I have been bullish about Chipotle Mexican Grill (NYSE:CMG) for several years, believing that Chipotle would eventually recover from its food safety problems. During 2018 in particular, the fast-casual pioneer made a lot of progress in accelerating its comp sales growth and returning to margin expansion (excluding one-time costs).
As a result, Chipotle stock has roughly doubled over the past year. On Wednesday, the stock hit a new multiyear high near $640 before retreating a bit, driven by optimism around the rollout of its long-awaited loyalty program.
However, with Chipotle stock having surged back toward its all-time high so quickly, shares of another up-and-coming fast-casual chain are starting to look attractive by comparison. Here's why I'm thinking of selling my remaining Chipotle shares in order to buy Shake Shack (NYSE:SHAK) stock.
Superior growth potential
Chipotle's 2019 guidance calls for a solid mid-single-digit comp sales increase. This strong outlook has been a key driver of Chipotle stock's huge year-to-date rally. Including the addition of new restaurants, analysts expect Chipotle to grow its revenue by 9% this year, followed by roughly 10% growth in 2020.
By contrast, Shake Shack's guidance calls for 0% to 1% comp sales growth in 2019. However, the company is adding new restaurants at a furious pace. Last year, Shake Shack expanded its base of company-operated locations from 90 to 124, with half of its 34 restaurant openings occurring in the fourth quarter. Shake Shack plans to keep its foot on the accelerator this year, opening between 36 and 40 new company-operated restaurants.
The net result is that Shake Shack expects revenue to surge 24% to 25% this year to a range of $570 million to $576 million. That would build on a 28% surge in revenue last year.
Shake Shack is planning for a similar level of new restaurant openings in 2020. In the long run, management sees the potential for at least 450 domestic company-operated Shake Shacks -- plus a large base of licensed locations, primarily abroad. Chipotle, which opened its 2,500th restaurant last month, simply doesn't have the same level of revenue growth potential.
An expansion-and-scale story
Bears are concerned about Shake Shack's meager comp sales growth -- especially because the company is relying on price increases to offset traffic declines -- and its relatively low pre-tax margin. However, these common metrics are not very useful right now, due to Shake Shack's small size and rapid growth.
First, Shake Shack doesn't add restaurants to its comparable base until they have been open for 24 months. At the end of 2018, just 61 of its 124 company-operated restaurants were in the comp base, so fluctuations in sales at a relatively small number of restaurants -- particularly in Shake Shack's home market of New York City -- can have a big impact on comp sales growth.
Second, because Shake Shack is growing quickly, it frequently cannibalizes sales at existing restaurants when it opens new ones nearby. This will be a significant headwind to comp sales growth and comp traffic growth for the foreseeable future.
Third, while Shake Shack's guidance implies that its pre-tax margin will fall below 5% this year, the company is incurring substantial expenses to support future growth. A surge in the minimum wage in many of its key markets has also weighed on Shake Shack's profitability recently.
That said, Shake Shack's restaurant-level operating margin was 25.3% last year. Management expects that metric to come in between 23% and 24% in 2019. By contrast, Chipotle posted an 18.7% restaurant-level margin last year. These strong unit-level margins mean Shake Shack could have enviable margins a decade from now, when it will have much greater scale.
Chipotle stock is cheaper, but Shake Shack looks like a better buy
Shake Shack stock currently trades for a sky-high 89 times its projected 2019 earnings per share. Meanwhile, even after its huge rally over the past year, Chipotle stock trades for a comparatively modest 52 times its projected 2019 EPS.
However, Shake Shack could deliver explosive earnings growth over the next decade or so as it grows into its full potential. Based on its initial 2019 guidance, Shake Shack will spend between $79.4 million and $82.2 million on general and administrative (G&A) expense and pre-opening costs this year -- roughly 14% of its projected revenue. That's a big obstacle to its profitability.
In the long run, pre-opening expense will decline -- particularly as a percentage of revenue -- as the rate of new restaurant openings slows. Furthermore, Shake Shack will be able to leverage its existing G&A spending as it grows. For example, Chipotle's G&A expense more than doubled between 2003 and 2007 but still declined from 10.8% of sales to 6.9% of sales over that period as revenue grew at an even faster clip.
Shake Shack is on pace to reach its target of 450 domestic company-operated locations within a decade or less. By the end of that period, revenue is likely to be at least four times 2018 levels, while Shake Shack's pre-tax margin should be well into double-digit territory as G&A and pre-opening costs decline as a percentage of revenue.
I still think that Chipotle stock has solid long-term potential. But Shake Shack is starting to look like a better bet for patient investors.