Chipotle Not Showing Signs Of Recovery

| About: Chipotle Mexican (CMG)
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What we originally believed to be a transient issue has turned into an extended public relations nightmare for fast-casual restaurant chain Chipotle.

Comparable store sales fell 22% on a year-over-year basis in the third quarter of 2016.

Activist investor Bill Ackman reportedly believes the firm’s board is long overdue for major adjustments and that it needs to ramp up marketing spending, cost controls and information technology capabilities.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

By The Valuentum Team

What we originally believed to be a transient issue has turned into an extended public relations nightmare for fast-casual restaurant chain Chipotle (NYSE:CMG). Though we do not necessarily question the safety of its food, we view its brand as damaged and the potential reward that would come along with a return to favor in the eyes of consumers is not worth the risk that the firm never comes out from under the shadow of the headlines that have plagued its results. Consumers are slow to forgive.

Chipotle has yet to show any real signs of a recovery from the food safety scandal that rocked its world in 2015. Comparable store sales fell 22% on a year-over-year basis in the third quarter of 2016, a continuation of recent trends and exemplary of the unforgiving nature of consumers when it comes to food safety and product quality.

Customers are simply not coming back at a rapid pace after the 2015 scandal, as comparable transactions fell 15% in the quarter, which helped shrink restaurant-level operating margins to half the magnitude of that of the year-ago period. Promotional gimmicks have not been enough to re-establish the allure the firm had as recently as mid-2015.

Activist investor Bill Ackman's hedge fund Pershing Square Capital Management, is the second largest shareholder of Chipotle, with its stake coming in just under 10%. Ackman reportedly believes the firm's board is long overdue for major adjustments and that it needs to ramp up marketing spending, cost controls and information technology capabilities.

Management has recently stated its plans to invest in digital ordering and payments, increase cost cuts, and will pursue other strategies for its ShopHouse Southeast Asian Kitchen concept after recording an impairment charge on its assets. While we do not disagree with Ackman's line of thinking, we believe at this point in time it will take more than improved ordering and payment technologies and cost cuts to fix what is truly wrong at Chipotle.

There is no question that Chipotle could right the ship very soon and get back on the track it was on only a little more than a year ago, but we are having trouble getting behind the firm, even at such relatively suppressed price levels, with such uncertainty surrounding it. Management expects declines to moderate substantially (low single-digit declines are expected) in the fourth quarter of 2016 before returning to significant growth in 2017 (high single-digit growth is expected), but we have a difficult time buying into such a stark turnaround.

Further, the company has set its expectations for 2017 earnings per diluted share at $10, indicating that shares are changing hands at nearly 40 times 2017 earnings. For a company currently surrounded by such a high level of uncertainty with the recent past of Chipotle, this is simply too high to entice us. With that being said, let's dig into the remainder of the firm's investment considerations.

Chipotle's Investment Considerations

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Investment Highlights

• Chipotle serves a focused menu of burritos, tacos, burrito bowls (a burrito without the tortilla) and salads, made using fresh ingredients. It prides itself on trying to find the highest-quality ingredients ('Food With Integrity') and providing an exceptional restaurant experience. The company was founded in 1993 and is based in Denver, Colorado.

• Chipotle continues to expand its restaurant count. As of the end of the second quarter of 2016, the firm's total restaurant count was 2,124. The food safety scandal that has surrounded the company recently is still impacting near-term growth, but we expect the firm to return to significant growth eventually

• Chipotle has been on a roller coaster ride during the past few years. The restaurant is facing strengthening competition from Yum! Brands' (NYSE:YUM) Taco Bell and even Jack's (NASDAQ:JACK) Qdoba. The recent food safety scandal caused a monumental drop in same-store sales in the fourth quarter of 2015, and such pressure has persisted.

• Chipotle earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 49.6% during the past three years.

• Chipotle is a fantastic company and a great concept with tons of potential growth ahead of it. However, consumer confidence has been shattered in the wake of food safety issues. We think Chipotle will eventually survive, though it may not come out of this unscathed.

Business Quality

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Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. Chipotle's 3-year historical return on invested capital (without goodwill) is 49.6%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Image source: Valuentum

Image source: Valuentum

Cash Flow Analysis

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Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Chipotle's free cash flow margin has averaged about 10% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Chipotle, cash flow from operations increased about 29% from levels registered two years ago, while capital expenditures expanded about 29% over the same time period.

Valuation Analysis

We think Chipotle is worth $498 per share with a fair value range of $349-$647. Learn more about why we use such a large fair value range here.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 10.1% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 18.1%.

Our model reflects a 5-year projected average operating margin of 14.1%, which is below Chipotle's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 8.6% for the next 15 years and 3% in perpetuity. For Chipotle, we use a 10.8% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

Image source: Valuentum

Margin of Safety Analysis

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Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $498 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Chipotle. We think the firm is attractive below $349 per share (the green line), but quite expensive above $647 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

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We estimate Chipotle's fair value at this point in time to be about $498 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Chipotle's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $678 per share in Year 3 represents our existing fair value per share of $498 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.