Weighing Chipotle As A Long-Term Growth Opportunity

Aug.12.14 | About: Chipotle Mexican (CMG)

Summary

Chipotle has had very impressive growth trends in its history and especially recently.

Unfortunately, its unattractive comps and other long-term concerns make it an unappealing investment.

A DCF analysis shows that the current stock price reflects the most optimistic perspective, leaving no room for the investor to benefit from Chipotle's future growth.

The purpose of this analysis will be to evaluate whether the stock of Chipotle Mexican Grill (NYSE:CMG) will continue to be a superior growth stock in the long-term (10-year) future. When considering the value of a stock such as Chipotle, it is especially prudent to first examine previous performance data of the company before projecting and speculating about its future potential. Although this would seem like an obvious point regarding any investing activity in the markets, it is doubly important to keep in mind when evaluating a growth stock as opposed to a value stock, considering the "value" in a growth stock is derived from its future earnings potential relative to its past performance. With that in mind, I will first discuss relevant metrics of previous and present performance. I will then appraise the significance of additional factors that could affect Chipotle's future margins of growth. Using these two areas of support, I will present three different price projections based on possible scenarios for the company's growth.

Previous Earnings

In the second quarter of 2014, Chipotle increased its revenue by 28.6% to $1.05 billion, beating analysts' estimates by close to $62 million and continuing a streak of six straight quarters of revenue growth above expectations. Diluted EPS increased to $3.50, also beating analysts' expectations of $3.09. Furthermore, the company accomplished notable 17.3% year-over-year comparable store sales growth, continuing a streak of four consecutive quarters of rising growth in that category. (This point is slightly misleading; Chipotle raised prices across the board in April as a response to higher costs associated with the prices of beef, avocado, and cheese, and has yet to see a negative response from customers. Chipotle does have an advantage over other QSR restaurants in that a relative price increase would not likely illicit as drastic a reaction from customers who generally are willing to spend more for Chipotle's product. However, an additional across-the-board price increase could begin to alienate customers.) This is especially impressive considering estimates of the restaurant industry as a whole peg growth at around 1% annually, and lunch and dinner times have seen declines the last few years as consumers continue to pinch their wallets since the recession. (Chipotle actually managed to increase throughput by 8 customers each during the peak lunch hour and peak dinner hour for the quarter, per the second quarter earnings report.)

In terms of growth from the first half of 2014 versus the first half of 2013 the figures are more of the same. Revenue increased 26.6%, diluted EPS increased 16.5%, and comparable sales growth increased 15.5%. Chipotle also opened up 89 stores in the first half of 2014, matching its strategy of opening up 185-200 new stores per year until the company reaches its target of 3,200-4,000 stores (they currently operate about 1,680 stores).

Looking further back at past growth trends of the company, Chipotle's revenue has maintained a strong geometric average growth rate of 20.64% since 2009 and has outpaced the rate of food costs. In that time frame, earnings of the company have grown at an even faster 26.67% rate and EPS has grown at close to 39% annually (in large part due to share buybacks) in the same time frame. Additionally, the average growth of free cash flow has risen at close to a 23% rate in the last five years due to steady growth in operating cash flow as a result of aggressive store expansion, allowing the company to reinvest more earnings back into its operating cash flow.

Additional Financial Report Observations

There are minor concerns in one of the company's growth patterns. Profit margins have been diminishing successively in the second quarter, from 11.82% to 10.76% to 10.50%, going back since 2012. Similar trends can also be detected in the first and fourth quarters as well as with regards to operating margins. These reductions are to some degree the result of rising food costs affecting the top line. Furthermore, the company is currently focused on rapid expansion, and inconsistent or even slightly shrinking margins are not the usual red flag that they may be otherwise. Assuming management is executing suitably, inconsistent margins could be a reflection of growth pains as a result of expansion into new or previously untapped markets.

