Rising Star Buy: Chipotle

This article is part of our Rising Star Portfolio series.

I've been coveting shares of Chipotle Mexican Grill (NYSE: CMG  ) to buy for the real-money Rising Star portfolio I'm managing for Fool.com for quite some time now. I kept waiting for a more reasonable price.

Sometimes waiting is how investors miss out on stellar returns; when will some of the greatest stocks our marketplace has to offer finally look "cheap"? It may take a really long time. So, I'm throwing over-caution to the wind and finally taking a bite of Chipotle.

The business
Formed in 1993, Denver-based Chipotle provides delicious burritos and other Mexican fare at a fast-food pace.

Oddly enough, in 1999 Chipotle became a subsidiary of fast-food giant McDonald's (NYSE: MCD  ) . Mickey D's divested Chipotle and it went public in 2006. One thing Chipotle has in common with its former parent is serious speed. In some locations, Chipotle has been able to serve more than 300 customers in an hour. Chipotle also allows customers to place orders by fax, online, and even though an iPhone app.

With the exception of the quick-serve element, Chipotle and its former parent McDonald's have little in common. Part of Chipotle's secret salsa has been its "Food With Integrity" mission. This mission goes far beyond fresh ingredients and burritos made before customers' eyes. Chipotle has committed to turning the traditional fast-food model on its ear, "serving customers the very best ingredients, all raised with respect for the animals, the environment and the farmers."

Chipotle does its best to source naturally raised meats, and a good percentage of its beans are organically grown. Chipotle also tries to serve locally grown produce when possible and when in season. Part of its mission is to seek out sustainable ingredients as well as ingredients that are free of pesticides, hormones, and antibiotics.

Why I'm buying
Chipotle is a well-run company that exemplifies purpose over profit, which is why it's a perfect addition to this portfolio.

Granted, I was hoping its most recent quarter would deliver a disappointment (and a relatively bargain price), but unfortunately for bargain hunters, Chipotle just delivered the same kind of amazing quarterly results it always does.

Chipotle still looks like one heck of a pricy stock. It's trading at 38 times forward earnings, and sports a PEG ratio of 2.13. This looks pretty insane compared to McDonald's, which trades at 15 times forward earnings (granted, Mickey D's PEG ratio is currently 1.70). Panera Bread (Nasdaq: PNRA  ) (which my colleague Jason Moser bought for his Rising Star portfolio) also commands a premium-looking price but looks cheaper than Chipotle, trading at 24 times forward earnings and a PEG ratio of 1.48.

Then again, who wants to buy fast-food purveyor Wendy's (NYSE: WEN  ) , another quick-serve rival? It may be in slightly better shape after ditching Arby's, but still trades at 21 times forward earnings and a PEG ratio of 1.29. I'd take Chipotle any day.

Chipotle's got plenty of solid reasons to command a premium price. Take room for growth. There are currently about 1,230 Chipotle restaurants. Compare that to McDonald's (33,510 restaurants, mostly franchised) or Wendy's (6,594 restaurants, again, mostly franchised). Panera is a bit ahead of Chipotle in terms of store count, with 1,541 restaurants (franchised and company owned).

In addition, as Sara Wright wrote recently on Fool.com, Chipotle is testing a promising ancillary concept, ShopHouse Southeast Asian Kitchen; there's already one in Washington, D.C., and Chipotle plans to open another in 2012. There's plenty of potential in Chipotle taking its operational expertise at wrapping quick, wholesome burritos and extending it to other fare, thereby giving it far more growth possibilities than Mexican burrito-peddling alone.

Chipotle's incredible growth over time gives us another reason to understand its high multiples. Check out compound annual growth rates for Chipotle versus the aforementioned quick-serve peers.

Company

Revenue, 5-Year CAGR (LTM)

Net Income, 5-Year CAGR (LTM)

Gross Profit, 5-Year CAGR (LTM)

Chipotle 22.5% 38.2% 25.1%
McDonald's 5.2% 8.6% 8.8%
Panera 16.8% 19.6% 17.5%
Wendy's 14.4% NM 11.9%

Source: S&P Capital IQ. LTM = last 12 months. NM = not meaningful.

Granted, in investing we're really focused on future returns, but given Chipotle's relatively modest store count, room for growth here and internationally, and the idea that it can translate its expertise to other concepts and cuisines, there's good reason to believe Chipotle can continue to deliver spicy growth for some time to come.

