Chipotle: Growth At Any Price?

| About: Chipotle Mexican (CMG)

Chipotle Mexican Grill] (NYSE:CMG) just closed another year of growth in 2011. Investors witnessed year-over-year revenue growth of 23.6% and year-over-year EPS growth of 20.2%. These results indicate that CMG is still growing.

During 2011, CMG's stock price grew as well. The stock price started calendar 2011 at $213 and closed calendar 2011 at $338, representing an impressive 59% increase. This performance was no doubt comforting to purchasers of CMG's stock a year ago, but is CMG a good investment now while the stock trades at the $380 level? That is the key question, considering past performance is no guarantee of future performance.

As a preliminary matter, let's note that CMG's stock price has risen dramatically over the past year largely as a result of P/E multiple expansion, as opposed to earnings growth. The stock price at the beginning of 2011 was $213 with a P/E multiple of 37 based on the $5.73 EPS reported for calendar 2010. If you apply that same 37 P/E multiple to recently reported 2011 earnings, the stock price would be valued at $255 today. Instead, the stock price is around $380 currently because the P/E multiple expanded from 37 to 55.

Investors, of course, would rather see the stock price appreciate as a result of earnings growth, rather than P/E multiple expansion. A rise in the P/E multiple indicates investors are placing a bigger bet on future EPS growth, which increases investment risk.

Is the recent rise in CMG's P/E multiple warranted? Maybe so, but only if CMG's growth prospects have improved dramatically over the past year.

Many analysts cite international expansion as a potential growth engine for CMG, which currently has two locations in London England and one location in Toronto Canada. To date, CMG's management has offered scant information concerning the financial performance of these locations, but the tax footnote disclosures in the 2011 financial statements imply the foreign operations generated tax loss carryforwards approximating $5.0 million through 2011, even though two of the three international locations were open at least 17 months before the end of 2011.

The losses may reflect the higher costs of doing business in international locations, where CMG faces reduced brand presence, different sets of laws and regulations, different consumer tastes and spending habits, and other challenges. The losses initially appear a bit worrisome knowing the restaurants have prime locations in Europe and Canada, but realistic investors should not be surprised. The results merely reflect the difficulties and steep learning curve associated with international expansion from scratch. It will take CMG many years to develop the people, processes, know-how, and customer base to operate successfully outside the United States, and realistic investors are expecting plenty of growth pains.

When can investors expect meaningful international growth? At the end of 2011, the three foreign restaurant locations represented only 0.2% of CMG's total restaurant count. If it is assumed CMG opens 5, 10, and 15 new foreign restaurant locations in 2012, 2013, and 2014, respectively, and it also opens 160 U.S. locations per year during this same time frame, the international locations will represent less than 2% of total restaurant locations by the end of 2014. Unless CMG's management announces a huge expansion of its international growth plan very soon, investors should prepare themselves for the realization that international activity will not materially contribute to profits for many years, if ever.

Persons with short-term to medium-term investment horizons will likely never see the benefits of CMG's international growth before they sell their stock, and they face a substantial risk of p/e multiple contraction in the meantime if investors grow impatient.

Several analysts also cite CMG's experimental restaurant concept, Shophouse Southeast Asian Kitchen ("Shophouse"), as another source of future growth. One Shophouse restaurant was opened in 2011, and a second Shophouse restaurant is planned for 2012. Beyond that, management indicates no commitment to expand Shophouse restaurants. In fact, management states the Shophouse restaurant concept is still in an experimental stage, and the concept may be entirely terminated in the future. Further, management states the Shophouse concept, if pursued, will not contribute meaningfully to growth for at least the next several years.

Prudent investors should listen to management and think twice before banking on Shophouse as a source of growth anytime soon, especially since initial market acceptance of the concept appears tepid. There are 187 Shophouse reviews on averaging to a 3-star rating on a 1-5 scale. A 3-star rating indicates an average restaurant, and this rating is unfavorable when compared to the 4-star rating typically achieved by CMG's traditional restaurants.

Further, investors should recognize that Shophouse's revenue and earnings streams are currently nominal. It seems foolhardy to believe nominal operations deserve huge valuations. Let's put things in numerical perspective. If only 10% of CMG's current market capitalization is attributable to investor's expectations of Shophouse's growth, this would value the Shophouse concept at approximately $1.2 billion, which implies a price-to-sales multiple of 600 assuming Shophouse revenues are $2 million per year currently. This level of optimism rivals the delusional market behavior we witnessed during the technology bubble. Growth investors would be wise to exercise a reasonable degree of skepticism here.

If, as management indicates, international expansion and the Shophouse concept will not contribute meaningfully to CMG's growth for many years, investors looking for evidence of growth in the foreseeable future must rely on CMG's ability to grow its traditional brand in the U.S., and this is where management says its efforts are focused. Fortunately, investors have seen increased revenue growth lately. CMG registered revenue growth rates of 14%, 21%, and 24% for 2009, 2010, and 2011, respectively. Unfortunately, it appears the law of large numbers is beginning to take hold of profitability. Despite the increasing revenue growth rates, EPS growth rates have been declining quite rapidly over the same time period. The EPS growth rates for 2009, 2010, and 2011 were 67%, 44%, and 20%, respectively. The bottom line matters most, and investors should be questioning the value of revenue growth when it is leads to decreased EPS growth. A continuation of this trend spells disaster for investors who are valuing CMG's stock based on expectations of strong profit growth.

The declining EPS growth rate suggests that cannibalization is a growing concern. With each added restaurant, CMG faces an increasing degree of revenue cannibalization as new locations steal revenues from existing locations. CMG's management recognized this problem in its most recent 10k filing. If a customer of an existing CMG restaurant location discovers a new CMG location in better proximity, that customer will be motivated to shift his/her business to the new location. When this happens, total fixed costs increase without any corresponding increase in revenue. Because the majority of new CMG locations are still being placed in "proven" markets where CMG already has a presence nearby, it seems clear investors should expect this cannibalization effect to increase. The impact of cannibalization is difficult if not impossible to quantify based on disclosed information, but it likely is a factor driving declines in the EPS growth rate.

Another factor driving recent declines in EPS growth is increased food and beverage costs. Food and beverage costs increased to 32.5% of revenues in 2011 from 30.6% of revenues in 2010. This is not likely to be a one-time occurrence. Management expects food and beverage cost increases in the mid-single digit range during 2012, and this will put tremendous pressure on margins. Further, one has to wonder whether steep commodity inflation rates are the new normal given the Federal Reserve's position on market liquidity.

Finally, with respect to EPS growth, management's compensation policies are not helping. Stock-Based compensation expense has risen 174% over a two-year period from 2009 to 2011. In addition, management indicated stock-based compensation will rise at least another 50% in 2012. These large increases are undoubtedly harmful to the EPS growth realized by investors, and they seem to indicate a fundamental shift in compensation policy. Management's compensation is now focused less on evidenced earnings growth, which is under management's direct control, and more on stock price, which is subject to the whims and speculations of the market. Investors looking for compensatory practices based on earnings growth and long-term interests of shareholders may find themselves disappointed if the trends continue.

In conclusion, with CMG's P/E level at a multi-year high, it appears current investors in CMG are assuming significant risk if history is any guide. CMG's P/E multiple has expanded and contracted wildly throughout its history. Now that CMG's EPS growth rate has slowed to 20% (as reported in 2011), CMG's current P/E multiple appears highly extended relative to historical levels. As a matter of utmost concern, the P/E multiple has been increasing while EPS growth has been decreasing, and investors would be wise to recognize this disconnect. After all, price and earnings are the two most important variables in any investment decision.

Disclosure: I am short CMG.