I have been following Chipotle Mexican Grill (CMG) for quite some time now, and it didn’t come as a surprise to me that it scored very well in a recent stock screen I made for companies which exhibit high, predictable growth and little debt. Chipotle Mexican Grill’s EPS has grown at a compounded annual rate of 39% over the past five years. Sales have grown at 23% per year. As of Dec. 31, 2012, CMG was trading for $297.46 which translates to a market cap of $9.15 billion.
I will now review the latest annual and quarterly reports in detail to determine if there are any red flags which would preclude an investment in Chipotle. Following that, we will attempt to determine a reasonable estimate for CMG’s current intrinsic value and use that information to set an entry price target.
CMG is an owner and operator of Mexican fast food restaurants which have a core menu consisting of burritos, tacos, and salads. The company does not franchise, and their claim to fame is their focus on high quality ingredients and training of their people. This has brought them a great deal of success thus far. Chipotle Mexican Grill’s most recent annual report was for fiscal year 2011 which ended on December 31, 2011. As that was now over a year ago, we will also pay close attention to the 3rd quarter report, which ended September 30. Following are the key takeaways from both reports.
2011 Annual Report Highlights
- CMG places an emphasis on naturally raised meat and dairy and locally grown produce. The company believes that this increases the quality, taste, and integrity of its food. There is inadequate supply of naturally raised meat to commit to this goal fully however, and some regions occasionally revert to conventionally raised meat in these cases. This is a potential red flag due to the company’s very ambitious growth aspirations. Will CMG’s suppliers be able to keep up with demand?
- The company is extremely focused on customer education and engagement. Programs include a web-based program called the Farm Team to educate customers about what makes CMG’s food unique, a Cultivate Festival which drew 17,000 people in Chicago, the production of a short film to expose customers to the benefits of sustainable farming, and finally the establishment of a non-profit organization to assist those who are making efforts in areas such as animal welfare and sustainable farming.
- The company has implemented a very strong management training program. They develop so called elite managers by putting people through their Restaurateur program. Restaurateurs now oversee 2/3 of CMG’s restaurants.
- CMG is expanding into new markets as evidenced by the opening of its first Shophouse Southeast Asian Kitchen in Washington DC. This is the first experiment for the company in marrying the fundamental principles that have brought success for its Mexican restaurants to a new type of cuisine, and could lead to entirely new avenues for future growth.
- Chipotle Mexican Grill is a fast food restaurant, and as such has stiff competition from the plethora of other restaurants currently in operation in the fast food, quick-service, and casual dining industry. The company charges a premium for its products due to the higher quality of the ingredients it uses.
- Strong marketing allows restaurants even in new markets to open with strong sales. In existing markets, CMG’s restaurants often open with volume at or near market averages. There was no mention of this trend tapering off in the annual report.
- Administrative expenses are due to increase significantly in 2012, due largely in part to the value of stock based employee compensation coupled with the much higher share price.
- The company leases its main office and substantially all of the properties it operates.
- CMG does not pay a dividend and does not foresee the payment of a dividend in the near future.
- Sales increase to just over $2 billion in 2011, a 9.2% increase from the $1.8 billion in sales as of Dec.31, 2010. This includes a comparable restaurant sales increase of 11.2% for the year. Same store sales are anticipated to increase by an amount in the mid-single digits in 2012. This led to a diluted EPS of $6.76 for 2011, an increase of 19.8% over 2010.
- 150 new restaurants were opened in 2011, including a new overseas store in London to seed future growth. As of fiscal year end, CMG operated 1,230 restaurants, all of which are located in the United States except for two in Toronto, Canada and two in London, England. The company plans to open between 155 and 165 restaurants in 2012. Future sales growth is primarily impacted by the opening of new restaurants as opposed to an increase in same store sales.
- The average cost to open a new restaurant in 2011 was $800,000 and this is expected to be about the same in 2012.
- Food costs increased in 2011 and this trend is expected to continue in 2012, resulting in the cost of ingredients becoming a higher proportion of total revenue.
- Total current assets are well in excess of current liabilities, and CMG has zero long term debt.
