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Why Buying Chipotle Looks Like a Mistake

May 26, 2014 | About:
vinaysingh

vinaysingh

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The value of a company, and therefore the value of its stock, is really a function of what the company will look like in the future instead of what the company looks like today. The expectation of strong growth into the future drives stock prices higher, but it's important to understand the risk/reward balance when investing in a fast growing company. Burrito king Chipotle Mexican Grill (CMG) is a good example of that balance becoming woefully lopsided.

The growth story continues

Chipotle reported strong quarterly earnings last time, beating analyst expectations and sending the stock higher. The stock is now not too far off from its all time high of around $440 per share, reached in 2012 before an epic collapse. Revenue increased 18.2% year-over-year to $817 million, driven mainly by the opening of new restaurants.

Comparable store sales rose 5.5% on higher traffic as well as one extra day in the quarter compared to last year. Margins slipped at the restaurant level as higher food costs had a negative effect. Net income grew 7.6% year-over-year to $88 million, while diluted EPS jumped 10.2% to $2.82.

Getting real

The problem with Chipotle is not the company but the stock. The stock trades around $410 per share after the post-earnings jump, roughly 39 times the average analyst estimate for 2013 EPS. Chipotle, by any reasonable measure, is expensive. But this price is based on the expectation that the company will continue to grow strongly into the future, and I have no doubt that it will.

But, does that growth scenario provide enough potential reward to justify the risk of buying a stock with a near 40 P/E ratio?

Let's make some assumptions about the next decade for Chipotle:

  1. The number of stores grows 10% annually.
  2. Comparable store sales growth is 5% each year.
  3. The net profit margin remains at 10%.

This scenario basically assumes that the current level of growth continues without any degradation for the next decade. I would call this the best-case scenario. Under this scenario, the number of stores balloons to about 3,900 by the end of the decade, up from 1,502 today. Revenue reaches $12 billion, and net income comes in at $1.2 billion.

Now, the return on the stock if bought today depends on what the P/E ratio is ten years from now. Considering that Chipotle will be a much bigger company, I doubt that the ratio will continue to be 40. If the P/E ratio does stay flat, the annualized return from the stock would be just shy of 14%, an impressive return.

If Chipotle's P/E ratio is 25 after ten years, still quite high, the annualized return would only be about 8.9%. That's not too much better than the stock market, as a whole, has done historically with reinvested dividends.

Under this best-case scenario, your stock return is unlikely to be much better than the S&P 500, unless the P/E ratio remains extremely elevated over the next decade. And, of course, it could be much worse if Chipotle can't maintain its current level of growth. Consider a less-optimistic scenario:

  1. The number of stores grows 10% in the first year, with that rate decaying uniformly to 5% by the tenth year.
  2. Comparable store sales growth is 5% in the first year, with that rate decaying uniformly to 3% by the tenth year.
  3. The net profit margin remains at 10%.

This still represents exceptional growth, with 3,160 stores after 10 years instead of 3,900 in the previous scenario.

Things don't look too exciting now. Even a P/E ratio of 30 a decade from now leaves you with just a 7.7% annualized return, not exceptional at all.

The point of all of this is to show that in order to achieve an exceptional return with Chipotle, not only does the current growth trend need to continue unabated into the next decade, but the P/E ratio has to stay elevated as well. If growth slows down, which it inevitably will as the store count grows, the P/E ratio will decrease.

The reward is limited by the extremely high P/E ratio you're paying today, and even the best case scenario isn't all that great.

Cheaper growth

If you want to buy a fast-growing restaurant stock, a better choice is bakery/cafe Panera Bread. Panera is roughly the same size as Chipotle in terms of store count, but the stock is significantly less expensive. Panera trades at 26 times the average analyst estimate for 2013 earnings, far lower than Chipotle's 39. Chipotle may grow a bit faster than Panera, but a 50% higher P/E ratio is likely not justified.

Panera is similar to Chipotle in that the company focuses on high quality ingredients, but Panera offers breakfast as well as other meals. Chipotle has reportedly been testing breakfast in some locations, but it's unclear whether customers will view Chipotle as anything more than a place to get a giant burrito.

Analysts are expecting 18% annual earnings growth over the next five years for Panera, compared to 20% for Chipotle. That spread is certainly not large enough to warrant a huge premium, and Panera is clearly the better value.

Another option, although a slower growing one, is Yum! Brands. Yum! operates the Taco Bell, KFC, and Pizza Hut brands and is heavily focused on expansion in China and international markets.

Yum! is branching out into the high-end market by testing the KFC Eleven concept. KFC Eleven will feature items such as flatbread sandwiches, rice bowls, salads, and boneless chicken, and the company will open a couple of stores over the next few months. This concept targets the same market that Chipotle and Panera target, and if successful, it could bring some more competition to the space.

Yum! trades at 23 times the estimated 2013 earnings, and analysts expect 11% annual earnings growth over the next five years. Yum! offers reasonable growth at a far lower valuation than Chipotle.

The bottom line

With every earnings beat, shares of Chipotle get more and more irrational, and eventually, the nosebleed valuation will correct itself. Even under the best case scenario, the return which can be achieved by buying Chipotle today is not worth the risk. Chipotle is a great company, and at a much lower price, the stock would be very attractive, but at the current price, buying Chipotle is a mistake.


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