Chipotle Mexican Grill: Buy The Stock At The Bottom Of The E. Coli Scandal

| About: Chipotle Mexican (CMG)

Summary

The E. coli scandal caused the stock to fall by over 30% during 2015.

Nevertheless, Chipotle has been showing excellent growth and operating metrics during the last five years.

Other companies (McDonald's, BK, Wendy's) have been in similar situations too, and as we know, are doing great now.

My DCF analysis shows the stock is extremely undervalued. Hence, I recommend buying this stock now, at the bottom of the E. coli crisis.

Chipotle Mexican Grill Inc. (NYSE:CMG) is a flagship of the restaurants industry. The company has had great success during the last five years. With a revenue CAGR in excess of 22%, an EBITDA CAGR of 23%, and a net income CAGR of more than 25%, it is one of the few industry winners. This year's revenue is going to increase by more than 15%, totaling more than $4.5 billion. The gross profit margin, the operating profit margin, and the EBITDA margin have all improved.

There are also other good points to mention. As you can see in Diagram 1, the operating profit and the net profit margins are not only at a good level, they are the best in the industry. Moreover, the trend is inclining, and there are no reasons why it should stop. Consequently, the ROA and ROE levels are also above average. The company's ROA is nearly two times higher than the industry's average, while the ROE is near is somewhat below the average. However, take a look at the D/E ratio. Chipotle has not raised debt yet! This means the company has the opportunity to improve the numbers by issuing bonds or borrowing long-term debt from the banks. Hence, the ROE level will be at the top, if the company decides to do that. Moreover, its WACC will also decrease, should the company raise debt, so the stock will likely experience a boost in price.

Diagram 1

Source: Data - Morningstar.com, infographics by author

What I like even more about Chipotle Mexican Grill is its robust cash flow generation ability. Look at Diagram 2. The operating cash flow (OCF) has been rising since 2010 and has never dropped during this period. The biggest part of operating cash flow is net income, which proves the excellent quality of its OCF. Then look at Diagram 3. The company shows excellent working capital management abilities, which make its cash conversion cycle be negative (a great thing). Despite the fact that the days of payables have decreased (it is a normal situation when the company is growing), the days of receivables have decreased too. As a result, the cash conversion cycle has increased by less than one day during the last five years, which is a great outcome.

Diagram 2

Source: Data - Morningstar.com, infographics by author

Diagram 3

Click to enlarge

Source: Data - Morningstar.com, infographics by author

Finally, Chipotle Mexican Grill uses stock repurchases as the main tool to compensate shareholders. I also see it as a good sign because the company's investors do not pay taxes on capital gains until they sell their shares. During the last five years, Chipotle has spent from 28% to 132% of its free cash flows on share repurchases. I am sure this trend will continue in the future (see Diagram 4).

Diagram 4

Source: Data - Morningstar.com, infographics by author

Chipotle's market capitalization has substantially increased each year during for the last five years. However, the stock has declined by 30% during 2015 (see Diagram 5). The main reason for that is the E. coli scandal, which made a lot of people think it is unsafe to eat at the company's restaurants. In my opinion, the people's fears have no solid ground. Why do I think this way? There are two reasons for that.

First of all, the company has made an official announcement on its website. The announcement consisted of a clear description of the problem and the actions Chipotle had already taken to solve the problem. Some of the measures include closing of 43 restaurants, a deep cleaning and sanitation of all restaurants in the area (conducting more than 2500 chemical tests), and hiring two consulting firms to make sure the problem has successfully been solved. After that, I do not think you are still in trouble while eating at the company's restaurants.

Secondly, some of the famous restaurant brands like Burger King (NYSE:QSR), Wendy's (NYSE:WEN), and McDonald's (NYSE:MCD) have had food-related problems as well. However, a lot of people still go there and enjoy their meals. This type of scandal is a part of the business and the risks the companies bear on a daily basis. Hence, unless the problem spreads nation-wide or the companies do not respond to the problems at all, there is no chance the business will come to a halt.

I think now is a good time to initiate a position in CMG stock. Before I do this, I have to value the company with different tools, such as the DCF, zero-growth, and comparative analyses, in order to value the shares properly.

Diagram 5

Source: Data - Morningstar.com, infographics by author

DCF analysis

My DCF model is presented in Diagram 6. In Diagram 7, you can see how different metrics are expected to change during this period. I have made several assumptions, which can be easily seen in the "Assumptions" tab of my Excel file.

My model shows that after subtracting the market value of debt, minority interest, and adding back cash and investments, the market value of equity is more than $25 billion in the Base-case scenario. Consequently, the fair value per share is $784 per share. This is more than 53% higher than the current price ($511 per share).

Diagram 6

Click to enlarge

Source: Data - Morningstar.com, DCF model by author

Diagram 7

Click to enlarge

Source: Data - Morningstar.com, infographics by author

Sensitivity Analysis

The sensitivity analysis is presented in Diagram 8. According to the Base-case scenario and the assumptions for the EV/EBITDA multiple and WACC, the fair price range is estimated to be between $710 and $870 per share. It represents a 39-70% upside opportunity for the stock.

Diagram 8

Click to enlarge

Source: Data - Morningstar.com, model by author

Zero-growth Analysis

The Zero-growth analysis has been described in one of my articles. You can read more about it here.

According to this analysis, the current stock price shows no margin of safety. The valuation gives a fair market value of equity of $11.9 billion, which transforms into a fair share price of $372. This price level is 27% lower than the current market value of the stock. If we only used net income in the calculation, the result would give a fair value per share of only $300. This is 40%+ lower than the current price. On average, the fair value per share is 33% lower than the current level.

However, this does not mean the company is overvalued. It may mean CMG is a growth stock, and hence, valued at a premium to the competition.

Comparative Analysis

My comparative analysis is based on three key ratios: P/E, P/S, and P/BV (see Diagram 9). The results are quite mixed. However, it is quite usual for a company with a rising net profit margin level to see undervaluation by the P/E ratio and overvaluation by the P/S ratio. Nevertheless, Chipotle shows a sign of undervaluation in the P/BV ratio, which is going to be even more vivid if it borrows debt. However, the current EV/EBITDA multiple is 14.0x, which is higher than the industry average of 12.7x (according to Damodaran's data tables). Hence, the stock seems to be overvalued relative to peers. However, the stock seems to be more of a growth stock than a value stock at the current time. I am looking forward to seeing high revenue and earnings growth in the future, which will justify the company's premium valuation to peers.

Diagram 9

Click to enlarge

Source: Data - Morningstar.com, infographics by author

Opinion

According to its growth and operating results, Chipotle Mexican Grill Inc. seems to be a good growth stock. The recent E. coli scandal will not make a terrible impact on its long-term revenue growth in the future. Even though the zero-growth analysis shows no margin of safety and the comparative analysis shows that the stock is a little bit overvalued, I rely more on the DCF analysis and believe in the company's high growth potential in the future.

Hence, I recommend buying the stock and set a target price range at a level of $710-870 per share. This price range means the stock is 39-70% undervalued.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CMG over 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.