- Chipotle is expanding its stock repurchase plan by an additional $200 million in 2012.
3rd Quarter Report Highlights
- For the nine months ended September 30, CMG’s 2012 revenue increase to $2.03 billion, an increase of 21% over the same period in 2011. Diluted EPS increase by 37% to $6.80 for the same time period.
- Current assets are over three times current liabilities, and the company still has no long term debt.
- The company opened 123 restaurants during the first nine months of 2012 for a total of 1,350 in operation. This now includes five restaurants in London, England, one in Paris, France, and four in Toronto, Canada. The company still plans to open a total of 165 restaurants (or thereabouts) by year end 2012. CMG now plans to open between 165 and 180 restaurants in 2013.
Chipotle Mexican Grill has been able to consistently beat sales and earnings targets and exhibit strong growth even in the face of rising operating costs. The company is looking to the future internationally, as well as with experimentation in using its fundamental principles in exploring new cuisine via its Shophouse Southeast Asian Kitchen concept. CMG has been able to achieve this with its current cashflow instead of relying on debt financing. The key area of concern is whether the success of its sustainable foods culture can continue as the company grows due to supplier’s inability to keep up with demand. As this is the primary differentiator that allows Chipotle to charge premium prices for its products, it would be a potentially huge setback for the company. That said, I would be interested in owning stock in CMG if it can be bought for a price below its intrinsic value. Let’s have a look now and determine what that valuation is.
Determining the Intrinsic Value
We will use the EPS Growth Capitalization method to determine a present day intrinsic value for Chipotle Mexican Grill. Numbers used in this analysis will be taken from GuruFocus, as they provide easy access to the past 10 years of historical financials.
CMG has not to my knowledge provided guidance as to its future anticipated earnings growth, however analyst consensus has it at 20.7%. Based on my review of the company reports and views on the market in general, I am more optimistic and estimate that future EPS growth will average about 22% per year for the next five years. This is based in part by the fact that CMG has achieved a compounded annual growth rate of over 39% the past five years and while they’re beginning to show signs of slowing, I don’t see it being cut in half in such a short time period.
Chipotle typical trades at a high valuation with respect to earnings due to its high rate of growth in recent years. For the past five years, its average PE ratio was 34.2 and as of Dec. 31 the stock was trading at a PE of 33.4 (ttm). I believe the company’s stock will trend towards a lower PE as the company grows, so I am going to estimate that a PE of 25 is reasonable five years from now.
We now have all inputs required to complete the intrinsic value calculation:
- Future EPS growth: 22% (estimated)
- Future PE ratio: 25 (estimated)
- Current EPS (ttm): $8.70
- MARR: 15%
- Timeframe: 5 years
Based on a compound growth rate of 22%, the future value calculation results in a predicted EPS of $23.51 in five years time. If CMG were to trade at a PE ratio of 25, this would equate to a share price of $587.84. To achieve our minimum acceptable rate of return of 15%, the present value of the stock and hence our intrinsic value equates to $292.26 per share. This suggests that Chipotle is fairly valued at current trading prices.
A margin of safety must be applied to the intrinsic value to account for any errors in our estimation, and should be based on the confidence level we have in the predictions. The estimated values we’ve used thus far have been speculative, as we have assumed that growth will slow and PE will contract as a result. Let’s have a look again and choose some even more conservative numbers to see how that affects the intrinsic value.
A PE of 20 is the lowest I would expect it to be short of something catastrophic happening within the company or the economy. Let’s also assume that the company’s venture into overseas markets is not as fruitful as hoped, causing EPS growth to come in at the 20.7% predicted by analysts. Running the numbers again results in a lower intrinsic value of $221.61 per share, which represents a 24% discount to the original intrinsic value of $292.26. I am going to compromise and use a 20% margin of safety, which should protect us from the uncertainty in our calculations. This results in a target entry price of $233.80.
Based on today’s trading price of $297.46, Chipotle Mexican Grill appears to be fairly valued in accordance with our calculated intrinsic value of $292.26 making a purchase in the near future appear unlikely. CMG will be added to the Stockodo watch list with a target entry price of $233.80 based on a 20% margin of safety.