Chipotle Mexican Grill: The Good, The Bad And The Unknown

| About: Chipotle Mexican (CMG)

As a frequent customer of Chipotle Mexican Grill (NYSE:CMG) I have been happy with the quality of food, promptness of service and reasonableness of price that I have experienced. Given that its revenue has expanded in the last five years at a compounded annual growth rate of almost 21%, there are many others that share that feeling. The company has risen as a leader in the "fast casual" industry, intelligently filling the gap that existed between less healthy fast food options and healthier but more expensive sit down restaurants. My own experience as a customer and Chipotle's incredible growth story has prompted me to don my investor hat and try to evaluate if buying the company's stock would be as satisfying as buying its delicious food.

The Good

1. Simple Concepts: Chipotle has built a business and a reputation by focusing on a few basic ingredients and serving dishes that are based on permutations and combinations of those. This makes it easier for the company to focus on improving the quality of these ingredients. It has done so by moving towards more organic, sustainably grown or raised, non GMO, lower carb raw materials.

In terms of service as well, having few simple ingredients is very helpful in keeping speed and service levels high in their assembly line style setup of made to order meals.

Every so often the company does expand its offerings to cater to a wider range of customer tastes and preferences. Some examples are sofritas or tofu for vegetarians or salad and burrito bowls for the carb conscious. But overall it has stayed true to using a few building blocks to build many different structures.

2. Strong Financials: Chipotle has been continuing along a path of robust financial growth for the last several years. After the company reported its solid Q4 2013 performance recently the stock soared 12% at opening the next day. The fourth quarter was another strong quarter for the company with revenue growth of nearly 21% and comparable restaurant sales growth of approximately 9% on a year ago basis. Operating margins for restaurants increased by a 100 basis points year over year, while earnings per share increased nearly 30% over prior year to $2.53 in the fourth quarter.

Historically, between 2009 and 2013 the company's revenue grew at a compounded annual growth rate of nearly 21% and diluted earnings per share grew at about 28% over the same period. The company ended the year 2013 with over $323 million in cash and cash equivalents and 185 more restaurants under its belt. Another attractive factor is that it has virtually no long term debt and total cash per share of $18.64. While the company does not pay cash dividends, reinvestment of cash into the business can compensate the stock holders by providing future returns.

3. Room for Expansion: The Company has been growing its culinary empire in three main ways; new restaurant openings, organic growth and international growth. As of year ended 2013 it operated 1572 restaurants in 40 states in the U.S., 7 in Canada and 9 in Europe. So there is still plenty of room for both domestic and international expansion. An instance is that the first Chipotle location opened up in Reno only earlier this month.

Additionally expanding its frontier overseas could be instrumental for the company in maintaining the pace of growth that it needs to justify its price. In the last quarter of 2013 the company opened up a total of 56 new restaurants and plans to open a total of 185-190 locations in 2014. Included in this growth are the company's ventures into Asian fast casual through its ShopHouse restaurants in the D.C. and L.A. areas, as well as, Pizza Locale, its experiment with pizza, in Denver. If it is successful in taking the ideas and culture that has helped make Chipotle a trailblazer in the industry and applying them to these new types of cuisines, then it could be a great way for the company to branch out and grow. It is also investing in a more enhanced marketing plan using digital media, food and music festivals to increase its reach to potential customers.

The Bad

1. Valuation Multiple: The least attractive thing about Chipotle for me right now is its valuation. From a Price to Earnings perspective it is valued at over 50 times earnings. This puts immense pressure on the company to deliver stellar financial results quarter after quarter and maintain strong sales growth rates, which can be challenging. For instance, 2013 revenue growth over prior year was about 18%, which while strong, was a little below growth rates from the previous few years. If this does prove to be a trend of plateauing growth, and the company is not able to accelerate with help from expansion into new markets and cuisines, then a multiple of this level will become very hard to justify. Also with such rapid growth and lots of public exposure, the company has to not only perform well but beat a lot of high expectations continuously to maintain growth in its stock price, and justify the high valuation.

2. Comparable and New Restaurant Sales: Drilling down into comparable restaurant sales, the company gave guidance of low to mid-single digit growth in 2014 mainly because of tough 2013 comps. This organic growth is important for the company as there are higher margins associated with it. Also, as noted in their 10-K filing, in the past the stock price has slid down when the company experienced slowing comparable sales. While the company is skilled in maximizing efficiency and productivity from each of its restaurants through strategies like its assembly line setup, placement of best employees during peak hours, etc., there is a peak beyond which it is not possible to increase productivity. For example, the record so far has been 300 customers served at a location in one hour. While impressive, this is neither the average, nor easy to maintain and exceed.

As far as new restaurants are concerned, the company has a lot of opportunity to grow in domestic and international markets as I wrote above. This is also the main source of sales growth for the company. But the guidance for 2014 indicates between 180-195 planned restaurant openings in 2014. In the years 2013 and 2012 the number of new restaurants opened were 185 and 183 respectively. So the rate at which new restaurants are added has not been accelerating in the last few years.

Additionally, the company does not franchise. This helps with maintaining consistency of product and service but can be a limiting factor on growth.

3. Brand Dilution: The Company has undoubtedly done well so far, establishing itself in the fast casual healthy Mexican food business. By extension it should be able to apply the same panache to its new Asian and pizza ventures. But there are also chances that by wearing too many hats the company may not only fail to succeed in the new initiatives, but also lose focus on its core business and take a hit to its reputation.

Another issue for the company is upward price pressures on its food ingredients in 2013, that are expected to continue in 2014 as well. Pressures such as these pose a difficult situation for the company since its USP is selling healthy, high quality food at a reasonable price. The tradeoff between potentially raising menu prices versus abandoning some of the company's organic, non GMO food initiatives could impact the image of the company.

The Unknown

Conclusion: Will Chipotle Mexican Foods stock keep going from strength to strength, or will it have a hard time justifying the high P/E multiple it is trading at presently, remains to be seen. Powered by continued financial strength and a business that has given new meaning to "fast food", Chipotle stock has been soaring. Between its last closing price and the same day a year ago, it has grown over 76%. While there are many factors that could propel its growth in the future, I think that at the moment the valuation puts it out of my comfort zone. It may continue to perform well but I think it might be a challenge to keep growth continually at the same pace, or ahead, of expectations.

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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am a self-taught individual investor and this article expresses my views based on my own research and is not professional investment advice. I am not being influenced or paid by any organization to write this article.