Chipotle Mexican Grill (NYSE:CMG) has been on a roll over the past year. The stock has soared, and the most recent earnings report showed that the company has the ability to push through a price increase without negative consequences. There is no dispute that Chipotle is a wonderful company, with exceptional profitability and growth prospects. But the stock's valuation has reached astronomical levels, with Chipotle trading at 65 times last year's earnings and 6.5 times last year's sales, and whether a satisfactory return is possible at the current price is a question worth exploring.
A wonderful company
Looking at Chipotle's most recent earnings report, it doesn't take long to come to the conclusion that Chipotle is a wonderful company. Here are some key points from Chipotle's results, with all comparisons year-over-year:
- Revenue of $1.05 billion, up 28.6%.
- Comparable store sales up 17.3%, driven by both higher traffic and a price increase implemented during the quarter.
- Net income of $110.3 million, up 25.5%.
- Operating margin of 17.1%, down from 17.9% due in part to an increase in beef, avocado, and dairy prices.
- Net income margin of 10.5%, down from 10.8%.
The fact that Chipotle can raise its prices without any ill effect is an attribute that is rare, and it illustrates just how strong Chipotle's brand really is. An operating margin of 17.1%, while down slightly from the same period last year, is still exceptional.
In terms of growth, Chipotle opened 45 new restaurants during the quarter, bringing the total to 1,681. This year, Chipotle plans to open between 180-195 restaurants in total, a store count growth rate in excess of 10%. Along with comparable store sales expected to increase in the mid-teens for the year, boosted by the price increase, Chipotle should post rapid growth in 2014.
This level of comparable store sales isn't sustainable, as another price increase is unlikely next year, but Chipotle's comparable store sales rose in the double-digits during the previous quarter as well, so high growth is still very possible.
Even a wonderful company can be a bad investment at the wrong price, however, and with the stock at an extremely high valuation, a good return from here appears unlikely.
A few scenarios
Let's imagine that Chipotle hits analyst estimates for revenue in 2014 of about $4 billion, a roughly 25% increase from 2013, and consistent with revenue growth during the most recent quarter. The current stock price of about $675 puts the market capitalization at $21 billion, or 5.25 times 2014 sales. If the net income margin remains around 10%, then the forward P/E ratio is about 52.5. There's an awful lot of growth baked into Chipotle stock price.
If both the store count and comparable store sales grow by 10% annually over the next decade, a lofty assumption, a 20% long-term revenue growth rate is a reasonable estimate. If the net income margin remains around 10%, then by the end of the ten year period revenue will have reached $10.4 billion, with a net income of $1.04 billion. This puts the current stock price at about 21 times projected 10-year earnings.
It's clear that this scenario isn't enough to justify an investment today. Chipotle isn't some hyped-up tech company with a potentially revolutionary product, it's an already-large chain of fast casual restaurants, so earnings growth is inherently limited.
Chipotle's margins need to increase as well, but a 17% operating margin is already exceptional. If Chipotle doesn't go the route of franchising, which it currently doesn't do, food prices will ultimately act as an anchor to profitability.
McDonald's (NYSE:MCD) has extremely high margins because the bulk of its restaurants are franchised, with McDonald's collecting a percentage of revenue and sometimes rent. In 2013, McDonald's managed a 31.2% operating margin, a number that Chipotle will come nowhere near if it sticks to its current model. I suspect that it's unlikely that Chipotle goes the franchising route, given that the brand is known for quality and franchising gives up some control over how the restaurants are run.
If, over the next 10 years, Chipotle's net income margin rises to 15%, along with the same revenue growth from the previous scenario, then the net income after ten years will be $1.56 billion, putting the 10-year P/E ratio at about 13.5.
At the current price, Chipotle needs to not only keep up its rapid revenue growth over the next decade, but also expand margins considerably in order for an investment today to make any sense at all. Even the most optimistic scenario presented above is unlikely to lead to an above-average return unless Chipotle still trades at a high P/E ratio in a decade. Possible, but more of a gamble than an investment.
Chipotle is one of the finest restaurant operators in the industry, but this has led to the stock price reaching levels that make no sense. I don't see how a satisfactory long-term return could possibly be achieved if Chipotle is bought at the current price, and it would be wise to wait until the stock price comes back to earth before considering an investment.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.