How Low Can Chipotle Mexican Grill Stock Go?

Image source: Chipotle Mexican Grill, Inc.

In early March, shares of Chipotle Mexican Grill (CMG +1.47%) rallied from nearly $400 a share to reach $540. But optimism that it had recovered from food-borne illness incidents that struck last year soon dissipated, sending its shares back down to within reach of its 52-week low.

Trading below $400 per share today, investors may feel tempted to load up on the burrito maker's shares. Before doing so, however, it would be prudent to think about further downside risk to the company. With this in mind, let's take a look at a pessimistic scenario where same-store sales don't make a meaningful recovery, unit growth falls below management's goal, and profit margins shrink as Chipotle loses pricing power and operational efficiencies.

A new baseline

Prior to last year's E. coli incidents, the average Chipotle restaurant generated $2.5 million in revenue. In the two quarters after its initial food-borne illness case, same-store sales declined 15% and 30%, respectively. However, there were signs of improvement as management reported that April sales declined 26% while transactions were down about 20% when excluding the benefit of the Easter holiday. In some parts of the country, comps improved to negative 15%.

After an aggressive marketing campaign that included free and discounted burritos, the transactions number should improve when Chipotle reports second-quarter earnings on July 21. Some customers may cash in their free burritos and never come back, but I imagine that an incident-free experience will be enough for many former Chipotle enthusiasts to return. Assuming what I believe to be a worst-case scenario that same-store sales stay 15% below their peak, average restaurant revenue would be $2.15 million per location.

Declining market opportunity

Despite the decrease in same-store sales, management hasn't throttled its pace in opening new locations. Chipotle opened 58 new restaurants in the first quarter and management said it plans to open 220-235 locations for the entire year. This will pay off if customers come back, but if sales stagnate then management will be forced to temper growth.

This ties into the fact that Chipotle had negative free cash flow in the first quarter. For this to turn positive, either sales and profits must increase, or investments in new locations must decrease.

For present purposes, I'm assuming that Chipotle maintains its current pace of store openings for the remainder of this year. If it hits the low end of its guidance, that will result in 2,228 locations. At one point, co-CEO Monty Moran hinted at a domestic market opportunity of over 4,000 locations. Although management would like to continue its growth momentum, let's assume a pessimistic scenario where the company's near-term prospects top out at 2,500 locations. 

Shrinking margins

At the end of April, Chipotle reported its first quarterly loss as a public company. Its two main variable costs, food and labor, were impacted by elevated expenses from improved food safety processes as well as higher legal expenses driven by a criminal investigation from the Department of Justice.

Chipotle can expect higher costs in the near-term, as it continues promotional activity and defends itself against shareholder and consumer lawsuits. But these should dissipate over time, leading to normalized profit margins, which, as you can see in the table below, have tended to fall between 9% and 11%.

Source: Company filings. Author's 

As referenced earlier, the pessimistic forecast for average restaurant sales at Chipotle are $2.15 million per location. The last time Chipotle's sales were at this level was 2013. Net profit margins that year were 10.2%. Going forward, I don't expect Chipotle to have the pricing power it once had. Therefore, I believe a low-end scenario of a 9% net profit margin is a realistic gloomy scenario.

Putting it all together

Armed with new assumptions for average restaurant sales, total locations, and net profit margins, we can come up with a rough estimate of the downside risk to Chipotle's shares. First, let's take a shot at measuring future profits.

Chipotle ended the first quarter with about 29,893,000 shares outstanding. It announced in May an authorization to repurchase an additional $100 million in shares, but for our purposes let's assume the share count doesn't change. Using the net income above and dividing it by its current share count future earnings per share would be $16.19 per share.

Chipotle has never been a "cheap" stock according to the price-to-earnings ratio. Today, the stock trades at 39 times trailing 12 months' earnings, while the 5-year average is 45. Because its earnings are depressed today, that number will naturally be inflated. But even during the depths of the great recession, Chipotle's P/E ratio averaged 22.

Since I'm modeling a hypothetically mediocre restaurant, let's slap a mediocre multiple on the company. DineEquity is the parent company of Applebee's and The International House of Pancakes. It reported a sales decrease of 7% in its latest quarter and trades at 15.4 times its trailing 12 months' earnings. This is a good baseline in a worst-case scenario.

So in a doomsday scenario, where the once mighty Chipotle Mexican Grill fails to make a meaningful recovery, its shares could theoretically trade for 39% lower than today's $397 price tag. But even the most pessimistic of Chipotle bears probably wouldn't compare the company to Applebee's and IHOP, so a situation where the fast-casual chain trades closer to $300 per share seems more realistic. This would put the downside at closer to negative 24%.

Bear in mind that this analysis doesn't include any growth from ShopHouse or Pizza Locale, Chipotle's Asian and pizza concepts. If these catch on, the downside would be even less. And if Chipotle is able to eventually grow same-store sales to pre-crisis levels or increase its store count above 2,500 locations, today's price could be a bargain. If you are a believer in any of these scenarios, today's price may even be a buying opportunity. However, it would be wise to consider the worst-case scenario as well in case a recovery never occurs.