In a time where the market is generally discounting growth stocks as high inflation and a weakening economy make future earnings less valuable, Chipotle Mexican Grill Inc. (CMG, Financial) stands out as a notable exception.
The quick-service Mexican-inspired food chain has a price-earnings ratio of 56.09, which stands far above its industry average of 23.60. The stock price has come down about 16% from all-time highs, but that is not much steeper than the S&P 500’s 15% fall from all-time highs as of this writing.
This high valuation begs the question: Why is the market still so bullish on Chipotle? The answer could lie with the more defensive nature of its business in the food industry combined with its rapid growth in recent years. Moreover, while competitors are trying to cut back on expenses, Chipotle is still chugging ahead with its expansion plans – and it is doing so while maintaining an incredibly strong balance sheet.
A growth plan in progress
Chipotle has been posting sector-leading growth for several years now, more than doubling its store count over the past decade from around 1,400 to over 3,100 while also improving its same-store sales consistently.
It has not all been smooth sailing. While revenue growth has been consistent at a rate of 12.30% per year for the past decade, earnings have been inconsistent due to a combination of growth investments, the pandemic and a shocking E. coli breakout in July 2015 that resulted in 43 store closings before federal officials declared it to be over in February 2016.
Due to the freshness of Chipotle’s food combined with the relative lack of preservatives and the fast-food setting, the company was susceptible to a food poisoning outbreak. Profits fell sharply as the company lost the trust of many customers and had to work to regain that trust with an enhanced food safety program.
Chipotle’s enhanced food safety program has withstood the test of time so far. This plan includes DNA-testing ingredients before shipping, changes to food prep and handling practices and even offering paid sick leave to employees to remove the incentive for showing up sick to work.
The company has laid out an ambitious long-term growth plan. With over 3,000 stores now, the company was all set to be halfway toward its long-term growth goal, but in February 2022, CEO Brian Niccol upped that guidance, saying, “Over the long term, we now believe we can operate at least 7,000 Chipotle restaurants in North America, up from our prior goal of 6,000.”
Unlike many peers, Chipotle can afford to continue investing in growth thanks to its strong financial position. The company has an interest coverage ratio of 4,894, a Piotroski F-Score of 6 out of 9 and an overall GuruFocus financial strength rating of 7 out of 10. In fact, the company announced on Thursday that it was seeking to hire 15,000 more restaurant workers to support is “aggressive growth plans.”
Given how Chipotle’s store count has exploded over the years, it is clear the restaurant chain is doing something right from the perspective of customers.
It is not just customers who love the food that are attracted to Chipotle. The company’s dedication to fresh and healthy ingredients makes it unique among large-scale fast-food chains.
Additionally, Chipotle’s meals are made to order rather than coming in a preset recipe that is impossible to change. For example, in many fast-food chains, you cannot even order a salad without certain ingredients because the salads are premade for sale. With Chipotle, you choose whether you want a burrito, bowl, salad, etc. and then you choose exactly which ingredients go into it. This makes Chipotle a top pick for picky eaters.
Another component of Chipotle’s rapid growth has been its early adoption of online ordering and advanced loyalty programs. Digital orders now account for around 37% of the company’s total food and beverage revenue. Other fast-food chains are catching up in this regard.
A key indicator of customer loyalty and the existence of a moat is whether demand can withstand price increases due to inflation. Food in general has built-in defensiveness because everyone needs to eat, but eating out at a restaurant is a mix between the need to eat and the desire/need for convenience.
Chipotle has increased menu prices several times in response to inflation hitting the highest levels seen in 40 years. Year over year, its menu prices are up about 13%, but same-store sales still grew 7.6% year over year in the third quarter of 2022, indicating some resilience. However, as the average consumer’s spending power erodes, people are more likely to just make food at home.
Activist investor Bill Ackman (Trades, Portfolio) has maintained a stake in Chipotle since the third quarter of 2016, as it was still reeling from the E. coli outbreak at some of its stores. In a November 2017 interview with CNBC, he said of Chipotle, “We’re going to work hard to help the company turn… This is an eminently fixable company.”
While Ackman did begin reducing the holding around the third quarter of 2018, he is still the top guru shareholder of the stock with 3.99% of shares outstanding. In August 2022, he wrote in a fund letter, “We believe Chipotle is one of the best-positioned consumer companies for the current inflationary world.”
Aside from Ackman, four other gurus hold shares of Chipotle as of their latest 13F reports: the late Spiros Segalas' Harbor Capital Appreciation Fund (Trades, Portfolio), Ray Dalio (Trades, Portfolio)’s Bridgewater Associates, Jim Simons (Trades, Portfolio)’ Renaissance Technologies and Joel Greenblatt (Trades, Portfolio).
With proven resilience to inflation, solid growth numbers and continued investments in expansion despite the uncertain economic environment, it is not hard to see why Chipotle still has a premium valuation. However, can the stock keep that value going forward?
According to GuruFocus’ discounted cash flow calculator, Chipotle will need to grow its earnings by around 27% per year for the next decade to be worth its current valuation. That is actually about half of the company’s three-year earnings per share growth rate, and Morningstar (MORN, Financial) analysts have projected a future three-to-five-year earnings growth rate of 29.34% for the company. If Chipotle can double its store count over the next decade like it did during the previous decade, even if it does not mean the 27% per year threshold exactly, it could make up the difference with high valuation multiples.