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How much would you pay for a restaurant that was bringing in $200,000 in profits annually? One million dollars? Definitely, you'd make your money back in 5 years. Two million? Probably, since it would only take you 10 years to recoup your investment, less if you were able to grow earnings during that time. How about $5 million? Maybe, although it would take you 14 years to earn back the purchase price in today's dollars (applying a 10% discount rate to future earnings) even if you were able to grow earnings by 20% annually.
What about $10M for a single restaurant that was bringing in $200,000 per year? You probably wouldn't want to pay that steep a price, since this would require 20 long years to pay off even at the optimistic growth rates assumed above. What if earnings growth drops off to 10% after 10 years? It would now take 25 years to recover the purchase price in today's dollars. What if there's a slowdown and growth drops to 5% after a decade? Try 40 years, and since you probably want to retire at some point, that would not be a very desirable investment.
Yet investors in Chipotle Mexican Grill (CMG) are happily paying even higher prices than these today. Chipotle's $16.5B market cap works out to almost $11M per restaurant based on the 1539 locations they had open at the end of the last quarter. Expected annual earnings of $10.47 per share add up to total corporate earnings of $324M, or about $210,000 per restaurant. At Chipotle's current stock price, these figures mean it is trading at a Price to Earnings (P/E) ratio of about 51.
Paying greater than 50 times earnings for anything, be it a single restaurant or an entire company, seems a little risky based on the above discounted cash flow analysis. Of course, a single restaurant would quickly hit earnings limitations if it were to grow profits at 20% per year, since attaining earnings 5 times higher in year 10 than year one would be unlikely without expanding to multiple locations. This is clearly what Chipotle continues to do, adding between 165 and 180 new restaurants this year and 180 to 195 new locations next year, or store growth of over 10%.
While impressive, this on its own is not enough to get the over 20% earnings growth that Chipotle is expected to achieve this year and over the next five as well, much less the decades we have seen it would take to break even at today's price. Existing restaurants are also contributing through outstanding same store sales growth, often referred to as "comps" in the industry, short for comparable restaurant sales. According to management on the last conference call, comps have steadily improved from 3% in the first quarter to 4.5% in the second, to 6.2% in the third quarter.
This is certainly encouraging, so much so that these trends prompted the company to raise their full year 2013 comp guidance to the "mid-single-digits" from the previous guidance of "low to mid-single-digits." However, they expect comp growth to return to the "low single-digit range" next year, unless they can successfully implement higher menu prices to pass through increased food costs. While management is optimistic they can achieve this, it's no guarantee that this won't hurt sales volume or even keep up with the rising cost of the non-GMO foods that Chipotle prides themselves on serving.
Investors are clearly counting on higher comp rates, and I think any slowdown in comps growth might cause the stock to sell off like it did back in 2012 over similar concerns. Despite accelerating comps so far this year, Chipotle probably can't keep up this level of growth from established restaurants for long and increasingly will have to rely on continued expansion in the number of locations. This is unlikely to continue forever either, since the company is in danger of reaching a saturation point in certain areas.
For example, near its corporate headquarters in Denver, they make up 8 of the 110 Mexican restaurants I was able to find in Colorado Springs on Yelp.com (YELP). Their presence is often even more widespread on the East Coast, where they constitute an even higher percentage in our nation's capitol (15 out of the less than 100 Mexican joints I could find in DC proper). Even the idyllic town of Nashua, NH (twice named the "Best Place to Live in America" by Money Magazine) boasts a pair of Chipotle locations to serve its less than 100,000 residents.
The solution to this potential overcrowding issue, according to many shareholders and management, is the rollout of several new concepts in addition their core competency of Mexican. The company feels that its success derives not from their focus on a particular type of cuisine, but rather from their operational strengths and embrace of the "Food With Integrity" concept of providing healthy, sustainable meals and an enjoyable customer experience for a reasonable price.
Therefore, the company has rolled out several of its ShopHouse locations, a "Southeast Asian Kitchen" concept serving Asian-inspired cuisine like rice and noodle bowls, as well as interesting sounding parfaits for dessert. This is certainly a bold concept, but there's no guarantee it will catch on and contribute meaningfully to Chipotle's overall business, yet investors are assuming it will be a resounding success without considering the possible downside.
The company has also started experimenting with pizza, starting with a single restaurant called Pizzaria Locale in Denver. Serving so-called "craft pizzas" with Chipotle's signature assembly line format in short wait times of as little as 2 minutes for a fresh pizza. The pies will presumably employ Chipotle's traditional focus on organic ingredients and will feature a gluten-free crust option to embrace that popular movement. However, as mentioned in this article and the associated comments, there will probably be no shortage of competition in this trendy area, including from Pizza Inn's (PZZI) Pie Five brand, and even from Buffalo Wild Wings (BWLD).
Branching out into two of the most popular types of food, Asian and pizza, seems like a good way to increase the company's runway to continued growth, but there are already high volumes of existing and potential competitors in these two spaces. There's no guarantee that they will experience the level of success that Chipotle has had with their flagship brand. Although core growth is still going strong, it will almost certainly slow at some point in the future as appetite for additional locations approaches satiety. Even if you believe that the company's new concepts will pick up the slack, there will probably be an opportunity to buy the company at a cheaper price sometime in the future when growth first appears to slow.
I fear that reliance on raising menu prices and moving to open many more restaurants, including unproven new concepts, could signal that Chipotle's stellar growth could begin slowing soon. Don't be caught holding the stock when this outstanding company starts showing cracks in its growth story, even temporary ones, since the stock is currently priced for perfection. It's probably better to wait until the stock returns to more reasonable valuation levels, something it has consistently done before, as articulated by this excellent article.
As pointed out by our example of a single restaurant at the beginning of this article, the price you pay is important in determining how long it will take the investment to pay off and what rate of return you'll achieve. Right now, the business performance and potential expansion opportunities of Chipotle might seem tempting, but as in any stock purchase you probably don't want to pay up for an optimistic outlook since you'll pay a premium price and not have an adequate margin of safety if the business has any bumps in the road.
Given that unlikely-to-continue accelerating comps and faith in untested new concepts are currently heating up demand for the stock like one of their new thousand degree pizza ovens, intelligent investors might want to wait a bit before diving in so they don't get burned.