Chipotle: Love the Burritos, Love the Guac...But, Not the Stock

Nicholas Ward

Let’s be real, it doesn’t get much more “millennial” that Chipotle (CMG). Unfortunately, Chipotle doesn’t pay a dividend and therefore, the stock doesn’t fit perfectly into the Income Minded Millennial’s typical coverage area. However, as many burritos as I’ve eaten there over the years that I ought to own some stock, so I decided to put together a piece anyway due to recent significant weakness in the shares.

First Things First: Chipotle’s New CEO

I was halfway through putting this piece together when it was announced that CMG hired Brian Niccol, who had been acting as Taco Bell CEO since 2015, to the same position at Chipotle after the bell on Tuesday.

Admittedly, the big bump that CMG shares got on Wednesday due to hiring Mr. Niccol takes some of the teeth out of the bearish sentiment that this stock was facing prior to the move. As I write, CMG shares are up nearly 16% at $291/share. When I began this piece CMG shares were trading for ~$250/share. Needless to say, Mr. Niccol has been a blessing for Chipotle longs (especially if you added recently).

So, who is this man that has sent shares roaring higher by ~16%? He’s fairly young for the C-suite at 43 years old, but his performance at Taco Bell is undeniable. Taco Bell has been at the forefront of fast food trends for years now and has a bit of a cult following because of it.

Prior to leading Taco Bell Mr. Niccol worked for Procter and Gamble (PG) for 10 years. He has a proven track record of integrating technology into branding in innovative ways and it seems the market is bullish on his ability to integrate technology into Chipotle’s current platform, a la Patrick Doyle, superstar CEO at Dominos (DPZ). It’s worth noting that some speculated that Doyle might be a Chipotle target in recent months so while they didn’t land arguably the top leader in the fast food/fast casual restaurant space, they hired someone with a similar outlook and skills.

Mr. Niccol’s hiring added over $1b to CMG’s market cap. That’s a lot of value added for just one man. That isn’t to say the market over reacted. CMG has always had a ton of potential due to its relatively small footprint and (former) brand loyalty. If it could sure up some of its recent operation issues and innovate the menu to bring back the customers that it lost due to the food borne illness crisis, then I think the shares might justify a growth premium. However, at the moment, that’s a big “if” and I think it’s probably too early to tell if Niccol can bring Chipotle back to its former glory.

While there are certainly many positive aspects to CMG’s recent hire, I have my fair share of qualms as well. Taco Bell has been a well run company under Niccol, but as a consumer, I haven’t shopped there in years. Taco Bell is all about cheap, fast, low quality offerings. Their burrito cost something like $1.99 compared to Chipotle’s in the $8 area. Yes, Taco Bell’s menu is much more diverse than Chipotle’s and I think Niccol can bring new and exciting offerings to CMG, but I hope it isn’t at the expense of Chipotle’s desire to serve natural and local ingredients. And you know what, even though the quality of the food available at Taco Bell is questionable if you’re into health goods, they have a much better safety record that Chipotle, so Niccol has that going for him.

CNBC’s Jim Cramer went on a rant regarding CMG’s hire, highlighting the fact that the company’s message used to be, “food with integrity.” With this hire, Cramer seems to think that Chipotle has gone to the dark side after years and years of fighting against so many of the things that Taco Bell (and the rest of the fast food industry) stood for. He continues, saying that Niccol is “probably the most opposite guy you could possibly find” in terms of the cultures and general ethos of both companies.

In my opinion, Cramer nailed it. If you have a few minutes of time, watch this video. The differences in the ingredient lists of a beef burrito at Chipotle (as it currently sits) and the beef burrito at Taco Bell spoke magnitudes. This is why I eat at Chipotle so often; I don’t count calories, but I do like to know what it is that I’m ingesting. I know the names of plants and animals…but when more than half of the ingredients are in the scientific form, red flags fly up for me, personally.

Chipotle needs a change. The company needs rebranding. Heck, the company might even need a name change because the current brand is so tainted by food borne illness concerns. However, I don’t think the company needs to abandon its food with integrity model. The perception of clean eating is what originally attracted me (and hordes of others to Chipotle) and it would be a shame if they turned into yet another company purveying low quality food in pursuit of high margins and quick, repetitive production.

The Fundamentals

Bulls and bears will argue the pros and cons of Mr. Niccol’s hire, but at the end of the day, it’s all speculation. What isn’t speculative are the numbers that the company has put up in recent years/quarters.

Let’s start with the most recent quarter, released on February 6th. CMG posted revenue of $1.1b with represented 7.3% y/y growth. $1.1b isn’t bad, but it’s still less than the $1.2b that CMG posted in Q3 2015 before the food borne illness crisis began. I suspect that CMG will surpass those previous sales figures in another quarter or two; quarterly sales totals have been trended upward for a couple of years now as consumers slowly forget/forgive CMG for its safety issues.

