Chipotle (CMG): Performance Continues To Be Immaculate; Risks Too High Ahead Of Earnings

Investment thesis

Our current investment thesis is:

• CMG is far too expensive for what it is. The company is trading at SaaS valuations with a <2% FCF yield and >30x EBITDA multiple.
• We believe Management is executing exceptionally well, delivering incremental improvements that are keeping investor sentiment positive, such as through “Chipotlanes” and international expansion.
• Looking ahead, we see little to derail its current trajectory. Brand development is linearly positive, the runway for new locations appears healthy, and consumer interest and spending are robust.

Company description

Chipotle Mexican Grill (NYSE:CMG) owns and operates Chipotle Mexican Grill restaurants. The company offers quesadillas, burritos, tacos, burrito bowls, and salads to its customers.

Unlike many of its competitors who use a franchise model, Chipotle primarily owns and runs its restaurants. This gives it greater reward, cutting out the franchisee’s cut, while taking on greater risk and responsibility (namely fixed overheads such as rent and employees).

For this reason, its operating profile is fundamentally different from its traditional peers, being asset-heavy and placing greater importance on its supply chain to drive value over time.

Chipotle operates in several countries but is principally a US business, with the vast majority of its earnings derived from this country.

Share price

We last covered CMG in Jan23, rating the stock a hold. We were fundamentally sold on the business, stating “Chipotle is a great business. It is growing very fast for a restaurant chain, in both like-for-like sales and new stores. Management has maintained strong controls over costs and is able to increase menu costs as required (so far). We think macro-conditions will impact the business but not to a level where growth is in doubt medium-term.” However, we struggled to reconcile its valuation with various risks that could impact growth.

Since then, the company’s share price has continued to soar, up +47%. Our colleagues at Seeking Alpha continue to maintain a hold rating, whilst Wall St. rates the stock a buy but has been hesitant to suggest upside beyond 10% at its current share price.

It is clear that CMG is highly popular, being ranked as the “most crowded stock” within the consumer discretionary segment, with ~26% of funds owning the business. Despite all the bullish sentiment driving its share price higher, markets still see value, with Baird‘s restaurant stock analysis suggesting CMG is one of a cohort of 6 with the most upside potential.

Commercial analysis

Presented above are CMG’s financial results on a quarterly basis.

CMG’s revenue growth has been impressive, with a CAGR of +12% during the last decade. The most impressive factor is the scale at which this has been achieved. CMG is almost a $10b revenue business, yet is still growing at double-digit levels YoY.

When zooming into its quarterly results, the company appears to be maintaining its existing trajectory. In Q3’23, CMG achieved revenue growth of +11%.

Much of CMG’s trajectory can be attributable to new locations, which Management has invested considerably in. As the following illustrates, the number of new locations per quarter has consistently exceeded 40, with 62 in the most recent quarter exceeding the 9-quarter average. This has been achieved despite a degree of delay.

The fundamental performance of its existing locations should not be understated, however. During the last 9 quarters, its average YoY Comparable restaurant growth rate was ~10%, partially reflecting inflation, but also growing demand for its offering. As the following illustrates, the company is close to the peak of its popularity (discounting the distorting effect of Covid-19), underpinning its impressive brand development.

Finally, the company is benefiting from the inherent “lag” associated with new locations. A restaurant that opened 1 month ago is unlikely to be at its peak performance, for a variety of reasons. With significant store growth in recent years, CMG is experiencing the benefits of the past.

The combination of these factors (New stores, popularity, and store ramp-up) is the reason for its impressive growth trajectory. Given the “formulaic” nature of this growth, it is unsurprising to see that according to BoA research, CMG is within the top 10 for efficient growth achieved. This research considered investment in costs and capex to assess the returns delivered from this.

The question thus becomes, can Chipotle maintain this store growth? The company currently has ~3,321 locations. By contrast, McDonald’s (MCD) exceeds 40,000, Domino’s (DPZ) exceeds 19,000, Taco Bell (YUM) exceeds 7,500, and Wendy’s (WEN) exceeds 7,000.

This implies the company has a strong runway for growth, particularly as Taco Bell and Wendy’s are primarily US-based. We highlight this because Chipotle’s cuisine, although popular in the Americas, is less so in Europe and Internationally, which will mean greater efforts are required to generate comparable popularity.

Business Model

CMG takes a differing approach to operations relative to its peers and is innovating in order to maintain its current trajectory. We highlight three key initiatives below.

Investment in staff:

CMG’s investment in employees has been a critical component of its strategy. During the last few years, the industry has experienced a shortage of staff, as wage inflation has contributed to greater attrition. Whilst this has impacted CMG negatively, the business has faired far better relative to others.

Most recently, the company unveiled a range of new benefits for staff, including financial wellness and mental well-being support. Although this adds additional cost, with the risk of no incremental financial benefit, we are highly supportive. CMG owns its locations and so has a significantly greater vested interest in the quality of the service its staff provides, the impact of this on customer perception, and more broadly, employee retention.

Chipotlane:

Chipotle operates “Chipotlanes”. If you think this is a perfectly named drive-thru, you would be wrong. Chipotlanes allow consumers to order online beforehand (through their website or app), essentially operating pickup locations that are also fundamentally technology-driven drive-thrus.

This contributes to greater time savings for consumers (~30 seconds per order vs. 325 seconds at Chick-fil-A) and greater efficiency for CMG. Management continues to invest heavily in these locations.