And now, the risks
I repeat: Chipotle's a highflier with a premium valuation; there's no doubt about that. Any investor who's been around the block a couple of times knows that a whiff of disappointment can send shares of such stocks plunging. (Should that occur, unless there's a severe problem with the business, it would make a perfect opportunity to buy more.)

Although Chipotle's Food With Integrity mission is a major reason I'm buying, it also spells out a particular challenge for the company. In its most recent 10-K, Chipotle warned that it is running up against shortages of naturally raised chicken and steak. In some of its restaurants, it has had to switch back to conventionally raised beef due to supply constraints early this year.

Rising food costs are an issue for all restaurants, and many of the ingredients Chipotle has sworn to include on its menu when feasible are often more expensive and in shorter supply. In addition, some competitors have caught on to increasing consumer attention to food issues like the ones Chipotle has addressed, and have begun offering similar ingredients. Emulation is flattery, but if enough rivals make these moves, Chipotle won't be as well differentiated.

Labor issues can hit Chipotle, too, and not just in the form of higher worker salaries. In 2010, the Department of Homeland Security conducted an audit at Chipotle's Minnesota stores, and the company lost 450 employees who happened to be unauthorized immigrants. Although Chipotle said it requires all workers to provide the correct documentation to ensure its employees are eligible to work in the U.S., clearly this issue has cropped up and could impact Chipotle. It's also undergoing current audits in Virginia and Washington, D.C.

Foolish bottom line
Overall, the future is bright for Chipotle, and I've long believed it's one of the truly great, innovative companies out there. Anchoring too much on valuation can cause investors to miss out. I'm taking a helping of the burrito stock for this portfolio, and looking forward to the future for the company and Food With Integrity.

I mentioned Chipotle's international potential as one of the biggest growth drivers in the future, but if you'd rather buy shares of companies that are already operating abroad with aplomb, I invite you to read "3 American Companies Set to Dominate the World." It's a free report our analysts have penned, and you can read all about it by clicking here.

Alyce Lomax does not own shares of any of the companies mentioned in her personal portfolio. The Motley Fool owns shares of Chipotle Mexican Grill and Panera Bread. Motley Fool newsletter services have recommended buying shares of McDonald's, Chipotle Mexican Grill, and Panera Bread. Motley Fool newsletter services have recommended creating a bear put spread position in Chipotle Mexican Grill. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (20) | Recommend This Article (27)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 27, 2012, at 12:09 PM, futbolgenius wrote:

    Braver than I, Alyce. I don't doubt there's money to be made here. But goodness, I'll be on the sidelines until that quarterly disappointment comes and then take up a short position.

    Institutional ownership of this stock is at or near 100%. It seems that the shares are being passed back and forth to make money for the big boys. Quite when we hit critical mass will be a very interesting question, the correct answer to which would make the short-seller a wealthy individual.

    My one specific concern besides valuation is cannibalization by their own stores, and by proxy market saturation. Where I live, you can seemingly run into a Chipotle every 2 miles, and they're building more! What happens when comps stagnate?

  • Report this Comment On April 27, 2012, at 12:36 PM, GordonsGecko wrote:

    Speed? Not at the Chipotle near me, brother (south portland, Maine). One register. Seemingly at least one new trainee every time I go.

    If I go anytime between 5:30 and 8pm, I need to give myself at least 20 minutes....just to get my food. That is not fast.

    On at least 3 occasions I have walked out of line because it was so slow and I had to be somewhere. I love the food. I love the brand. I own the stock.

    I just wish that our store up here had the speed you speak of.

  • Report this Comment On April 27, 2012, at 2:06 PM, zpoet wrote:

    ^^ 20 minutes because the line was long.... definitely not because they are slow to prepare your food!

  • Report this Comment On April 27, 2012, at 4:46 PM, GordonsGecko wrote:

    Incorrect. The lines aren't that long. Maybe 15 deep at most. You can take a look at the reviews on yelp and find support for my comments. The location is plagued by slow service...both for in store orders and (worse) on-line orders.

    The problem is two-fold - slow employees and only a single cash register. The first issue is somewhat understandable as everyone needs training at some point. But, it does seem like someone is always getting trained. Maybe I'm off my rocker...maybe not.

    The 2nd issue is simple operations management 101. Identify the bottleneck and correct it. In this case, another register. Not difficult at all.

  • Report this Comment On April 27, 2012, at 7:51 PM, tennis1972 wrote:

    its a bunch of overated slop with loads of sodium and do some research there chicken is mixed in with dark meat so they can save money and now as the author just noted they are not buying naturally raised steak until prices come down. As far as the stock price it is going much lower as they have no chance of making 2nd quarter numbers.

