"Eat breakfast like a king, lunch like a prince, and dinner like a pauper" Adelle Davis (1904 - 1974)
This phrase is one we've all heard before but for some reason, it doesn't seem to apply to investors in Chipotle Mexican Grill (CMG). With a share price that is up 1000% since its low in November 2008 one must wonder if Chipotle is cooking up a feast that can feed an army. Only recently Matthew Ygelasis argued that Chipotle is the Apple of the fast-food world. For an investor focused on fundamentals, the continued overvaluation in Chipotle makes little sense, and there will be no apple-filled burritos served up anytime soon.
Chipotle has seen rapid growth over the past few years driven by a growing interest in premium fast-food (fast-casual as it's becoming known) and by a public dissatisfaction with "unhealthy" traditional American chains. There has been explosive growth in fast-casual all over the states. We can see the trend in companies such as Panera Bread Company (PNRA) - trading at all-time highs and expanding aggressively and Chop't - a New York local chain of upscale salad restaurants that has experienced rapid growth in the NYC metro area.
Take the fundamentals
Chipotle is a company that is trading at 57x trailing price/earnings, based on 2011 earnings of $6.81 and a stock price of $387.42 at the close on February 24th. From 500 stores in 2006 to 1200 today, Chipotle has expanded at a year on year rate of 14%. In 2011 revenue increased 23.6% to $2.27 billion. We can calculate the average store contribution to profit as $0.005 per share.
One oft-cited reason for a stock to trade at very high trailing p/e is because of anticipated future growth. Clearly for Chipotle to justify its current valuation then it has to deliver this growth. The question is - how much growth does Chipotle need and is that likely to be achieved? (While I note the following figures are speculative they do offer a glimpse of the huge growth required).
Let us assume that a reasonable price/earnings ratio is 15x - consider that Apple (AAPL) trades at 14x and the SP has averaged around 18x. Then in order to reduce its trailing p/e ratio to 15x, Chipotle needs to increase its yearly earnings to $25.83 per share to justify its current stock price - an increase of 280% over the 2011 full year figures.
Let us further assume that average store profits would remain consistent for future stores (i.e., future stores are no more, and no less profitable than current stores - a reasonable assumption), then to increase profits by 280%, Chipotle would need to expand to roughly 4560 stores. This means one store for every 64,700 Americans. Even Steve Ellis - founder of Chipotle - believes 2000 stores is a reasonable target.
Now is a good time to remind the reader that McDonalds' (MCD) operates in 13,700 stores - one store for every 22,700 Americans - and has an average ticket price considerably less than Chipotle. Does anyone seriously believe that the target store count is roughly a third that of McDonald's when its products are predominantly a lunchtime item? It seems that McDonald's doesn't - it's already disposed of its investment in Chipotle.
Clearly there is a market for this kind of product. However the barrier for entry is extremely low. There are a number of competitors to Chipotle who are also expanding rapidly. The number of Qdoba restaurants is up to 580, Panchero's Mexican Grill now stands at 55 outlets, Baja Fresh has 260 stores, California Tortilla is available in 36 areas and Moe's Southwest Grill now available in 36 locations, all offering essentially the same product. In addition Yum! Brands (YUM) are revamping the Taco Bell image to try and arrest their declining share of the Mexican take out market.
A further consideration is the increase in supply costs. 2011 saw food and beverage costs average 32.5% and management expect increases to continue in the middle single digits over the next year. This would bring food and beverage costs to around 40% of revenues, driving margins down and putting more pressure on earnings.
Despite Chipotle hitting new highs on a consistent basis over the past few years, profits have failed to keep pace. Its 2011 Q4 earnings were $1.81 a share. Its 2010 Q4 earnings were $1.47 a share. An increase of approximately 25% - in the same time the share price has increased 50%. In fact, taking the 2009 Q4 earnings into account, the picture is bleaker - $0.99 against a share price under $100 at the time. It seems that the company is indeed growing at a fantastic rate - albeit one checked by an even more fantastic growth in the share price.
Without doubt Chipotle has been a fantastic investment for those smart enough to jump in before the cooking pot reached boiling point. While the company remains a well-run and profitable business, its days as an explosive growth stock are potentially over. When you consider the low barriers to entry, consumers ever changing tastes, and the inevitable slowing of expansion, it is hard not to see an overvaluation or bubble in this stock. With the market due a pullback sooner or later, now could be an ideal time to lock in any profits in Chipotle and take it to the portfolio chopping board.