Looking beyond growth patterns, Chipotle's ratios offer few undervaluing opportunities. Its Price-to-Book ratio is close to twice the industry average (11.9x to 6.8x), its Price-to-Sales ratio is close to three times the average (5.8x to 2.2x), and its P/E ratio is grossly out of line with the industry average (59.2x to 27.2x). Most critically, its PEG ratio of 3.10x is vastly underwhelming for a growth stock with supposedly much room to grow. (By way of comparison, Buffalo Wild Wings' PEG ratio is 1.43, Yum! Brands' is 0.917, Brinker International is 1.394, Burger King Worldwide is 0.471, and The Wendy's Company is 1.43, all less than the industry average of 1.94.)

One bright spot is Chipotle's Debt-to-Equity ratio, consistently lying in the 30-38% range, which for a stock still in its growth stage can be very advantageous. As the Federal Reserve relates more guidance regarding their timeline to raise interest rates, running a growth operation that is leveraged significantly less than its counterparts could be an added boon. Additionally, Chipotle's Return-on-Assets is almost twice the industry average (17.4% to 9.1%), a nod to the company's conscientious efforts to get the most profit out of each store through meticulous preparation of store layouts. Chipotle currently averages about $2.3 million in sales per store and its $891 per square foot is well above industry peers.

Management Guidance

The guidance provided by company management maintained the view that the strong first half performance will continue through the end of the year. Management raised their guidance for comparable store sales growth from the high-single digits to the mid-teen percentages for the full year after the first half's strong performance. They also reiterated that the company is still on pace to hit management's target of between 180-195 new store openings in 2014, keeping in pace with their plan to reach between 3,200-4,000 stores.

Concerns Moving Forward

There are several concerns that need to be factored in to the long-term potential of Chipotle. The most significant of these is the increased competition that Chipotle can expect in the future from other competitors in the Mexican-inspired fast casual sector. Chipotle's main two competitors are Qdoba Mexican Grill, a similar concept owned by Jack in the Box, and Moe's Southwest Grill. Qdoba has been an outperformer for Jack in the Box, as stores recorded 7.5% same-store sales growth this past quarter and catering sales recorded double-digit growth. After closing down 65 underperforming stores this past quarter, Qdoba is primed to continue gaining market share as it expands from its current 600 stores by 60-75 stores a year. Moe's Southwest Grill is another competitor that will increasingly vie for market share. The company has seen positive same-store sales growth for 19 consecutive quarters and is rapidly expanding from its current 550 stores into many significant markets (in 2014 alone the company has opened up 120 stores). The landscape will look very different in 5-10 years and heightened competition could limit many of Chipotle's growth opportunities.

Another concern that I have is with regards to Chipotle's marketing strategy. The company points to its successful marketing campaigns as one of the main drivers of the their exponential growth. Chipotle engages in nontraditional marketing techniques that attempt to raise awareness not just towards the foods that its consumers eat, but also towards the way in which those foods are made. The company departed from traditional marketing venues, such as television and radio ads, and instead created a series of social media campaigns and online series and launched a trio of Cultivate food and music festivals whose missions are to increase awareness towards a healthy and organic lifestyle. I am worried about the long-term potential of these strategies because these campaigns mainly thrive on attracting new customers by bringing recognition to the Chipotle brand, and to a lesser degree to the company's actual products. Because Chipotle has a limited set of menu options and has not introduced new or seasonal/limited-time items as of yet, they may not have positioned themselves to engage in traditional campaigns that will raise awareness towards their actual products in the future. (Chipotle is also at a disadvantage to introduce new menu items in the future that could likely have an adverse affect on the company's levels of throughput.)

