Chipotle: Too Much Growth Priced In (NYSE:CMG)

Thesis

Chipotle (NYSE:CMG) has been outperforming the S&P 500 by a wide margin over the last few years, as it has almost been a four-bagger over a five year period. I, however, believe that its dramatic price increase has made the stock extremely overvalued. Currently it trades at a very high P/E ratio of over 40, which is in my opinion not justified by its current and future growth rates. The growth rate of its restaurants is a lot lower than the expected growth rate in its share price and Chipotle is already a large player on the US market with a limited growth potential. Furthermore, profitability can be an issue when restaurants start competing with each other. Most growth has already happened and it will be very difficult for Chipotle’s stock to outperform the market over the coming years. It is definitely a great company, but even a great company at the wrong price might turn out to be a lousy investment.

Strong outperformance in recent years

Chipotle has recently been on a downward trend, just as the market as a whole has been. It has, however, outperformed the S&P 500 over the last twelve months by around 4 percentage points. Currently the stock trades at $1,364 and is down -14.5% over the last twelve months. It currently trades at a lofty P/E ratio of just above 40, which is almost 3 times as high as the sector median. Chipotle’s P/B ratio is also sky-high, at 16.3, compared to a sector median of just 2. It is thus by no means a cheap stock and a lot of its growth potential has already been priced in. Its growth has been spectacular nonetheless, however, in my opinion it does not warrant the current lofty price. Revenue growth YoY has been around 17%, compared to the sector median of around 12%. Chipotle is however also more profitable than median enterprise in the sector, with an EBITDA margin of 15.8% compared to the sector median of 11.1%. It has also become more profitable over time as EBITDA growth is significantly higher than revenue growth, at 27.5% YoY compared to the aforementioned 17%.

Strong, but expensive, fundamentals

Chipotle boasts a strong balance sheet. There is no big risk of defaulting in the future, as it operates without long term debt and has a decent amount of cash and cash equivalents on hand (although dwindling over the last twelve months). Total debt is around $3.7 billion, mostly due to capital leases. This does, however, pose no big risks to the company. Its book value per share ($83.87) compared to its price ($1,364) is however very high, resulting in a P/B ratio of 16.3. Cash flow is also strong, and growing, at $32.28 per share, tripling over the last five years. Next to this, Chipotle also boasts two times higher returns on capital and equity than its sector equivalents, at 11% (sector median at 6.6%) and 12% (sector median at 4.4%) respectively. This all looks very attractive, but it is also priced as such with a P/E ratio above 40 and a P/B ratio above 16.

Growth opportunities

As discussed, Chipotle’s valuation implies that there is a lot of potential growth for the company. The figure below shows that Chipotle has been dramatically increasing its number of stores in the last few years. Over the previous 10 years the number of Chipotle restaurants has more than doubled from 1,410 restaurants in 2012 to 3,100 restaurants in the third quarter of 2022. Over the same period Chipotle’s revenue tripled and its EBITDA turned in 2.5 times higher. For 2023 management stated that it anticipates opening roughly 255 to 285 new restaurants, which is slightly above (8-9%) growth rates from previous years (~7%). Chipotle management also expects to boost profitability with more takeaway orders from its “Chipotlane” business, tapping into the drive-thru and digital economy as well. This has especially boosted profitability in the last few years, as restaurants have adopted this. About the long-term goal for the number of restaurants that Chipotle aims at, Chipotle’s CEO Brian Niccol has said the following during the fourth quarter earnings call:

We now believe we can operate at least 7,000 Chipotle restaurants in North America, up from our prior goal of 6,000.

These are great growth rates and targets for a business such as Chipotle. The long-term goal as communicated by Brian Niccol is in line with the number of restaurants that one of Chipotle’s main competitors, Taco Bell (NYSE:YUM), has. However, in my opinion, even these are still too low to justify its current price if we expect a reasonable margin of safety, as I will discuss in my DCF analysis.

