Chipotle Mexican Grill: Does the Growth Justify the Price?

One of the great success stories of 2007 is Chipotle Mexican Grill (CMG) which is up 157% for the year. The company has revolutionized the idea of fast food and developed a very loyal customer base that drives stability and growth. One of the primary reasons it has been so successful in retaining customers is the commitment to healthy ingredients and respect for the process by which it raises meat, poultry and dairy products. In keeping with the trends that made such successful food and beverage retailers as Ben & Jerry’s and Starbucks (SBUX), The company has nurtured a culture that spans beyond the eating experience to a way of life.

It seems quite odd that such a firm would have been incubated by a behemoth such as McDonalds (MCD). However, while the culture is very dissimilar to that of the Golden Arches, management was able to learn from some of its parent company’s strengths. These strengths manifest themselves through operating efficiency and disciplined growth as Chipotle continues to beat guidance numbers and improve the profitability of the firm. Despite food cost increases including scarcity of avocados this year, operating margins continue to trend higher as evidenced by a 23.0% margin in the Q3 report versus 21.5% in the year ago quarter.

The most recent quarterly earnings release uncovered the typical positive surprises as earnings beat consensus numbers at $0.62, with comparable restaurant sales up 12.4%. The comp store sales increase number has become an increasingly important metric as the installed base of restaurants open for one year now exceeds 500 stores. Looking to new locations, CMG opened an additional 28 new stores with the majority being placed in markets the company already has a presence in. New stores in existing markets should benefit from existing customer knowledge and loyalty and need fewer promotional resources to drive sales. As far as new markets are concerned, the company has targeted Salt Lake City, Birmingham and Philadelphia as the newest additions to cities it serves.

Presently, the company operates all of its restaurants within the US and believes the potential for domestic stores is around 3,000 locations. Since current restaurants only comprise a quarter of that level, there is significant room for growth before the company runs into restrictions. Management expects 130-140 new openings for 2008 and that is on top of expectations towards the high end of 110-120 locations in 2007. While domestic growth is still the primary focus, the company will open its first non US store in Toronto, Canada next year. This will likely give management a chance to test out its ability to manage currency risk and international regulatory issues which could be beneficial if international growth became more of an objective in the future. While no plans have been announced beyond the single Toronto store, this is likely a test for management to gain experience for further growth long-term.

Chipotle’s balance sheet is quite healthy with $167m in cash at the end of the quarter. Typically companies with such strong cash positions would begin to talk about share repurchase plans or dividends to investors. However, CMG cannot use cash in this manner at the present time as that would jeopardize the tax-free status of the company’s spin-off from McDonalds. Instead, the company will use the cash to fund new store openings and continue its aggressive growth strategy. Additional capital can be spent for measures that drive efficiencies such as a new hand-held POS system which allows staff to charge customers while they are standing in line which decreases the wait time and bumps up the number of customers able to be served during peak lunch hours.

Despite the impressive cost saving efforts, and robust growth plans, most analysts do not recommend purchases of the stock. There is an incredible amount of respect for management and the strength of the Chipotle brand, but since the stock is trading at 54 times next year’s consensus numbers, there is little room for any error. If any important metric were to slip or the growth rate was called into question, it is likely that the stock would take a significant hit. One has to look no further than Crocs (CROX) to note how vicious a sell-off can be when a momentum name stumbles.

Despite my recommendation to buy the stock in June and again in August of this year, I am now suggesting that investors take a careful look at their own investment style to consider if this name is right to hold. For those who wish to invest in quality companies with strong management and hold those positions indefinitely, there is nothing wrong with CMG’s long-term prospects. However for those who are opportunistic traders, I would suggest moving capital out of this name as the likelihood of the stock increasing 157% next year is very poor. I would expect the stock to be range-bound for the next several quarters as fundamentals catch up with the stock price and therefore the risk/reward ratio for owning this well oiled machine is not favorable to me at this time.

Disclosure: Author does not have a position in CMG

Comments

[wax]

From a discussion board post 10/25/07. As far as I'm concerned, nothing has changed.

