Why Chipotle Is Severely Overvalued

Shares of Chipotle Mexican Grill (NYSE: CMG  ) have been on a tear since the beginning of 2013, nearly doubling during that time. The chain of quick-service burrito restaurants has rapidly expanded while its earnings have grown at a blistering pace, and its over 1,500 locations generate $3.2 billion in revenue each year. While the popularity of Chipotle is undeniable, so too is the unrealistic valuation given to the shares by an overly exuberant market. While the company certainly has real growth prospects, the expectations of investors have sharply diverged from reality.

Comparing Chipotle
There is no doubt that Chipotle is a wonderful company and that its dedication to quality ingredients differentiates it from many of its peers. Operationally, Chipotle is top-notch with a high operating margin and an exceptional return on equity. However, the return that an investor achieves depends on the price paid for the shares, and in that regard Chipotle doesn't look so great. Here is a chart that compares Chipotle with Panera Bread (NASDAQ: PNRA  ) , a smaller chain with similar characteristics, and McDonald's (NYSE: MCD  ) , the global fast-food behemoth.

Chipotle and Panera have a lot in common. Both are roughly the same size, both use high-quality ingredients, and both have similar operational metrics. Chipotle has a higher operating margin and Panera has a higher return on equity, but both have grown earnings at roughly the same rate over the past five years, around 25%-27%.

It's surprising, then, to see that Chipotle is trading at twice the P/E ratio of Panera. While Panera sports a P/E ratio of about 27, a high number but one that is possibly justifiable given the company's growth, Chipotle's P/E ratio of 54 simply makes no sense at all. This isn't some upstart tech company that we're talking about, it's a chain of fast-casual restaurants.

The arguments for Chipotle revolve around the company's fantastic growth prospects, not only with its namesake restaurants but also with the company's concept Asian restaurant, Shophouse. While the company certainly has plenty of room to grow, it will face significant challenges as it becomes larger.

First, one of Chipotle's main draws is the quality of its ingredients, and as the company grows larger it will become more difficult to source high-quality ingredients. The company has already had some issues on this front, as a shortage of antibiotic-free cows caused its stores to occasionally resort to serving conventionally raised beef. This problem will only get worse as Chipotle grows, and maintaining Chipotle's rapid growth may require sacrifices on the quality front which would thus diminish the company's key advantage.

Another issue is the question of whether or not the Chipotle concept translates well to international markets. Almost all of Chipotle's restaurants are in the United States, with just 16 locations in other countries. There are two conclusions that can be drawn from this. First, the company has a huge opportunity in international markets. Second, the Chipotle brand is unproven outside of the United States.

There is no guarantee that Chipotle can achieve the same success abroad as it has in the United States, and investors should not treat this as a foregone conclusion. Another issue, going back to my first point, is that sourcing quality ingredients in markets like China and India is likely far more difficult than it is in the United States. The assumption that Chipotle won't enter markets abroad in a meaningful way until the ingredients become available may mean slower growth than many assume.

Chipotle has impressive margins, with its 16.5% operating margin besting that of Panera by about 3.5 percentage points. Looking at McDonald's metrics, it would appear that Chipotle still has plenty of room to grow its margins. McDonald's managed an operating margin in excess of 30% in 2013, nearly twice that of Chipotle. However, McDonald's has a very different business model than Chipotle, with a large portion of its restaurants franchised. Chipotle owns all of its restaurants, so the company will never even come close to McDonald's margins. McDonald's makes a lot its money by collecting franchise fees and rent, not selling burgers, and that's why the company's margins are so high. If anything, the difficulty in sourcing quality ingredients will lead to higher food prices and lower margins for Chipotle in the future.

The bottom line
Chipotle is a wonderful, well-run company, but investors are ignoring the issues that could sabotage the kind of growth that a P/E ratio of 54 demands. Chipotle trades at twice the P/E ratio of Panera, a company with similar characteristics, which is a clear sign that optimism has driven Chipotle's stock price up too high. Can the stock go higher? Sure. However, the stock no longer reflects the company's fundamentals, and that's a dangerous situation for overzealous investors.

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Read/Post Comments (7) | Recommend This Article (1)

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  • Report this Comment On March 31, 2014, at 9:42 AM, deepakchipotle wrote:

    The crux of your argument is faulty. These two companies really aren't all that similar. Panera has attempted to serve the lunch market with soups and sandwiches. My local Chipotle has long lines from lunch through dinnertime, and serves an entirely different clientele. In terms of quality, it's like comparing a generic supermarket with Whole Foods. Your other points are just trying to turn potential upsides into negatives, e.g. no international exposure. That simply means a tremendous growth opportunity for CMG, which YUM and other restaurants have seen abroad. You claim that a lot of bad things "may" happen as this company continues to grow. In other words, some growing pains. I'm guessing you shorted this stock recently. Good luck.

  • Report this Comment On March 31, 2014, at 12:36 PM, Addddam wrote:

    Disclosure: I own CMG, but eat at both restaurants.

    I am in agreement with deepakchiptle. One makes a decent sandwich - the other makes a sizable serving heaven wrapped in a halo of tinfoil. I have yet to hear anyone say, "You have GOT to try a Panera sandwich."

  • Report this Comment On March 31, 2014, at 1:22 PM, anindakumars wrote:

    This is an absolutely sound point - "sourcing quality ingredients in markets like China and India is likely far more difficult than it is in the United States" and applies to most Asian countries since there are no comprehensive food safety organizations or lax regulations and oversight.

    Plus a lot of people in america visit Chipotle because it is tasty and quick. That won't be the case in India or China or SE Asian nations, where road side food is quite common and extremely cheap. And some of these countries haven't been bitten by the "healthy eating" bug yet, since their native food is by and large more suited to the local climate.

  • Report this Comment On March 31, 2014, at 1:24 PM, anindakumars wrote:

    deepakchipotle - CMG won't get the same warm reception in India or Asian countries as a Starbucks or MCD got. Most Asian food already tastes similar to what CMG serves, in fact you could get better for less. MCD didn't have this problem since burgers et al were new to Asian countries whereas chicken with some vegetables are subpar to any Asian including myself.

  • Report this Comment On March 31, 2014, at 3:30 PM, Alexa225 wrote:

    Chipotle has a big opportunity to exploit in Europe before it goes anywhere near Asia.

  • Report this Comment On March 31, 2014, at 4:24 PM, whodidntante wrote:

    Wish I had skipped this article and went right to the comments... deepakchipotle hits the nail on the head...

  • Report this Comment On April 02, 2014, at 1:31 PM, deepakchipotle wrote:

    Anindakumars, there's no way to accurately gauge Chipotle's future sales in Asia. That was my main issue with the article: citing problems that "may" happen. Western companies doing business in China have never been assured of a warm reception. However, Ford's new car sales are booming. The demand for cow's milk is another change in Chinese tastes stemming from economic growth. Demands change along with the economy. Finally, isn't all food basically just protein with vegetables and carbohydrates? This kind of myopic, reductionist thinking is what fatally flawed the original article. PNRA isn't CMG. Asian street food isn't either.

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