  • Report this Comment On April 27, 2012, at 9:24 PM, Rouleur wrote:

    Tennis-are you serious? They beat almost every quarter. Please short the stock, it help provide a great pop when you get squeezed.

  • Report this Comment On April 28, 2012, at 2:41 PM, crca99 wrote:

    I'm ok saying I missed this opportunity. There will be other chances to make money. I have purchased high flying growth companies before only to watch the business continue to grow, but P/E multiple shrink, and stock stagnate.

  • Report this Comment On April 29, 2012, at 3:48 AM, LoadDrive wrote:

    I want to buy this stock, but that said "I think I'll wait just a bit and see if it comes down some! But wishing Good-Luck to anyone that buys at these prices !

  • Report this Comment On April 29, 2012, at 10:31 AM, buffalonate wrote:

    I own Buffalo Wild Wings, Panera Bread, and BJ's Restaurant but I wouldn't touch Chipotle as an investment. The valution is ridiculous. If their p/e ratio ever gets around 35 I would be a buyer. The way Chipotle is valued now is too risky to own. One bad quarter and half of the companies value will vanish.

  • Report this Comment On April 29, 2012, at 7:02 PM, Darwood11 wrote:

    Sorry, but I think CMG is overvalued. Gross margins peaked and are falling.

    There is no doubt that CMG is a leader in its sector. That however is insufficient to get me to buy. At 4x 2010 prices, I think it's expensive.

  • Report this Comment On April 30, 2012, at 10:38 AM, drgroup wrote:

    How anyone can buy this stock at over $400/sh is beyond me. The food is horrible if you enjoy eating healthy. Paying $7.00 a plate for gobs of dried out rice, overbaked beans, bland non-dicript meats and mystery veggies is waste of hard earned money. Give me Pollo Tropical anyday over the overrated SOS at Chipole....

  • Report this Comment On April 30, 2012, at 10:09 PM, TrojanFan wrote:

    I couldn't disagree with this pick more. It is at the top of my list of companies that I would consider shorting in the next downturn.

    Anchoring too much on valuation???

    That is investing blasphemy!!!

    There is nothing more fundamental to an investment decision then valuation. It trumps all other factors. Without sensible initial valuation, you are relying almost entirely on speculation regarding future execution which may or may not ever materialize. You are also relying on the greater fool theory (small f) in order to realize your investment thesis. Basically, you're hoping the next person will accept an even more outrageous valuation then you did.

    Here's the most important valuation metric of all and that is enterprise value per location.

    CMG's share price implies a valuation per store of aroung $10 million per location. That is absurd any way you slice it!

    That is an average number of course.

    I recommend that you and all of your reader who might be considering following this recommendation swing by their local Chipotle and ask yourself would you pay $10 million to buy this location. They generate about $3 million of sales per location with considerably less then that in profits.

    It doesn't make sense to pay up for growth that hasn't happened yet on the hope that it one day will. Basically you are spotting the market the first 5 years or so of actual business execution to "grow into" your starting valuation. If your returns are flat or worse over the next five years, don't be surprised.

    Just about the only factor you control in investing is what you pay when you buy and that is all about valuation.

    By the way, if you buy into Wendy's that's more like $500K per location. Sure it's a lower growth business, but there is a turn around story that's underway there and the valuation is much more reasonable and there management team is very good. They just passed up Burger King to become the 2nd largerst burger chain by sales in the US 2nd only to McDonalds, of course.

    If you'd be unwilling to pay $10 million to own a single location then you should also be unwilling to pay $13 billion to own all of them. This is sensible advice.

    Wendy's isn't sexy like Chipotle. It doesn't have the "sustainable and environmentally friendly" food story going for it, but that's the point. Successful investing of the Warren Buffet variety is all about avoiding sexy because it's too expensive and instead seeking out the boring and the unloved because it's cheap.

    If you seek the comfort of popularity in your investment decisions that is very likely to end in dissappoint, disillusionment and inferior returns.

    This is a lesson that I learned the hard way in the dot com bubble and I hope to save many of your readers similar pain, dissappointment and economic losses.

    Investing in unrealized future potential is a dangerous proposition.

    I've analyzed this company from many different directions and my analysis keeps telling me that its fair value is somewhere in the $150 to $170 per share range.

