Perhaps no other industry was shattered more during the pandemic than restaurants. As indoor dining was restricted, restaurants that were able to leverage online ordering to satisfy customer cravings were able to survive.
Chipotle Mexican Grill (CMG 0.35%), on the other hand, absolutely thrived. The Tex-Mex chain has seen its sales surge. The stock, up 200% since March of 2020, has doubled the S&P 500's gain and now carries a price-to-earnings ratio (P/E ratio) of 68. Investor optimism is through the roof.
With that being said, here's why I believe this top restaurant stock is overvalued today.
Image source: Getty Images.
Strong momentum leads to huge ambitions
As of Sept. 30, Chipotle operated 2,892 restaurants, nearly all of which are in the U.S. Over the long term, though, the leadership team believes that there could be 6,000 total locations in North America. That's still a tremendous expansion opportunity for a business that has seen rapid growth in recent years.
Management's confidence is undoubtedly sky-high due to the company's performance since the pandemic started. Chipotle leaned heavily on its digital infrastructure, so hungry customers could order online via the website, mobile app, or third-party delivery services to get their favorite menu items. The ordering experience has become frictionless. Digital sales increased 8.6% year over year in the third quarter, and they more than tripled in Q3 of 2020. Chipotle has a remarkable 24.5 million members of its loyalty program today.
Of the 41 new locations opened in the latest three-month period, just five were built without a Chipotlane, the company's extremely popular drive-through. These Chipotlanes will be an important driver of future success as the locations register 10% to 15% higher sales after opening and produce better margins.
As dining rooms slowly opened back up, management found that only about 15% to 20% of customers use both in-person and digital channels. "We're encouraged by this dynamic as it gives us several future opportunities, including the ability to convert more of our in-restaurant guests into higher frequency digital users," CEO Brian Niccol said on the Q3 earnings call.
It's safe to say that Chipotle's business is firing on all cylinders right now.
But the stock is expensive today
Let's assume that in 10 years the company is able to hit its target of 6,000 total stores in North America. If each restaurant generates $3 million in annual unit volume (AUV) as management believes it will, Chipotle would have $18 billion in yearly sales a decade from now. Trailing 12-month revenue was $7.2 billion.
The company would have to open new locations at an annual pace of approximately 300, something it hasn't done before. And if Chipotle carries a profit margin of 15% (something it also hasn't achieved), which is outstanding for a restaurant business, net income in 2031 would total $2.7 billion. At the current market capitalization of $48 billion (as of market close on Dec. 15), Chipotle's stock trades at just under 18 times my projected earnings in 2031.
If the market values the stock similar to Starbucks' current forward P/E ratio of 33, Chipotle's shares will underperform the S&P 500's historical 10% annualized return. Starbucks is a relevant comparison because it's a dominant restaurant company that has matured, a stage Chipotle will likely reach in 2031.
The stock definitely looks overvalued today, as it provides for a paltry annual return of just 6.2% over the next decade based on an aggressive store-opening schedule and margin outlook. This doesn't include the potential for increased share buybacks or dividends, but you get the idea of what shareholders must believe to get an adequate return.
To own the stock, prospective investors would not only need to believe that the leadership team can reach its goal in North America over the next 10 years (a tough task), but that international expansion will be substantial as well. Even then, there is no margin of safety. There's a ton of optimism surrounding the stock right now.
Make no mistake about it -- Chipotle is an excellent business. However, I'm waiting for a pullback before I become a shareholder.