One last concern that I have is with regards to Chipotle's two ancillary concept restaurants, ShopHouse Southeast Asian Kitchen, which serves Asian-inspired cuisine, and Pizzeria Locale, of which Chipotle is currently an investor. The company currently operates a total of seven combined restaurants in Washington, D.C., Los Angeles, and Denver. In their 2013 year-end 10-K, company management said the following with regards to their short- to medium-term plans to develop these concepts:

"Notwithstanding our opening of ShopHouse and investment in Pizzeria Locale, our immediate focus will remain on thoughtfully growing the Chipotle brand. As a result, we do not expect ShopHouse or Pizzeria Locale to contribute to our growth in a meaningful way for at least the next several years, and we may determine not to move forward with any further expansion of ShopHouse or Pizzeria Locale."

Based on that guidance I would assume that the company is planning on leaving the development of these concepts out of its immediate future. However, CFO Jack Hartung mentioned ShopHouse and Pizzeria Locale in the company's recent second-quarter earnings in the following context:

"We continue to believe that the best use of our cash is to invest in our high returning restaurants and we'll continue to develop additional growth options by planting seeds including ShopHouse, Pizzeria Locale and Chipotle outside the US…"

There is the potential here for mismanagement of time and funds as well as underwhelming performance if the company haphazardly chooses to develop these concepts that do not stand to strengthen the Chipotle brand in the near future.

Discounted Cash Flow Analysis

When modeling Chipotle's growth for a ten-year window, I chose to estimate three scenarios: an optimistic scenario, a reasonable scenario, and a pessimistic scenario. The reasonable scenario is based on what I judge as rational calculations based on the company's performance adjusted for reasonable concerns that may affect the growth of the company in the medium to long term. The optimistic and pessimistic estimates are not "best case" and "worst case" estimates; they are estimates for situations that run slightly above or below what would be the reasonable expectation. For instance, an extended streak of ill-advised management decisions could lead to underwhelming growth for the company, as well as a set of particularly strategic decisions could lead to growth that would have been seen as overly optimistic several years prior. Each model forecasts a nine-year growth window followed by a terminal growth rate of 3%.

One caveat is that when examining the year-to-year composition of Chipotle's free cash flows, I noticed that the growth rate of capital expenditures is much more volatile than the growth rate of operating cash flows. At one point, consecutive year increases were 30.4% to 1.5%. This is due to the unpredictable nature of store expansion and these fluctuations could have an effect on the future growth potential for Chipotle's cash flows. I have chosen to introduce some rate volatility in my optimistic and pessimistic models due to the assumption that wide fluctuations are most likely to occur during periods of rapid expansion or mismanagement.

For the reasonable and pessimistic models, I chose a starting growth rate of 25% (30% for the optimistic model) with moderately trailing growth. Accordingly, the reasonable estimate suggested that the price of Chipotle should be closer to $635, and is about $35 overpriced. These estimates assume growth restoring to more historically modest levels and the P/E and PEG ratios falling closer in line with the industry averages. The pessimistic estimate calculated a price range near $542, in which case the current price would be in line for about a 24% correction. This estimate assumes that current guidelines are not met due to entirely feasible issues such as botched store rollouts, heavily increased competition for market share, negative media attention, or product costs that rise above current levels. The most optimistic model suggested that the current price represents the most optimistic outlook for the company, and the price could even rise in the long term to around $676-681. This is fairly logical considering Chipotle is currently marked up well above historical industry comparable averages and is in truth priced based on management's optimistic guidance for the medium- and long-term. This estimate is based on the assumption that the company will progress at about the same pace as it has been for the next three years followed by near-perfect management performance.

Conclusion

It appears that even according to the most optimistic view Chipotle's price has already been marked up to the point that no further growth opportunities can be taken advantage of in the medium- to long-term future. Although some volatility in the stock price would still be likely to occur as the company (or the market as a whole) experiences intermittent corrections, I do not believe that there are sufficiently predictable timing opportunities that will allow investors to take advantage of this volatility. I would look for other opportunities in the industry that present similar growth at a cheaper price.

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. The author has no business relationship with any company whose stock is mentioned in this article.