Why Chipotle's Valuation Is Absurd

| About: Chipotle Mexican (CMG)


Chipotle, the company, has some good times ahead of it, but its stock valuation is out of whack.

We think Chipotle is more exposed to a market correction than most.

The firm's Valuentum Buying Index score is not promising.

As part of our process at Valuentum, we like to perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. Now, many investors believe that a discounted-cash flow model is based on assumptions and forecasts, many of which are difficult to predict. We agree. However, the factors behind a discounted cash-flow model (the future, interests rates, etc.) are largely how the markets operate and how assets are valued. We cannot just ignore the important inputs because they are uncertain. The past is already history. Let's take a look at Chipotle (NYSE:CMG) through a discounted valuation model and apply the Valuentum process to shares.

But first, a little background to help with the terminology in this article. We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. To many investors, this is just common sense, but we're the only provider that actually builds a fully-populated, three-stage discounted cash flow model and considers technical and momentum indicators in a timeliness assessment.

This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). One of the most successful investors of all time - Bill Miller - liked to combine value and growth characteristics, and another great investor - Warren Buffett - understands that growth is but a component of value. Since Warren Buffett's stocks have generated good momentum in the past (strong outperformance) and he likes to scoop up undervalued ideas, the Oracle of Omaha's process and outcome is very close to the Valuentum style. Mr. Buffett may not even know it.

At the methodology's core, if a company is undervalued both on a discounted cash-flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Chipotle posts a Valuentum Buying Index score of 4 on our scale, reflecting our 'overvalued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. It's very important that investors note that the VBI is the consideration at the time of the action - so for example, if Chipotle had registered a 9 or 10 in the past (a 'we'd consider buying' rating), we'd still hold shares until they register a 1 or 2 (a 'we'd consider selling'). Our process is very straightforward in that respect. We like underpriced stocks that are going up, and we hold them until they are overpriced and going down. For relative valuation purposes, we compare Chipotle to peers Starbucks (NASDAQ:SBUX), Yum! Brands (NYSE:YUM), and McDonald's (NYSE:MCD), a good mix of fast-growers and strong established brands. Let's dig into the report.

Chipotle's Investment Considerations

Investment Highlights

• Chipotle earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 52% from 45.2% during the next two years.

• Chipotle serves a focused menu of burritos, tacos, burrito bowls (a burrito without the tortilla) and salads, made using fresh ingredients. It prides itself on trying to find the highest-quality ingredients ('Food With Integrity') and providing an exceptional restaurant experience.

• Chipotle has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 10% in coming years, and the firm had no debt as of last quarter.

• Chipotle has been on a roller coaster ride during the past year. Recent results suggest that the company needs to raise prices to maintain margins. It says it has pricing power. The restaurant is also facing strengthening competition from Yum! Brands' Taco Bell and even Jack's Qdoba.

• Without a doubt, Chipotle is a fantastic company and a great concept with tons of growth ahead of it. However, a good company does not always make a good stock. Its shares are far from cheap at present, even after factoring in rapid and sustainable growth.

Recent Restaurant Industry Trends

Though Chipotle's upscale focus puts it more in the fast-casual segment, the company's breakneck 13.4% comparable store sales increase during the first quarter ended March 31 indicates that traffic wasn't terrible across the entire industry, even if weather did play a role. The comp number at Chipotle was its best in some time, though on a firm-specific basis, food costs continue to impede earnings expansion. Food costs were up 150 basis points (as a percentage of revenue) during the firm's quarter as avocado, beef, and cheese prices were all higher. Chipotle, which could be considered the biggest direct competition to Taco Bell's successful entrance into breakfast, has backed off plans to enter the breakfast market. We don't think the decision had anything to do with the market for breakfast burritos, but more a result of consumers not venturing far from what they already know they like at Chipotle.

Chipotle's Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Chipotle's 3-year historical return on invested capital (without goodwill) is 40.7%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Chipotle's free cash flow margin has averaged about 9.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Chipotle, cash flow from operations increased about 29% from levels registered two years ago, while capital expenditures expanded about 32% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Chipotle's shares are worth between $297.00 and $551.00 each. Shares are trading at about $500 at the time of this writing. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. We think this fair value range is an adequate range to expect Chipotle's shares to trade in through the course of the economic cycle at times. Said differently, we would not think anything of it if Chipotle's shares fell to $300 or moved to $550 - both scenarios are within the range of probable outcomes. With that said, if Chipotle's shares fell to $250 or so, we'd sure be interested, but that's quite the correction.

The estimated fair value of $424 per share represents a price-to-earnings (P/E) ratio of about 40.5 times last year's earnings and an implied EV/EBITDA multiple of about 20 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 15.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 20.5%. Our model reflects a 5-year projected average operating margin of 18.6%, which is above Chipotle's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 8.6% for the next 15 years and 3% in perpetuity. For Chipotle, we use a 10.8% weighted average cost of capital to discount future free cash flows. Given that its point fair value estimate is below its current share price, we think Chipotle is more exposed to a market correction than most.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $424 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Chipotle. We think the firm is attractive below $297 per share (the green line), but quite expensive above $551 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Chipotle's fair value at this point in time to be about $424 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Chipotle's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $577 per share in Year 3 represents our existing fair value per share of $424 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Valuentum's Take

We see no reason to touch Chipotle's shares at current levels. To think that another downturn will never come is just too optimistic of a view. We're confident Chipotle will trade toward the lower end at some point during the next trough of the restaurant cycle, and at that time, investors will have a better opportunity to enter shares. We remain on the sidelines at this juncture.

In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score, as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

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.