2023-07-19 17:20:13 ET
Summary
- Chipotle’s financial results over the past few years have led the market to assign a high earnings multiple to its stock.
- This high multiple makes the most sense when looking at the past 2 years specifically and with a comparison to Lululemon, which trades at a similarly high multiple.
- I estimate the stock to be about fairly valued, but rate it a sell as I see a higher chance of downside risk than upside surprise in future results.
- In this article, I discuss why the stock trades at such a high multiple, how the stock compares with Lululemon, and my estimate of the value of the stock.
Chipotle Mexican Grill, Inc. ( CMG ) has a history of solid growth and high ROIC. These metrics have especially risen the past few years as consumers have been willing to accept larger price increases and has subsequently led the market to assign Chipotle’s stock a high earnings multiple as it trades at a P/E ratio of about 55 using trailing twelve month GAAP figures.
This high multiple makes Chipotle’s stock look expensive when compared to many other restaurant stocks and the current market multiple. However, when it comes to valuing Chipotle, I think it is a mistake to compare it with other restaurant businesses such as McDonald’s Corporation ( MCD ) or Domino’s Pizza, Inc. ( DPZ ). I will discuss this in more detail below but, despite operating in the same industry, they have different business models which leads to different economics.
I think a more appropriate comparison is a business like Lululemon Athletica Inc. ( LULU ). Lululemon caters to a similar target customer, and past growth and ROIC has been similar to that of Chipotle. As such, both stocks trade at a similar multiple of trailing GAAP earnings.
In this article I will discuss Chipotle’s business model, its high growth and high ROIC, its similarities with Lululemon and my estimate of Chipotle's intrinsic value. While I do think the stock is likely fairly valued, the risk/reward is unfavorable given a potential reversion to the mean ROIC. I rate the stock a sell.
Business Overview
Chipotle is a restaurant chain that operates primarily in the U.S. Currently there are 3129 Chipotle restaurants in the U.S., 53 international Chipotle restaurants, and 5 non-Chipotle restaurants. Chipotle is different from many large chains such as McDonald’s Corporation ((MCD)) and Domino’s Pizza, Inc. ((DPZ)) in that all of its restaurants are owned and operated by the company and non are franchised. Revenue from franchised locations make up a little under half of Domino’s revenue and about 60% of McDonald’s revenue.
McDonald's has the highest percentage of revenue from franchised locations, followed by Domino's, followed by Chipotle which has none. The franchise model is inherently higher margin and causes fundamental difference in how revenue turns to earnings. This can be best seen by a comparison of the different gross margins for the three companies.
Chipotle’s current strategy is basically the same as it has been in the past: continue to grow the store count, increase same restaurant comparable sales, and increase margins through efficiencies and increased digital sales.
Past Financial Performance
Chipotle’s revenue has grown at an 15% CAGR since year-end 2018 and the company operating margin has expanded from 7% to 13.7% in that same time. Also since 2018, the number of open restaurants has increased by 100-200 per year, from 2452 in 2018 to 3129 in 2022. They have also recently updated their long-term target of total North American restaurants to 7,000 and they plan 8-10% growth in new restaurants per year.
Chipotle Restaurant Count (Statista)
Chipotle’s ROIC in 2018 and 2019 was 15% and 19% respectively, while it was 45% and 40% in 2021 and 2022. I am not including 2020 as it was an outlier year due to the pandemic lockdowns. Obviously the more recent numbers are more impressive and if sustainable, should lead to the stock commanding a premium earnings multiple. As of now, using the high trailing P/E ratio as a gauge, the market seems to believe the more recent ROIC is sustainable.
Comparison to Lululemon
As I wrote above, I don’t think a comparison to other restaurant businesses that get a large percentage of its revenue from franchised locations is appropriate. This causes a large difference in the fundamental economics of the businesses and makes a comparison of multiples less meaningful.
I think a comparison with a business like Lululemon is more meaningful when discussing valuation. Both target more active and health conscious gen z and millennial demographics, and both have customers that tend to be more affluent given the higher prices. Additionally, the basic business model is the same for both companies. They are both trying to increase earnings per share by increasing their total number of owned stores/restaurants, growing same store/restaurant sales, and increasing margins by increasing efficiencies in stores/restaurants and pushing their digital strategy.