    Don't get me wrong. It's a good company and I like their food, but that doesn't mean it will make a good investment at these prices. If it ever becomes available at a price below the range noted above (and don't think that it couldn't) then it might be worth considering to buy. At these levels that is an insane investment that leaves little to no room for errors in business execution or encroaching competition. There is no margin of safety at this price.

  • Report this Comment On May 01, 2012, at 2:54 PM, drillerjim101 wrote:

    Reading all these dour posts has made me hungry...I'm going to get a CMG burrito!

    James Fregia

  • Report this Comment On May 01, 2012, at 6:39 PM, CaptainWidget wrote:

    Chipotle doesn't have nearly the same kind of grown potential as McD. A mexican burrito from an American chain isn't going to go over very well in China or the Ukraine. They're just going to go say "why?"

    Their store growth is also hampered by the fact that they no longer franchise. The entire capital for every store needs to come internally. There's got to be a point of diminishing returns somewhere.

    I think it's rated 2 stars for a reason

  • Report this Comment On May 04, 2012, at 1:18 PM, Truth2Power wrote:

    "A mexican burrito from an American chain isn't going to go over very well in China or the Ukraine."

    Don't be so sure. After all, what Mexican chains do you know that could enter the Chinese or Ukranian market on the scale that Chipotle could? I wouldn't have believed that the French would take to McDonald's the way they have, but if you go to Paris, bags with the golden arches are everywhere.

    Guess there's no accounting for taste ;)

  • Report this Comment On May 09, 2012, at 4:58 PM, ravens9111 wrote:

    I know most on here probably don't look at charts, but CMG is broken on the daily. If you look at the weekly, it bounced off the 20 dma but most likely will head lower towards the 50 dma where there is some support between 300-350. I would wait for that price as a buy point if it can hold. Let it form another base. Once it breaks out of that new base, then I would go in. In the grand scheme of things, 300-350 is only about 15% away. It's not a huge drop from where it is today. Never chase a stock on the way up and never buy a falling knife.

  • Report this Comment On May 11, 2012, at 11:15 AM, StopPrintinMoney wrote:

    current PE is 56. Are you seriously buying this stock???

  • Report this Comment On May 11, 2012, at 11:19 AM, StopPrintinMoney wrote:

    btw the stock is trending down (check the technicals yourself) , so if you are determined to buy it, wait for the price to get lower. https://www.tradingview.com/v/CoKx8qyS/

  • Report this Comment On May 19, 2012, at 10:32 AM, assisgnmeaname wrote:

    "Chipotle is a well-run company that exemplifies purpose over profit, which is why it's a perfect addition to this portfolio."

    - Hey Alyce...what do you make of the SEC investigation of CMG's management? It must be related to their lack of disclosure about the long-running illegal immigrant hiring scandal. What is the "purpose" of that? Not sure who should be angrier...the right wing, mad about the hiring of illegals to begin with, or the left wing furious over duping poor undocumented workers into jobs that documented workers apparently wouldn't take...in any case if I was a big mutual fund holding CMG stock I would definitely be worried about the increasing stink this food with integrity is emitting. BTW, do you or others at Motley Fool get any direct or indirect compensation for your insights? I would think the SEC should take that whole enchilada into account. Stay tuned.

    And yes, I am short the stock.

  • Report this Comment On January 29, 2013, at 10:05 PM, bcellars wrote:

    Very interesting to read all this in hindsight. I watched it go up and up, wondering why and how long it would continue. It's nice to know that 'experts' can also be oh so wrong and make basically, dumb emotional investments like the rest of us.

    Lesson learned: smack your hand and don't let it hit the buy button. And if you really, really must, then just buy a tiny bit and hope that it goes down.

    And then in July she bought more at the bottom of the slide, just before it hit the cliff and plummeted from $400 to $300. Yikes!!

    After the second plummet to below $240 I couldn't resist taking a closer look and after reading how much people like the product and how long the lines are, I figured now it's worth risking some real money, but still, only a little.

    It's recovered nicely since then, and I think I'll let it run a little longer before cashing in half. The same strategy worked out well last year with GMCR and TPX and DECK. I didn't pull the trigger on FSLR unfortunately but I wasn't convinced its troubles weren't real and across the whole sector.

    Bottom line. It's encouraging to see 'experts' make bad decisions. I've made my own as a rookie, but you can be sure I won't be buying at the top ever again. Advice to other rookies: be patient!!! And don't jump on the fallen stock too quickly either. Give it some time to make sure it's really the bottom.

    ps. I think a first position in AAPL wouldn't be a bad idea now, but it could easily go lower before it hits bottom.

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