratio of 51.4x current earnings.

When you look at Chipotle's current valuation in relation to where it has been since the McDonald's spin-off in 2006, you will see an abundance of opportunities to buy the stock at 35x earnings or below.

In 2007, when the company was generating $2.13 per share in profits, you had an opportunity to buy the stock below 35x earnings, or $74.55.

During 2008 and 2009, the company experienced once-in-a-generation valuation, in which the stock price came down below 20x earnings even as the company increased its earnings by 139% throughout the financial crisis (profits of $2.36 in 2008 grew to $5.64 by 2010).

In 2010, investors had yet another opportunity to buy Chipotle at less than 35x earnings, as the stock spent a good portion of the year trading below $197 per share.

Come 2011, the same story holds: investors had an opportunity to buy Chipotle at a valuation below 35x earnings (for a price below $236). And the following year, investors had an opportunity to buy the stock below $306 (which would have been the 35x earnings equivalent).

Even when you recognize that the financial crisis was a period of abnormally cheap valuations and manually remove it from your analysis, you can still see that prospective Chipotle owners had an opportunity to buy the stock at a valuation below 35x earnings in 2007, 2010, 2011, and 2012 as well.

That's why it looks like the company's shares may be 30% overvalued: the only way you could justify paying a 30% premium for Chipotle shares in relation to its historical valuation in normal stock market conditions is if you believe one or more of the following three things: the balance sheet has improved, the earnings quality has improved, or the company's growth prospects have improved.

It's unlikely that Chipotle's balance sheet has improved much to warrant a spike in valuation: the company carries no debt on its balance sheet, it has no defined pension plan to fund, and the company has no issued preferred stock outstanding. That has been the case for much of its trading history, so it is unlikely that this is the course of Chipotle's higher valuation.

The company's earnings quality has improved as its financial strength has grown: it now has the earnings power of 1,500 franchises rather than just a few hundred. As the profit matures into a franchise with dependable profits, it is possible that this warrants a modest uptick in valuation as the company gradually grows stronger in producing reliable cash flow. However, the additional rollout of stores is probably not enough to warrant a 30% premium above prices available at some point in each of the years from 2007 through 2012.

That leads us to the third potential cause of the rise in Chipotle's valuation: high perceived future growth. To put it bluntly, Chipotle is still growing fast. Sales are increasing by 17% on an annual basis. When you look at the same stores, you will see annual growth of 7% in 2013 relative to 2012.

And that does not even take into account Chipotle's international expansion by rolling out new stores. We won't know the specifics for a few months, but it looks like Chipotle created 175 or so new outlets this year (including expansion into Canada, Britain, France, and now, Germany). This is a company that is still growing at 17% annually: about 60% of that growth can be explained by new food outlets that Chipotle is rolling out, and the other 40% can be explained by the growth in sales at existing food outlets that is single-handedly advancing the earnings per share clip at 7-8% annually.

And what has really impressed me and gotten me excited about Chipotle's management is that they are doing everything with existing cash flow rather than debt. It takes patience and good stewardship to grow that way, rather than just visiting a bank and taking out a big loan to invest, and I appreciate Chipotle's record of keeping the balance sheet clean. There is no debt on the balance sheet currently, and the company has not diluted shareholders through secondary offerings to get their hands on money to fuel growth: there were 32 million shares of Chipotle in existence in 2007, and now there are a little less than 31 million in existence. Instead of raising capital to fuel growth, they've actually bought back a little bit of stock, and this management of the shares protects the shareowners by letting them lay claim on all of the profit growth without any dilution.

Even at today's price, you'd still probably make money when you look back five years from now. The problem, though, is that the price of $532 per share gives you a negative margin of safety-if growth slows down to 4-5% per year (recessions don't necessarily put out the blinking lights before they arrive) or something like that, you could lose a lot of money from P/E compression even though the company's profits continued to grow. When you pay 50x earnings for a stock, you have no price protection: the stock must continue to grow at a rate in excess of 10% each year for you to do well. Considering that Chipotle has traded at under 35x earnings in every year since 2007, you might as well be patient.

Personally, with a growth company like Chipotle, I'd be comfortable investing with no margin of safety in terms of price, but I would not be willing to take on a negative margin of safety in which a 30% decline in valuation would appear to be warranted based on each of the last six years of trading history. A reasonable price with Chipotle stock isn't something like Haley's Comet that only comes around once or so in a lifetime. You've seen prices below 35x earnings for the stock in each of the past six years. It will come again. Even with a company as impressive as Chipotle, you don't want to give up 30% in valuation just because you couldn't be a little bit patient.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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