Chipotle: Turnaround In 2017?

| About: Chipotle Mexican (CMG)


Like other American restaurant chains who suffered similar food safety incidents, Chipotle will also recover from this tough period; it's a matter of time.

Technically, the stock has been asleep the entire year but there has been some improvement in the MACD and RSI indicators and the moving averages slope is softening.

Fundamentally, the stock valuation is reasonable in terms of sales unless you consider the company margins will be stuck at 3% in the years to come.

It is worth waiting at the $400 support for good news to strike, as all the bad news are already discounted in the price.

Previous reviews

Back in May, I shared some thoughts on Chipotle (NYSE:CMG).

At the time, I mentioned some of the biggest restaurant chains in America suffered from similar food safety incidents in the past (such as McDonald's in 1982, Jack in the Box in 1992, Burger King in 1997, Yum Brands in 1999, Sizzler in 2000, Chi-Chi's in 2003, Wendy's in 2006, Jimmy John's in 2008 and 2013 and Frederico's in 2013). Some of these restaurant chains were hardly affected, while others took a few years to recover. But not only did they all survive, many prospered afterwards. Looking back at the months after these incidents, those were good times to purchase the stocks at discounted prices. Following this reasoning that time will also heal Chipotle's problem I concluded saying that "I don't mind waiting at the $400-$450 support range for good news to strike, as all the bad news is already discounted in the price".

What happened since then?

The stock has been asleep the entire year of 2016. Technically, this consolidation around $400 is reassuring. In fact, both the MACD and RSI have improved throughout the year and are now close to 0 and 50 respectively (the bear/bull barriers). Also, all the moving averages (short, medium and long term) are at a "good week's" reach and their slope is softening. These 3 indicators show that the selling momentum is over and open good prospects for 2017.

Source: Trading View

Many investors use the last week of the year to reduce their tax bill by selling their losers. In this regard, Chipotle's stock could be under pressure next week. This could be a good time to initiate a position in the stock, because the underperformers of the current year usually outperform the following year (for example, commodity stocks and bonds outperformance in 2016 after 2015's underperformance).

Chipotle's success story

Despite current difficulties, Chipotle is arguably one of the most successful restaurant chains of the past decade. I still remember when it went public in January 2006 and doubled in price on the first day of trading, from $22 to $44. The growth went on for many years, with the stock reaching $750 in August 2015. Let's look into this amazing story (please note that 2016's figures are forecasts).

Chipotle sales grew at a strong and fast pace. From 2007 to 2015, sales grew at a 19.5% compounded annual rate. That's outstanding growth rate and note that I started the series in 2007 on purpose because it's the year before the financial crisis. But even good companies such as Chipotle have bad years and in 2016 sales are likely to fall almost 15% versus 2015's all time high due to the food safety incident. Even so, 2016 will still be the third best year in terms of sales for the company after 2015 and 2014.

Source: Author

It is also interesting to note that the top line growth was reached while keeping a stable operating margin of 11.6% of revenue between 2007 and 2015. This shows the company is committed to deliver both top and bottom line growth (which is not always the case as many companies choose to grow their sales by cutting their profit margins). In fact, from 2007 to 2015, operating income grew at a 24.1% compounded annual rate and net profit grew at a 26.9% compounded annual rate. However, it comes with no surprise that margins contracted drastically in 2016 to the low single digits and as a consequence Chipotle will probably end up 2016 with its lowest net income in more than a decade and the smallest operating income since 2008.

Source: Author

Please note that I made small adjustments to the depreciation & amortization & impairment, financial and extraordinary components of the operating income so that it is comparable with the other stocks I follow. Without those changes, the operating income would be slightly higher than the one presented in these graphs.

It is important to note that the growth in revenue, operating income and net profit is even more impressive if we take into account the share buybacks. In fact, from 2007 to 2015, Chipotle bought back over 1.7 million shares, or almost 5% of the shares outstanding in 2007. So, if we take this into consideration, revenue per share grew at a compounded annual rate of 20.2%, operating income per share grew at a compounded annual rate of 24.9% and net profit per share grew at a compounded annual rate of 27.7%. In 2016, the company bought back (as of September the 30th) another 2.1 million shares or almost 7% of the shares outstanding in 2015. This decision has worked as a pillow for investors and the company purchases have helped to support the stock around $400 throughout the year. If we take this into consideration, then sales per share decline versus 2015 is around 9% (instead of 15% in absolute terms) while the decline in operating income per share and EPS would remain practically the same as in absolute terms.

