Chipotle Has More Upside Potential


Chipotle Mexican Grill is one of the most spectacular success stories in the restaurant business over the last years. But the stock is trading at a considerable premium versus competitors like McDonald´s , Yum! Brands , and Buffalo Wild Wings . Can Chipotle continue outperforming in the long term?

On growth and valuation
Chipotle´s premium versus its competitors is easy to understand if we consider valuation ratios in the context of each company´s growth rates. Chipotle has outperformed big and stable companies like McDonald´s and Yum! by a wide margin, and the company has also done much better than another high-growth player like Buffalo Wild Wings during the last five years.

Even if Chipotle is materially more expensive than its peers in terms of P/E and forward P/E ratios, the PEG ratio - P/E divided by growth expectations - tells a very different story. Chipotle´s PEG ratio is moderately higher than those of McDonald´s and Buffalo Wild Wings, but cheaper than Yum!´s.

Higher growth rates deserve a higher valuation, so the right way to look at valuation ratios is in relationship to growth expectations. Wall Street analysts are expecting Chipotle to compound earnings-per-share growth at 21.4% per year over the next five years, and the company would be trading at a reasonable valuation if it can deliver that kind of growth.

Even if that would be a considerable deceleration versus the 32.7% annual growth rate Chipotle has produced over the last five years, it would still be a demanding target for a restaurant chain.

Besides, growth tends to slow down as companies become bigger over time, so extrapolating past performance into the future is not precisely the best way to evaluate growth prospects. On the other hand, Chipotle has plenty of room to run from a long term point of view.

Still hot
Chipotle delivered a strong earnings report for the last quarter, revenue increased by 18% to $826.9 million on the back of 37 new restaurants and a big jump of 6.2% in comparable restaurant sales during the quarter. Even as Chipotle continues expanding its store base, comparable sales performance shows that demand remains healthy and there is no sign of saturation or cannibalization at this stage.

Restaurant level operating margin was 26.8%, a decrease of 60 basis points from the prior year period due to rising food prices and marketing costs which management partially compensated with price increases. The company will most likely raise prices again in 2014 to translate higher costs to consumers:

As a result of this elevated food cost level and with expectations of making additional investments in moving to non-GMO ingredients for all of our food by sometime next year we expect to raise prices sometime in 2014.

Chipotle has proven an uncommon ability to continue growing while raising its prices, but higher food costs represent a considerable risk to watch in the near term.

The company reported diluted earnings per share of $2.66 during the quarter, a healthy increase of 17.2% versus the same period in the prior year.

What the future holds
In terms of long-term growth prospects, Chipotle still has plenty of opportunities. The company has 1,539 restaurants as of the end of the last quarter, and it plans to open between 180 and 195 new restaurants during 2014. Keeping in mind that demand remains as strong as ever judging by comparable restaurant sales, the company is doing the right thing by betting on growth via new store openings.

International markets are still practically untapped, Chipotle has only 14 international locations, and that represents a huge opportunity if the company can replicate at least partially on a global scale the same kind of success it's achieving in the US.

The company opened its third ShopHouse location during the last quarter, and it has plans to open more locations in Washington DC during the next year. Even if demand has been encouraging so far, both international expansion and ShopHouse are considered long-term growth opportunities as the company continues focused on opening new Chipotle stores in the U.S. as the main growth venue in the middle term:

We continue to view both ShopHouse and our international expansion as future growth opportunities rather than near term drivers of our growth. And we will continue to carefully support these growth seeds as we develop them for long-term success.

The company continues expanding its catering program to different markets and new products like its vegetarian entrée option Sofritas should generate more sales and wider variety for its customers.

All in all, Chipotle has plenty of room for growth, both in the middle and long term.

Bottom line
Chipotle is priced for growth, and current valuation levels make the stock vulnerable to any slowdown which may occur in the middle term. Rising food costs are a particularly important risk to monitor over the next quarters. On a long-term basis, however, the company still has huge potential for growth, so any pullback should be considered a buying opportunity in this red hot burrito company.

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Andrés Cardenal has no position in any stocks mentioned. The Motley Fool recommends Buffalo Wild Wings, Chipotle Mexican Grill, and McDonald's. The Motley Fool owns shares of Buffalo Wild Wings, Chipotle Mexican Grill, and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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