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Chipotle Looks Like a Buy — But One Pitfall Looms

Published 30/12/2022, 14:10
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  • CMG isn’t cheap, but given impressive growth it shouldn’t be.
  • A long history of outperformance suggests the recent dip can be bought.
  • But one key risk looms on the margin front.
  • Even with a 15% decline over the past four weeks, Chipotle Mexican Grill Inc (NYSE:CMG) stock looks like a dicey pick here. In a nervous market, shares trade at 41x this year’s consensus earnings per share estimate. Inflation and, potentially, recession are both obvious risks.

    But fundamentally, CMG does in fact look attractive on the dip. Without exaggeration, this might be the best restaurant business of the century. Barring a very good reason — and Chipotle did take a big hit from the e.coli outbreak of 2015 — CMG is not going to be cheap. And in the context of current growth, the valuation here looks reasonable at worst.

    Of course, that in turn requires that current growth continues. On that front, there is one key risk investors can’t ignore.

    Why Chipotle's Valuation Is Better Than It Looks

    41x earnings is a steep price to pay in this market, but at the rate Chipotle is going, its earnings multiple is going to compress in a hurry.

    Earnings per share should grow about 31% this year. At the moment, Wall Street consensus sees another 29% increase in 2023; even the low estimate implies 23% growth.

    At 32x forward earnings, and with 20%-plus growth going forward, the fundamentals here can work. That’s particularly true given that growth doesn’t necessarily have to end.

    Chipotle still sees a path to 7,000 locations over time, up from a current 3,000. That store count growth requires entry into small-town markets — and early returns from that strategy are strong.

    As long as same-store sales keep growing, the steady boost from new restaurants should drive earrings higher — and CMG stock with it.

    Inflation and Recession

    One obvious concern is that the external environment will throw a monkey wrench in that strategy. Inflation is a risk to any restaurant chain, even one like Chipotle that, relative to the industry as a whole, operates at a lower price point. Should inflation be combined with a recession in 2023, Chipotle traffic likely slows, and so does growth.

    This risk can’t be completely ignored — but it’s worth noting that Chipotle has managed through the current environment just fine. At the restaurant level, operating margins year-to-date are positive, including a 180 basis point expansion in the third quarter. And management said on the third quarter conference call that while the chain is losing visits from lower-income customers, more well-off patrons are purchasing with increasing frequency.

    Chipotle has to keep executing, of course. But if 2023 looks like 2022, investors should have some confidence that the chain will be able to manage through.

    Labor concerns the bigger threat

    That is, assuming the company can keep labor expense in check, and keep its restaurants staffed.

    Here too it’s been so far, so good. Labor costs rose about 11% year-over-year in the third quarter, while revenue increased 14%. Year-to-date, the two metrics have risen roughly in line.

    But Chipotle is ramping up its store count, and adding drive-through lanes as well. Guidance for 2023 suggests the total number of restaurants will increase about 9%. As noted, some of those new locations will be located in smaller markets which already may be facing a stretched labor market.

    Chipotle’s size and brand likely give it an edge against other employers, but managing labor might be the biggest challenge the company faces in 2023. Wages that outpace revenue would pressure the company’s industry-leading margins, and dim the bottom-line growth being created by same-store sales growth and new restaurant development. But understaffed restaurants could turn away customers, chipping away at the multi-year turnaround Chipotle has executed.

    As a result, investors need to trust management, and the brand. But if they do, this dip in Chipotle stock is an opportunity.

    Disclosure: As of this writing, Vince Martin has no positions in any securities mentioned.

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