Chipotle Stock: Priced For Mediocre Returns (NYSE:CMG)

Chipotle Reports Quarterly Earnings

Justin Sullivan

Chipotle (NYSE:CMG) shares have staged a remarkable comeback over the past five years increasing nearly six-fold as operating profit has doubled. Food safety issues (2015) which threatened the brand and decimated the stock are now but a distant memory. Meanwhile digital sales now represent nearly 40% of total revenue and the company is again growing its restaurant footprint at an impressive clip.

Chipotle has several attractive investment characteristics including a strong brand, excellent unit economics, and plenty of runway for continued growth in restaurants and digital sales. Further the company has demonstrated pricing power. While inflation has taken its toll on many restaurants, Chipotle has flexed its pricing muscle and increased operating margins in 2022. While financial results have been excellent, the current share price seems to fully reflect this, which implies relatively low future returns.

Current Results

For 3Q, Chipotle reported strong revenue (13%) and Adjusted EBITDA grew 33% year-over-year. Revenue growth consisted of 7.6% same-store revenue with the remainder coming from new locations.

While Chipotle produced great results, one source of concern is that the company has increased prices too far (+13% year-over-year) which led to a 1% decline in year-over-year transactions. Negative transaction trends have continued into the fourth quarter.

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Price/Transactions growth in 3Q22 (3Q22 Chipotle Conference Call Transcript from Seeking Alpha)

Prices appear to have increase in excess of inflation – Chipotle showed an improvement in labor and food costs on a year-over-year basis. Further, Chipotle’s price hikes have been ahead of other fast food operators like Portillo’s (PTLO) which has deliberately increased price less than competitors and Shake Shack (SHAK) which has taken relatively modest price increases:

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Shake Shack 3Q22 Price versus Volume (Shake Shack 3Q22 Conference call transcript from Seeking Alpha)

While consumers have generally been willing to foot the bill, it is possible we could see accelerated declines in transactions going forward, particularly amongst low-income consumers (who have been hit the hardest by inflation and seen spending power reduced) or if we enter a recession. An acceleration in traffic declines could cause Chipotle to re-think its price hikes, particularly if the company believes it is losing market share. At present there is no indication that this is the case – on the 3Q call management voiced confidence in the company’s relative value proposition:

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Relative value (Chipotle 3Q22 Conference Call Seeking Alpha)

While price hasn’t been a big problem thus far, this is something to keep an eye on as we move forward.

Medium-Term Expectations & Valuation

Chipotle plans to open 255-285 new locations in 2023 or an 8-9% growth in total restaurant count. Beyond 2023, I expect the company will open a similar number of restaurants annually (with roughly equivalent average unit volumes to current levels) as the company marches toward its 6,000 restaurant target. Adding in 3-4% same-store sales growth, I expect total revenue to increase 11-13% per year.

I assume operating margins continue to expand beyond 2022’s mid 13% level, reaching 16% in 2025. Today Chipotle reports restaurant level (4-wall, excludes technology, administrative, marketing expenses) EBITDA margins of 25% which is near the very high end of all restaurant chains. I assume further growth in operating margins to 16% operating margins as incremental operating profit increases with new unit growth (assumes 25% unit level EBITDA margins are sustainable).

Assuming all free cash flow is used to repurchase shares (at the current price), I get $59-60 per share in 2025 expected EPS. This puts the company at ~3,900 restaurants in 2025 giving the company ample runway for continued unit expansion beyond 2025. With above average growth prospects beyond 2025 (8-10% annual sales growth), a solid brand, and exceptional unit economics (as shown above) I think a premium 30-32x P/E multiple (65-70% above average S&P P/E multiple) is reasonable suggesting a fair value of $1,800-1,925 per share (12-20% upside). This implies 4-10% annualized return between now and 2025.

Conclusion

I am not excited by the risk/return in Chipotle shares. If everything goes well – successful new restaurant growth, positive same-store sales, continued margin expansion, stock continues to trade at a significant premium to the overall market – investors will earn an uninspiring 4-10% annualized return. Should a weaker economy cause transaction/same store sales to falter or were something unforeseen to occur, shares could perform significantly worse. I would only be interested in owning Chipotle at much lower prices.

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