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Chipotle: The Recovery Continues

Chipotle (CMG) recently reported results for the third quarter of fiscal 2019.

Revenues in the quarter increased by 15% to $1.4 billion. Growth in the quarter was attributable to a 3% year-over-year increase in the number of restaurants, as well as an 11% increase in comparable store sales (comps). The increase in comps was driven by traffic / transaction growth (contributed 7.5 points) and an increase in price / mix as a result of menu price increases implemented last year (contributed 3.5 points). As shown below, the company's comps have consistently improved over the past two years and have been in the double-digits each of the past three quarters.


The significant increase in revenues (+14% year to date to $4.1 billion) led to operating leverage, with operating margins up 230 basis points to 8.3%. As a result, Chipotle has delivered a significant increase in profitability through the first nine months of fiscal 2019.

Non-traditional (standing in line) orders are driving meaningful growth for Chipotle. As CEO Brian Nicol noted on the call, "digital remains highly incremental and we continue to see residual lift in delivery sales that last beyond any promotion". In the quarter, digital revenues nearly doubled year-over-year, and now account for 18% of Chipotle's total revenues (a run rate of roughly $1 billion).

Chipotle is also seeing early signs of success with "Chipotlanes" (think of a fast food drive-thru lane, with the twist that orders must be placed online), with plans to have it offered at 60 locations by year end (compared to a store count of ~2,630). Looking ahead to 2020, Chipotle plans to open 150 - 165 net new restaurants (implies ~6% YoY unit growth), "with more than half including Chipotlanes". While its not feasible to add Chipotlanes at the majority of the company's legacy locations, I think this an interesting long-term opportunity for the company that helps address one of the biggest problems they face at busy locations (throughput).

Valuation

While it's clear that Chipotle has made meaningful strides in recent quarters, I'd argue the stock price largely reflects that reality. Said differently, Mr. Market is much more optimistic about the long-term prospects for this business than he was just a few quarters ago.

Let's put some numbers on that: assume that terminal / normalized margins are 200 basis points below the fiscal 2015 peak (when Chipotle reported 26.1% restaurant margins and 17% EBIT margins on $2.4M AUV's), with the difference due to incremental food safety costs (management previously said to expect 100 - 200 basis points in higher run rate expenses) and higher marketing spend over time as the brand ages and customer acquisition becomes more expensive. Note that this outcome would require operating margins to nearly double from the 8.3% reported through the first nine months of fiscal 2019 (And for what it's worth, here's what CFO Jack Hartung said about operating margins on the call: "I would say that from an overall margin standpoint, we're pretty much right on track... at $2.1 million AUV's, we should generate a 21% [restaurant level] margin and we're right about there... if we get back to our peak volumes of $2.5 million, we're still confident that we'll be right in that margin range of 25%. So, we think the flow-through so far is on track.")

On top of the significant operating margin expansion, let's assume that comps normalize at +4% per annum and the unit count increases by 6% per annum (with that latter estimate in-line with what Chipotle should report in 2019 and 2020).

Given those assumptions, revenues and net income five years out (fiscal 2023) will be around $8.1 billion and $890 million, respectively. I also give the company credit for $825 million a year of repurchases over the next few years (to account for the cash accumulating on the balance sheet, which leads to a roughly 25% decline in the share count by 2023 (cumulatively).

With those assumptions, which I would argue are quite generous, Chipotle would earn just north of $40 per share in 2023. At a low-twenties multiple in the terminal period, that's roughly $900 per share. Discounted at 9%, that gets you to a present value of $590 per share - or roughly 25% below where the stock currently trades.

Conclusion

It's interesting to think about the trajectory of this stock over the past five years. In 2015, the valuation implied that the runway stretched for miles and that management could do no wrong. Two years later, following the food safety issues and the failure of new concepts like ShopHouse and Pizzeria Locale, the investment community became quite doubtful that this company would ever return to its former glory. Today, I would argue that we are back to a position where the valuation suggests that many once again believe that the future is very bright for Chipotle. Personally, while I think the company will continue to perform well, I can't justify today's stock price. I think you have to believe AUV's and margins will rival - or even exceed - the levels reported at its peak in 2015. I don't think that's a conservative base case. For that reason, I am not interested in buying CMG at these levels.(Long-time readers may remember that I owned the stock a few years back - and sold way too early. So maybe I'm just salty that I missed out on some huge gains. Time will tell.)

Disclosure: None

This article first appeared on GuruFocus.