In the meantime, the company has kept a very healthy balance sheet. Please note that I calculate net liabilities by deducting the current assets from total liabilities (both current and non-current liabilities and both financial and operational liabilities). I believe this is a more comparable metric because many companies reduce their financial debt (loans) at the expense of their operational debt (payables). Also, some companies increase their cash positions by anticipating receivables, among other "financial report-dressing" tactics.

In absolute terms, net liabilities were positive every single year from 2007 to 2015, which means that the company's current assets (such as cash, receivables and inventory) are bigger than total liabilities (such as loans and payables), therefore the minus signals on the following graph. 2016 is the first year in this series in which net liabilities turned negative but only slightly.

Source: Author

In relative terms, the ratio of net liabilities to operating income improved from 2007 to 2015 as the operating income grew and net liabilities decreased and remained below zero every single year in that period (which is very uncommon and highlights how healthy, safe and sound Chipotle accounts are). Even in 2016, despite the massive drawdown in operating income and the small increase in net liabilities the ratio remains at a comfortable 1.2 times.

Source: Author

Putting everything together, the company value (calculated as a sum of the market cap with net liabilities) averaged 31.2 times its operating income and 3.7 times its sales from 2007 to 2015. In fact, note that this has always been an expensive company and even in 2008 it traded at 13.2 times its operating income and 1.2 times its sales. On the other hand, when the bull market is at full speed the company value (calculated as a sum of the market cap and net liabilities) could easily reach 40 times its operating income (2007, 2011, 2013 and 2014) and 5 times its sales (2011, 2013 and 2014). As we've seen, this high valuations were sustained by the impressive growth track record during this period. In 2016, the invested capital to operating income looks scary at first glance but I wouldn't pay too much attention to this metric unless you think Chipotle margins have structurally changed for good. Instead, I would use the invested capital to sales metric which is at the lowest level since 2009.

Source: Author

In fact, even though the stock price grew at a 18.0% compounded annual rate from 2007 to 2015, the market cap only grew at a 17.3% compounded annual rate in the same period (due to the share buybacks). That's below the 20.2% sales per share growth 24.9% operating income per share growth and the 27.7% EPS growth. As for the period between 2007 and 2016, the market cap grew at a 12.4% compounded annual rate, which is again below the sales per share growth of 16.6% but higher than the 4.0% operating income per share growth and the -19.1% EPS decrease. However, as I explained previously, I wouldn't use the operating income, neither the net income to value Chipotle in 2016 for the sole reason that the current operating margins of 3% of sales are an outlier (the company average from 2007 to 2016 is 10.8%). Instead, sales seem a better metric to value the company in this abnormal period.

In summary

As I have mentioned in my previous article, nobody knows for sure when the business will get back to normal, but if history is any guide, that will happen, it's just a matter of time.

Technically, the stock has been asleep the entire year but there has been some improvement in the MACD and RSI indicators and the moving averages slope is softening.

Fundamentally, don't try to value the company using metrics indexed to Chipotle's operating income or even worse net income in 2016 because this is an abnormal year (mostly in terms of margins) and you'll get absurd values for the stock. Use sales indexed indicators instead and if you do so you'll conclude the current stock price is reasonable from an historic perspective. Furthermore, the company balance sheet remains in reasonably good shape.

Summing it all up, my message remains the same: It is worth waiting at the $400 support for good news to strike, as all the bad news are already discounted in the price.

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.

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Tagged: , , , Restaurants, Busted Growth, Contrarian, Cyclical Swing, High Quality Business Model, Industry Leader, Management Change, Management Concerns, Margin Contraction, Multiple Contraction, Multiple Expansion, Pullback, Share Buyback, Steady Revenue Growth, Steady Value Accumulation, Takeover Target, Temporary Headwinds, Turnaround
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