We consider this critical innovation, as it continues to push Chipotle toward the mainstream. It is unlikely that its foods will reach the popularity of a burger or pizza within the next few decades, but CMG is strong strides to close the gap.

Digital Sales:

Finally, the business has heavily invested in its digital sales capabilities, with sales growth through this channel regularly exceeding 30%. This is in part due to the Chipotlane approach but also a strong focus on developing a closer relationship with its customers through their digital account. This is a key driver of improving unit economics through lower customer acquisition costs.

Competitive Positioning

CMG’s emphasis on fresh, high-quality, and customizable menu items aligns with the growing trend of health-conscious consumer preferences, contributing to market share gains and sustained growth. This is likely an underappreciated component of CMG’s appeal, allowing it to differentiate from the traditional QSR brands.

Further, CMG’s brand resonates with younger demographics who are seeking new and exciting brands that are offering something different from the existing suite of QSR offerings.

Finally, Chipotle is focusing more greatly on international expansion, where it has relatively small exposure compared to its peers. The company maintains its existing ownership approach, although has shown an appetite to franchise in the Middle East. Although this has led to a slower penetration rate, we see scope for success if CMG can sufficiently convince markets of its offering.

Economic & External Consideration

Economic conditions have impacted CMG, with pressure on comparable sales, although for the most part resilient consumer spending and its broader trajectory have limited the visibility of this.

Inflation has been the primary factor impacting the company, driving a portion of the top-line growth achieved, as well as pressures on its cost base. Given CMG operates its locations, there is a greater risk due to its direct exposure, but once again, Management’s execution has been impeccable as margins continue to improve.

Margins

CMG’s margins have consistently improved in recent years, primarily attributable to scale and the ramp-up of locations, allowing for economies of scale. Further, the business has benefited from efficiencies and its transition toward greater digital sales.

The company’s restaurant-level margins continue to tick up, implying despite the gains achieved thus far, there is scope for further gains.

Balance sheet & cash flows

Whilst investment in new locations has been considerable, Management has balanced capital allocation to ensure shareholder returns are maximized. Management has consistently repurchased shares while spending ~6% of revenue on Capex.

We expect capex spending to dilute over time, as should S&A spending, both of which have been broadly flat over the last decade. Whilst there is small evidence of this occurring thus far, we are comforted by the long-term scope for value here.

Outlook

Presented above is Wall Street’s consensus view on the coming years.

Analysts are forecasting a continuation of its current trajectory, with a CAGR of +12% into FY28F. Alongside this, margins are expected to sequentially improve gradually.

We broadly concur with these estimates, primarily due to the combination of its store growth trajectory and the runway for new locations in the US and Globally, as well as further scope for economies of scale.

For Q4, we are expecting top-line revenue growth of ~13% and an EBITDA margin of ~17%. This is based on an expected holidays bump, supported by Nov23 retail sales. Alongside this, we are conservatively expecting flat margins compared to Q4’22, following normalization at these elevated levels post-Q2’22.

Beats and Misses

It is worth highlighting that CMG has been consistent relative to analyst estimates, likely reflecting an inflection point following significant expansion. Investor sensitivity to misses, reflected in its 1D share price performance in Q3’22, Q4’22, and Q2’23 implies only a beat will be sufficient to maintain its current trajectory.

Industry analysis

Presented above is a comparison of CMG’s growth and profitability to the average of its industry, as defined by Seeking Alpha (36 companies).

We will not spend too long on this section because it’s fairly definitive. CMG is in a league of its own. Despite its franchising peers having a completely different financial profile, CMG has superior margins and growth, reflecting its impressive position.

Valuation

CMG is currently trading at 36x LTM EBITDA and 31x NTM EBITDA. This is a premium to its historical average.

Without commenting on the absolute value of its historical valuation, a premium to it appears reasonable. CMG’s trajectory has maintained despite scale, it has a good runway for further growth, margins are improving, and innovation is succeeding.

Further, CMG is trading at a sizeable discount to its peers (LTM EBITDA: 48%, and NTM P/E: 23%), similarly reflecting its impressive trajectory and relative financial performance.

Once again we reach this point. Highly praising CMG, only to be unable to reconcile its valuation. The company is trading at a NTM FCF yield of 1.3%, an eyewatering valuation. Even NVIDIA (NVDA), whose share price has grown considerably in the last 24 months, is trading at 2.9%.

This aside, we do want to leave some food for thought regarding its valuation. A day will likely come (we speculate), potentially decades from now, when it will seek to refranchise what will be its enormous portfolio of restaurants, creating enormous short-term returns for shareholders as the business is flush with cash.

Management

CMG’s Management has been aggressively selling stock during the last 12 months, with ~$105m in sales compared to ~$2m in buys. This is generally a bearish indicator, implying Management sees the stock as overvalued.

Key risks with our thesis

With a valuation this high, but close to perfect execution thus far, the risk to CMG is centered around the ability to continue to execute. A moderate miss at Q2’23 contributed to a one-day share price decline of ~10%, reflecting the level of perfection required.

Final thoughts

We were wrong about CMG. When we last reviewed this stock, we had high praise but clearly completely underappreciated what Management was building. We believe this stock is a long-term winner, so long as CMG can continue to sell the idea of Mexican fast food globally.

This said, it is once again hard to justify its price. CMG’s share price is robbing the future to pay investors today. At a 1.3% yield, we just cannot see sufficient value at low double-digit growth.

We suggest investors continue to remain patient, even if its share price runs further, as value cannot be realized at this price.