Stay Away From Chipotle, It’s a Growth Trap
The word “chipotle” is derived from the ancient Nahuatl name for a particular strain smoke-dried jalapeño. While it certainly isn’t the hottest chili pepper around, it may be the most widely used spice in everything from Tex-Mex to traditional Mexican themed cuisines. Much as the chipotle has become the ubiquitous ingredient this food genre, the restaurant chain Chipotle Mexican Grill (NYSE: CMG) has become the most popular player in the booming fast-casual dining market. With over 1,200 locations in the states alone, Chipotle has blossomed into a $12.6 billion company, as the chain can lay claim to a devoted customer base of young adults in love with its healthy-ish menu options, high-quality ingredients, reasonable pricing, and universalized interior styling. In a post-recessionary environment devoid of large cap multi-bagger stocks, CMG has been one of the Street’s biggest success stories, quintupling its value in three short years. Aside from one other restaurant chain, which can be read about here, Chipotle has been the favorite of food-oriented investors.
As one would expect, much of this growth has been driven by Chipotle’s astoundingly high top and bottom line expansion, which has supported by solid margin improvement. Since 2008, the company has grown its revenues by an average annual rate of 19.4 percent, trumping the restaurant industry average (4.4%), and competitors like Panera Bread (NASDAQ: PNRA) at 11.9%, Brinker International (NYSE: EAT) at -13.3%, Yum Brands (NYSE: YUM) at 3.8%, and Jack in the Box (NASDAQ: JACK) – which owns Qdoba – at -4.8%. Over this same time, Chipotle’s earnings have skyrocketed to the tune of 42.0 percent per annum, outpacing its aforementioned competitors, as operating (+68.5%) and net (+64.1%) margins have been boosted significantly.
From a valuation standpoint, even the most bullish, burrito-loving investors cannot deny that at $395, shares of CMG are priced at a premium. CMG sports a Price-to-Earnings ratio (54.4X) that is oodles higher than the industry average (20.8X) and competitors like PNRA (29.9X), EAT (18.5X), YUM (20.3X), and JACK (17.4X). The real kicker, though, can be seen when looking at historical norms. Specifically, Chipotle is trading at a higher P/E than its 5-year (41.1X), and post-IPO (41.7X) averages, even though it experienced similar levels of growth in these earlier years. In fact, since going public in the middle of last decade, the company’s earnings have historically traded at a 172 percent premium to those of the S&P 500. This year, shares appear more expensive, trading at a 271 percent premium. Using this logic, we can say that fairly valued shares of CMG should trade somewhere in the $365 range, about 7.5 percent lower than their current market price.
When earnings growth is factored into the equation, the stock sports at a PEG ratio of 1.8, which is above PNRA (1.1), EAT (1.0), YUM (1.4), and JACK (0.9). It seems that the market is pricing Chipotle for a higher level of bottom line expansion than it is tangibly producing, which would be acceptable if earnings growth wasn’t slowing down. By the end of this year, analysts’ consensus is that Chipotle will report an EPS growth of 31.1 percent, with this figure declining to 24.9 percent by the end of 2013. Now, these forecasts are nothing to shake one’s head at; if they hold, CMG has upside of $415 by next winter, but the risk of a negative revaluation looks to outweigh upside potential at current price levels.
Over the past 12 months, Chipotle’s cash flows have been slowly deteriorating, with TTM operating (-10.5%) and free (-20.7%) cash flows declining by double-digit margins. Much in the same manner described above, investors are also valuing CMG at a Price-to-Cash Flow ratio (33.7X) way above its own 5-year (20.1X) and post-IPO (22.3X) historical averages. Computing the stock’s PCFG ratio (2.3) just adds to this concern; typically any figure above 2.0 signals overvaluation. The formulation of the PCFG ratio is identical to that of the PEG ratio; here’s a refresher course on ratio analysis if you need it.
To recap: Chipotle has experienced stellar growth in many facets of its operations over the past few years, which explains the company’s stratospheric valuation metrics. Going forward, however, this growth is expected to slow down, meaning that we may have a growth-trap on our hands. In the spirit of the old investment adage “past performance is not indicative of future returns,” investors must be cautious of CMG’s gaudy historical numbers by placing a larger importance on future expectations. In this particular case, it may be wise to wait until the stock reaches a fairer value, say in the $360 range, before taking a position.
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Disclosure: The author has no holdings in the stocks mentioned in this article and has no plans to initiate any positions within the next 72 hours. He does, however, have the intention of rating these stocks on WealthLift.com, a social media website where investment ideas are shared openly and free.