Wax

...The stock closed yesterday at $123.55, down $3.58, which seems like a pretty good drop to me, but what struck me is unless you are a momentum/short term investor, why would you want to own a stock with a PE of 75, and more specifically why would you want to own this stock?

I don't mean to put you on the spot, and it's really none of my business why you want to own the stock, I asked because as an investor, you have to put things into perspective, and the first question any investor should ask is why am I buying this stock? What do I want an investment in this stock to do for me?

To me there are only two answers. The first answer is short term price appreciation. I'm buying this stock because I believe that momentum is going to drive the stock price higher over the shorter term.

The second reason is long term price appreciation with a reasonable expectation of capital preservation.

I poked around some and found that with yesterday's close, the stock has overhead resistance at $133.63, meaning from current levels the stock has an upside potential of about 5-6%.

In addition, the stock has first support at $112.26, meaning from current levels the stock has initial downside risk of about 11-12%, and second support at $83.19, meaning from current levels the stock price has the potential to decline by about 35%.

I also took a look at some of the company's historical pricing. I found that for period ending 01.26.06, the stock price closed at $42.20 on volume of 7,184,700 shares. As the volume falls pretty dramatically after this, I assume that the company's shares came out of lock up around that time, or the company's IPO came out, or something along those lines.

I notice that the stock price and volume don't fluctuate much until the period ending 04.30.07, when the stock price jumps to $78.37 and the volume spikes to 1,534,800 shares traded.

This general trading/volume range remains until period ending 07.30.07, when again the volume increases to from 686,600 shares, to 1,1182,200 shares and the price moves from $81.50 to $97.90.

The next week, same thing and the week after that the volume decreases but the price continues to increase. And that is the current pattern for the stock.

Which brings me back to my original question of what do you hope an investment in this stock will do for you?

If I were going to invest in the stock of this company it would be as a short because to me, the only place the stock price can go is...down.

[DanielJacome]

Restaurants are in a stagflation cycle - in 2H08, they will recover. Insiders at restaurant stocks (RT, for ex.) are buying stock down here on what we think are depressed valuations.

CMG only has 670 restaurants in the US - there is still a ton of room to grow and there is no name out there that offers a value proposition close to Chipotles. Go to ANY college town, 22 year olds will wait 20 minutes in line for a burrito. They cornered the mkt very shrewdly and when we launch coverage on 2/15/08, we'll shoot out our report to Alpha readers.

~ Dan

[ZacharyScheidt]

I don't think there is any question that the chain will be successful. My argument is that the stock more than accounts for that potential success. A poor market environment in 2008 has the potential to bring down multiples on strong and weak companies alike. I like the restaurant, I'm just exercising caution on the stock.

[borisb]

Zach your right. the issue seems to be what will the low point be. at this time it seems that the B shares are already $26+ less then the A shares. if the B shares go any lower its looking extreme. maybe some extra price weakness before or after the 2/14/08 earnings would sweeten the low point for new longs.

[borisb]

Chipotle's was slammed by what seems to be a bogus downgrade by Raymond James. the B shares traded down to $83, a dip of $47 or 36% from $130 high point.. even more impressive is this is down by $72 or 46% from A shares high point of $155 even thought eps is identical. would that be buying a world class company for almost half price? Raymond James upgraded faulty Mortons of Chicago in the same report rasing doubts of accuracy further. Chipotle did an investor presentation on 1-15-2008 when they affirmed previously guided sales and cost trends, suggesting they were on course but also tried to manage expectations. With terrific premium quality entrees without all the drama priced around $6 Bucks it would seem the sky is the limit for CMG.

[mkreisel]

CMG missed by 2 cents, lowered guidance, stock down 15% AH.

The author was right: the price was too high.

The analyst downgrade wasn't bogus, it was spot on!

[DanielJacome]

no one was right. CMG reversed the 15% haircut and bounced nicely. It ended up closing down just 3% - amazing.

Best thing to do is wait for a 70-80 stock - that is what the EVA/DCFs/comp models we are looking at are telling us. Still, we may never see that gift of a pullback b/c there is still some fresh capital on the sidelines that is getting interested in this historic buying opp in CMG shares