Lululemon Store Count (Statista)
Since 2018, Lululemon's store count has grown at a 10% CAGR which also lines up with Chipotle's long-term guidance of 8-10% growth in new restaurants per year.
Financially speaking, both companies have had similar returns on invested capital and growth over the past few years. Lululemon’s ROIC in 2021 and 2022 was 47.5% and 42.5% while Chipotle’s was 45% and 40%. Lululemon had higher absolute revenue growth as it grew 42% and 29% in those same years compared to 26% and 14% for Chipotle. Despite this difference, Chipotle has had higher growth in operating income over the past 2 years as it grew 157% and 43% in 2021 and 2022 versus 69% and 25% for Lululemon. More recently, in Q1 Chipotle’s operating income grew 93% while Lululemon’s grew 54% year over year.
The market sees these similar high ROIC and the high growth rate metrics and is applying similar P/E ratios to the stocks. Although the ratios are high, they makes sense if this performance over the past few years continues into the future. The appropriateness of this earnings multiple can be seen in my DCF below. If the financial results from the past few years continue going forward, the stock appears to be fairly valued.
Valuation and Forecast
Chipotle DCF (Created by Author)
Chipotle DCF Continued (Created by Author)
In my model, I am using analyst estimates of revenue in 2023 which calls for growth of 14.36%, followed by 14% growth through 2027. I am using analyst estimates for operating margin in 2023 of 16%, and I have it increasing by 1% per year through 2027 to 20%. I’m assuming D&A is 3.5% of revenue in 2027, capex 5.5% of revenue in 2027, a 21% income tax rate in 2027, and diluted shares outstanding to decline to 27 million in 2027. Finally, I’m assuming a terminal growth rate of 3% and a WACC of 8%.
These assumptions lead to an estimated value of $1,957 per share. Despite the fact that this estimate makes the stock fairly valued based on the current share price, I am giving the stock a sell rating because my assumptions call for the positive trends of the past few years continuing. If, for example, consumers become less willing to accept price increases, profitability and ROIC will drop.
Many arguments are made that increases in restaurant efficiency will drive margins higher. This is also a key talking point from Chipotle executives. For example, the new "Autocado" innovation has been making headlines recently. This is a new machine that Chipotle is using in restaurants to prepare avocados before they are made into guacamole. While this is an interesting development and could lead to higher margins over the long-term as it is rolled out into more restaurants, this will not drive meaningful margin expansion in the near-term.
I say this because, from the most recent 10-Q, management noted that the increase in same restaurant comparable sales was primarily due to "an increase in menu prices, and, to a lesser extent, higher transactions." This will continue to be the main driver of margin expansion over the next 6-12 months as price increases will continue to be the main driver of same restaurant comparable sales. This makes general economic risk and downside for Chipotle's stock more worrying in that time frame.
I see less of a chance for a surprise upside scenario as it would require higher upside from the already positive results of the past few years that my assumptions take into account. This is less likely to occur than a reversion to the lower average ROIC from before 2020.
Final Thoughts
Chipotle has had a history of a high ROIC and steady growth, especially over the past 2 years. The market is acknowledging this and is assigning a high multiple to Chipotle’s stock. Though some may argue that the market is incorrect with Chipotle’s current trailing GAAP P/E ratio at 55, which is quite high compared to the current market multiple and other restaurant stocks, I think a comparison with Lululemon, which trades at a similar multiple for similar reasons, shows that the market is making reasonable assumptions with this valuation.
This high multiple has been great for investors that currently own the stock but it could lead to a sharper decline if economic conditions worsen and consumers don’t accept further price increases. Despite innovations that may eventually increase efficiencies such as the "Autocado", most margin expansion in the near-term will come from price increases.
This leads me to rate the stock as a sell despite looking fairly valued with my estimates. My estimates extrapolate from the already positive results of the past few years so there is more room for downside risk in growth and earnings than there is for surprise upside.
For further details see:
Chipotle: Fairly Valued, But Downside Risk Looms