Summary
- After reaching a multi-year high in 2014, Chipotle's growth rate is set to decline meaningfully over the next few years.
- Contribution of new store opening to sales growth will decline as law of large numbers set in.
- Comparable Store Sales will also decline in absence of menu price increases as Chipotle is not known to raise menu prices frequently and management is focused on catering to masses.
- The stock looks expensive trading at 40 time current year EPS.
Chipotle's share price has seen a good correction post its recent earnings release. While it is not uncommon to see corrections in such overpriced stocks, identifying whether a correction is short term in nature or an indication of major shift in trend is important for long term investors. I believe current correction is the beginning of a major shift in Chipotle's fortunes. Chipotle has reported average annual sales growth rate of ~20% over the past six years (see table 1). However, according to my estimates the company's growth is set to decrease meaningfully going forward.
Table 1: Chipotle's sales and growth rate
Source: SEC filings
In this article, I am presenting a detailed forecast and analysis of the company's revenue growth to support my argument. There are two key drivers for the company's revenue growth: new store openings and comparable store sales. Here's a look at them individually.
New Store Openings
One of the key bull argument for Chipotle is the company's expansion potential. According to management, the company has potential to open and operate ~4000 restaurants in North America versus current 1783. The company has been aggressively opening new stores each year which has proved to be a major driver of its topline in the past. While absolute contribution of new stores to the company's revenue is expected to remain stable over the next few years as the company plans to open ~200 stores each year, percentage contribution of new store to revenue growth is expected to decline as law of large numbers come into play.
In FY2014, Chipotle opened 205 stores and total topline contribution from these stores was $353.6 mn - an average of $1.725 mn per store. For FY2015, the company's guidance is to open 195-205 stores. Assuming the company opens 200 stores (mid point of the guidance) in the current year, it will yield incremental revenues of $345 mn (= 200* $1.725 mn). While this amount could have meant 19% increase in FY20101, it now amounts to 8.4% increase or 1060 bps less ( see foot note 1 ). Going forward, this amount is likely to become incrementally less meaningful unless Chipotle significantly increase its store opening rate - some thing which is unlikely given maturing concept and increasing competition.
Comparable Store Sales
One of the main triggers for the current correction was the company's disappointing guidance for comparable restaurant sales (low to mid single digit versus 8% consensus estimates). The following table shows Chipotle's comparable store sale growth for the past few years.
The company's Comparable store sale growth rate in FY2014 saw a significant jump versus prior years. There were two key drivers for it:
- Menu price increase of ~6.3% which started rolling out from 2QFY2014 and was implemented across the board by 3QFY2014
- New offerings like sofritas and rollout of catering services which were tested later in FY2013 in select restaurants and then rolled outnationally in FY2014.
However, these factors are unlikely to repeat over the next few years. Management has made it amply clear that across the board menu price hike is unlikely this year ( see foot note 2 ). The company's strategy is to go for the masses and not charge a premium pricing. Chipotle also has a history of not raising menu prices frequently (its previous menu price increase was 3 years ago). So, one can assume flattish pricing over the next few years. Also, there are no major product or services roll out scheduled in FY2015.
I believe 2013's Comparable Store Sale (5.6%) gives a good proxy for what Chipotle can deliver in steady environment ( see foot note 3 ) when there are no company specific factors to accelerate or decelerate comparable store sales. In the first half of FY2015 the company is likely to see easier comparisons on the pricing side as menu price increases started rolling on in late April 2014. So, I don't consider 1QFY2015 and 2QFY2015 as steady state. However, back half of this year and the next few years (if there is no another recession) will be much closer to steady state thanks to the lack of further menu price increases or any major product/service launch. So, the company is likely to post Comparable Store Sales of ~5% during the back half of this year ( see foot note 4 ) and for the next few years.
The company is likely to benefit from easy comparisons on pricing side in the first and second quarter. For the first quarter, if we assume steady state comp sales of 5% and add 6.3% from menu price increase, we will get 11.3% or a low double digit Comparable Store Sales. For the second quarter, the comparisons will be slightly tougher as the company had already started increasing menu prices in select outlets in 2QFY2014 which helped Chipotle's Comp Store Sales by 2.5%. So, 2QFY2015 sales will be likely around 8.8% (=11.3%-2.5%) or in high single digit. If we combine (take average of) quarterly comp sales we get around 8% Comparable Sales growth in FY2015, slowing to around 5% from next year onwards.
Estimates and Valuations
As discussed above, if we assume that Chipotle is able to post 8% in comparable sales growth in the current year followed by 5% comparable sales growth over the next four years, and it generates approximately $345 mn every year from ~200 new stores it opens, we will have the following growth rate projections ( see foot note 5 ):
Assuming the company's net income margin to expand to 12% by FY2019 versus FY2014's 10.8%, we have an EPS of $27.8 for FY2019 ( see foot note 6 ). At current price, this means the company is trading at 23.74 times FY2019's EPS. Now, one could have justified this valuation if the company was likely to maintain its topline growth rate in high (or even low) 20s which it had seen in the last year. But given the slowing growth trajectory, I believe it will be tough for Chipotle to sustain these valuations. Further, we have assumed steady state macro environment with no recession. We are in sixth year of bull run which began in 2009. If past stock market cycles are any guide, there is a greater probability to see another slowdown before 2019 than not.
To conclude, Chipotle's revenue growth rate has peaked in FY2014 and is likely to slow down going forward. The stock is trading at ~40 times current year EPS and is unlikely to sustain such a premium valuation as its growth slows.
Foot Notes:
1. Chipotle posted revenues of $1,836 mn in revenues in FY2010. $345 mn in incremental revenue would have meant 345/1836 or 19% increase. Chipotle's revenue for FY2014 was $4108. $345 mn in incremental revenue would have meant 345/4,108 or 8.4% increase.
2. "We don't have any plans for an across the board menu price increase in 2015 since we just increased prices and because we're currently earning at or near record margins and returns. In addition it's important to us that we remain accessible or affordable to our customers as this is the core to our ability to change the way people think about any fast food." John Hartung, Chipotle's CFO on its latest earnings call.
3. 2010-2012 was a period when the company was recovering from recession while in 2014 there were company specific factors like menu price increase and launch of new products and services which helped Comparable Store Sales. 2013 is a much better proxy of what Chipotle can do in a steady state environment
4. Management has also guided for low to mid single digit comparable store sales for the company in FY2015 which is in line with what Chipotle posted in 2013. Chipotle's management has history of being conservative. While I believe they are in the ballpark when it comes to back half of FY2015, their estimates for the first half doesn't seem to be building easier comparison from menu price increases which started rolling out only from 2QFY2015.
5. Revenue calculated using the formula:
Revenue for a particular year = Previous year's revenue x (1+comp store sales) + $345 mn (from new stores)
6. Net income = Net income margin x Revenues =12% x $7,299 mn = 875 mn. Assuming 31.5 mn diluted shares outstanding, EPS = $27.8
