Chipotle: Impressive Momentum But Valuation Is Too Aggressive

Chipotle Mexican Grill (CMG) is on fire lately, shares of the fast-casual Mexican food chain are up by almost 70% year to date on the back of strong revenue growth and increasing profit margins. Management is leading the company in the right direction, and vigorous momentum could provide a powerful upside fuel for the stock in the short term.

On the other hand, past performance does not guarantee future returns and Chipotle's stock looks too expensive at current prices.

Outstanding Momentum

Chipotle is delivering rapid revenue growth and increasing profit margins, this means that earnings are getting a double boost from solid revenue growth in combination with a larger share of revenue being retained as profits. The company is also making a lot of progress in its digital transformation, which is a crucial success driver in the industry nowadays.

Some highlights from Chipotle's financial reports for the fourth quarter of 2019:

• Revenue increased by 13.9% to $1.3 billion.
• Comparable restaurant sales increased by 9.9%.
• Digital sales grew 100.7%, accounting for 15.7% of sales for the quarter.
• Restaurant level operating margin was 21%, increasing from 19.5% in the same quarter last year.
• Adjusted diluted earnings per share reached $3.40, a 59.6% increase versus the same quarter last year.
• For the full year 2019, management is expecting mid to high single-digit comparable restaurant sales growth and 140 to 155 new restaurant openings.

It's not just that the company is doing well and producing solid growth rates, Chipotle is also doing better than expected by Wall Street, and this has a major impact on returns.

Current stock prices reflect certain expectations for a company. If the numbers come in above expectations, then the stock tends to move higher in order to reflect enlarged earnings expectations going forward. Chipotle has announced earnings numbers ahead of expectations in every quarter since the fourth quarter of 2017.

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Source: Seeking Alpha Essential

We can see in the chart below how earnings estimates for Chipotle in both the current year and next year have significantly increased over the past several months. Like usually happens, earnings estimates and stock prices tend to move in the same direction, and fundamental momentum is a strong tailwind for Chipotle's stock.

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Data by YCharts

Valuation Ratios

Chipotle is one of the best players in the restaurant industry, and the stock clearly deserves a valuation premium in comparison to the sector. However, the magnitude of the current premium could be a reason for concern among investors in Chipotle at current levels.

The table below compares key valuation metrics for Chipotle versus the sector median, and the numbers are clearly showing that Chipotle is comparatively expensive across the board.

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Data Source: Seeking Alpha Essential

Discounted Cash Flows

Offering a similar conclusion, the stock looks overvalued based on discounted cash flows. The discounted cash flow analysis for Chipotle is based on the following assumptions:

• Current sustainable free cash flow is $350 million.
• Free cash flow growth is assumed to be 15% annually over the next five years.
• Free cash flow growth is expected to slow down to 9% over the five-year period in the decelerating growth phase.
• The terminal growth rate is 3%.
• The required rate of return is 9%.

Based on these assumptions, we reach a fair value estimate of $440 per share for Chipotle, which would mean that the stock is overvalued by almost 40%.

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It is entirely possible that Chipotle could outperform these growth expectations, perhaps through international expansion, over the years ahead. This would obviously mean that the stock is worth more than what the analysis above indicates.

But the growth rates incorporated in the discounted cash flow analysis are already far superior to what most companies in the restaurant industry can deliver. Assuming that Chipotle will broadly outperform the industry over the long term is quite a risky assumption to make when making investment decisions.

The main point in the discounted cash flow analysis is not making accurate predictions about long-term cash flow generation, which is practically impossible to do with precision anyway. The idea is assessing if the stock is reasonably priced in accordance with conservative cash flows assumptions, and in this particular case, Chipotle looks too expensive.

Multi-Factor Analysis

When analyzing an investment from a quantitative perspective, it makes sense to incorporate a wide variety of factors into the equation, including not only valuation but also other numerical drivers based on financial quality, fundamental momentum, and relative strength. From that perspective, Chipotle is a solid sock in broad quantitative terms, but valuation is still quite demanding.

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Data from S&P Global via Portfolio123

In simple terms, the factors related to the timing of the position are clearly bullish, and the stock can easily continue doing well in the coming months. But valuation is uninspiring at current levels, and this is a major risk consideration for investors in Chipotle over the long term.

The Bottom Line

Chipotle is doing a great job in terms of recovering from its health safety crisis in 2016, and management deserves recognition for that. Nevertheless, it's hard to justify current valuation levels from a long-term perspective.

The company is a good name to add to a watchlist and consider buying on a price pullback. But, at current prices, the risk vs. reward tradeoff looks unattractive.