Risks to the business

Chipotle’s business is heavily dependent on consumer trends, which demand more fresh and healthy food, something that Chipotle, while being a fast-food business, provides. The main selling point is healthy and fresh, especially when compared to other fast-food chains. Next to that, Chipotle provides full customization of its food to fully cater to its more health-aware customer. It however provides no clean slate on the hygiene of its food, as it has dealt with multiple cases of food poisoning over recent years (2015-2018). These food poisonings also resulted in limited revenue growth over the same period. Since 2018 the company has however increased revenue ever more rapidly. Food poisoning does nonetheless pose a real risk to a large healthy fresh food chain such as Chipotle, more so than for some of its competitors.

Moreover, there are only a limited number of restaurants possible for a Mexican style food chain such as Chipotle until they start competing with each other, yielding lower profitability per restaurant. Finally, expansion outside of the US has proven to be difficult for larger restaurant chains such as Taco Bell, with only a limited number of restaurants outside of the US, and will therefore most probably also prove to be difficult for Chipotle, limiting potential future growth.

Discounted cash flow (DCF) analysis

As discussed above, Chipotle has proven to grow fast (7-9% a year), but this might not even be enough with the current stock price to outperform the market in the future. To justify this, I performed an elaborate discounted cash flow analysis. Chipotle’s latest free cash flow per share comes in at $32.28, at a stock price of $1,364. For my DCF analysis I will be using the aforementioned cash flow per share as a starting point, a terminal growth rate of 3%, a discount rate of 10% and a time horizon of 10 years. As growth rates for free cash flow per share of Chipotle have been very unstable over recent years, I calculate the intrinsic value for a range of growth rates, from 5% to 20% a year. Below I also added my calculations for a growth rate of 17%, which results in an intrinsic value which comes closest to Chipotle’s current market price.

A growth rate of 17%, which is implied by Chipotle’s current market price, is significantly higher than the industry average, but below Chipotle’s most recent 5-year compound annual growth rate. As already discussed, the CAGR over the last 5 years for Chipotle’s cash flow per share has been wildly unstable. Growth rates have varied from 8% a year to 200% a year. I, however, think a 10-year growth rate of 17% a year is unsustainable for a restaurant chain as Chipotle, which already has a significant market presence in the US. I arrive at this conclusion by looking at the long-term growth rate of the number of restaurants, which constitute the vast majority of future growth. These grow pretty stable at just under 10%, lower than the 17% discussed above. Moreover, there is a limited number of restaurants possible for a restaurant chain. Long term targets are set around 6,000 to 7,000 restaurants, which will yield a lower than 10% growth rate for the coming years (around 8%). I therefore think it is a great business, but not a great investment at this time, as too much growth has already been priced in to expect above market returns. Currently, there is no room for any margin of safety, even when management goals will be met.

Discussion

Chipotle’s stock has soared over recent years, returning north of 300% over the last five years. During the last year, Chipotle stock has been on a downward trend but still outperforming the S&P 500. This outperformance has resulted in a very expensive stock, with a P/E ratio of above 40 and a P/B ratio of just above 16. Also when compared to other businesses in the same industry, these valuations are very high. Chipotle is, however, not like most businesses in the fast-food industry, as it boasts stronger revenue growth, higher margins and a higher return on capital and equity than comparable businesses. It has a strong balance sheet, with no large debt-threats, and management has big plans for the future with more and more restaurants opening up. I, however, think that too much of its growth has already been priced in, with an estimated growth rate of 17% YoY being expected by the market. Especially taking into account the new number of restaurants opening up (<10% growth rate), the inherent limitations on the number of restaurants possible and the real risks concerned with a fresh food business such as Chipotle, I think the stock is overvalued at the current price. It is, however, a great business and could be a very lucrative investment at a more reasonable price. Taking all this into account, I assign Chipotle a “Sell” rating at this time.