The company opened 38 new locations and same store sales on the whole were up a meager 0.9%, though I suppose that’s better than negative comps that the restaurant had seen in recent quarters. Margins were up an impressive 1.4% to 14.9%. All in all, it was a fine quarter. I don’t think it was a smash hit, but it wasn’t terrible either.

At this point in time, it’s not the company’s operations that really concern me. I think it’s clear that the company is making a comeback from its August, 2015 issues. Instead, it’s the premium valuation that the market has been willing to pay for exposure to this performance.

CMG is being priced as if it is a leading growth company and this simply isn’t the case anymore. There was a time when Chipotle was viewed as a best in breed company in the new age, healthy fast casual space, but I think times have changed and this crown goes back to Panera.

Could Chipotle get its mojo back? Possibly. But do I want to put my capital at risk assuming so? No, I don't. Waiting for deeper value and/or better proven performance here could prove to have a high opportunity cost, but I'd much rather risk theoretical gains than actual losses.

Source: F.A.S.T. Graphs

Even after trading down from a peak of nearly $760/share back in August of 2015 to ~$280/share today, Chipotle is still trading with a 45x ttm EPS multiple. Even on a forward basis, with continued recovery and tax reform benefits (CMG primarily operates in the U.S. due to international growth issues) in mind, CMG is trading for 33x an $8.50 average analyst estimate for 2018 earnings.

Back in 2014, CMG posted 27.8% top line growth. I’d say that a 33x forward multiple might be justified for a company with that sort of growth. However, CMG only posted 14.7% growth in 2017 and while this is well above the -13.3% that it produced in 2016, I don’t think investors should be paying 33x for ~15% growth. If you’re looking for growth you could pay 20-25x forward multiples for Facebook (FB) or Alphabet (GOOGL) in today’s market who have top-line growth potential in the 20-40%, so why would you pay a 50% premium for CMG, which seems to have less potential?

What’s more, while CMG’s sales have nearly recovered to pre-crisis levels, earnings still have a long way to go. In 2015 CMG’s bottom line came in at $15.10. If it wasn’t for the crisis late in that year, I suspect the company would have posted EPS in the $18 area. Well, in 2017 CMG only produced $6.17 in earnings. 2018 estimates currently fall in the $8.50 range and looking 2 years out we see analyst estimates in the $10.80 area. $10.80 in 2019 would represent solid growth over the last couple of years, but paying ~26x for earnings 2 years from now, especially in a rising rate environment when these future earnings should theoretically be discounted further, just doesn’t make much sense to me.

So, What is the Right Price to Buy?

Obviously no one has a crystal ball and the answer to this question is highly subjective, depending on one’s risk profile, the level of their bullishness on Chipotle, especially under new management, and their view on the fast casual restaurant space as a whole.

Competition for CMG is rising with the likes of Del Taco, which posted 4.1% same store sales in its most recent quarter, Qdoba, which was recently taken private by Apollo Global Management (APO), and the myriad of local, mom and pop Mexican restaurants and food trucks that seem to be all the rage in many of the urban areas I’ve visited recently. It’ll be interesting to see how any changes that Niccol makes to CMG’s menu or operations effects the competition that CMG is in.

As far as growth goes, the restaurant space isn’t my favorite place to me, which is why I’m not willing to pay the current market premium for CMG shares. Like I said in the intro, I’m a regular customer of CMG. I like what Peter Lynch says about buying what you know. It does help investors stick with stocks through volatility and not make the common mistake of selling low rather than high. It also helps individuals make channel checks (albeit small ones); I’ll surely be able to keep tabs on any changes that new management makes during my regular trips to the local stores.

Using the ~$8.50 and ~11.00 forward looking multiples, I’ve decided to target shares in the $200 area, which would represent ~23x and ~18x multiples on 2018 and 2019 EPS estimates, respectively. In other words, I’m willing to take a chance on Chipotle with a relatively small percentage of my portfolio at a similar valuation to Facebook (which is another company that has tremendous growth prospects but also faces strong competition and potentially significant operational headwinds; Facebook’s come in the form of government oversight/legislation and Chipotle’s come in the form of the tarnished brand name via potential changes my new management makes and/or continued food safety concerns).

If/when I buy Chipotle, it won’t be a large position for me. CMG doesn’t pay a dividend and remains highly speculative at this point in time. With that said, the company has a relatively small footprint in terms of store fronts and I think its food with integrity message will continue to resonate once it puts together a streak of incident free weeks/months in terms of food borne illness. I don’t know if it will see its prior highs in the $750 range any time soon, but I think there will become a time when the risk/reward is attractive, even to conservative investors.

We’ll see in this Niccol bump is long lasting or not, but in the mean time, I will continue to monitor this company’s stock while I add to the top line via several weekly burritos: brown rice, pinto beans, chicken, pico, corn, lettuce, sour cream (and guac, if my pocket book is heavy enough that day).

disclosure: I am long FB and GOOGL.