The biggest change to financial markets in 2022 has been the return of inflation across the globe. The Consumer Price Index is up 8.2% over the past 12 months in the United States. That's one of the highest readings in decades and has major implications across the economy.
For businesses with major labor, commodity, and transportation costs, inflation can wreak havoc on profit margins when input costs rise faster than revenue. Restaurants are good examples as they have to deal with complex supply chains, food prices, and a significant labor force.
Most restaurants have struggled in 2022. But not Chipotle (CMG 1.67%). The Mexican fast-casual restaurant chain continues to weather inflation through price increases with minimal impacts on its business. But does that make the stock a buy today?
Q3 earnings: mainly good, a little bad
Chipotle reported its third-quarter earnings on Oct. 25. Revenue came in at $2.2 billion for the period, up 13.7% year over year. This was driven by 43 new restaurant openings and 7.6% comparable-restaurant sales growth. "Comp sales" measure revenue growth from existing restaurants. This 7.6% figure shows that Chipotle has been able to grow its business by raising prices without severely affecting business.
On the conference call, CEO Brian Niccol shared that the average price of a chicken burrito bowl (Chipotle's most popular item) is still less than $9 across its stores. This is still much cheaper than other lunch options out there, at least those that aren't fast food.
The most impressive part of the quarter was Chipotle's operating leverage. The company had an operating margin of 15.1% in Q3, up from 12.3% in 2021, leading to an operating income growth of 40% year over year. Facing inflation headwinds, Chipotle has still been able to significantly expand its operating margins, mainly due to price increases. If and when inflation recedes, it wouldn't be surprising to see operating margins inch higher toward 20% each quarter.
After reading the report and conference call, there was only one negative I could find with Chipotle's quarter, and that was traffic to its stores. According to management, transactions in the third quarter were down 1% year over year, mainly driven by a decline in group orders and as well as from lower-income customers. While only a small decline that is likely not nearly as bad as at other restaurants, it shows that Chipotle does not have unlimited pricing power it can tap into every year to drive growth.
NYSE: CMG
Key Data Points
Long-term growth is still there
Luckily, Chipotle still has plenty of room to grow by expanding its store count, and it shouldn't have to entirely rely on raising prices to drive revenue growth. At the end of Q3, the company had just over 3,000 stores across North America. Over the long term, management thinks there is room to have 7,000 Chipotle locations in the U.S. and Canada.
Over the past 12 months, Chipotle has generated a touch over $8 billion in revenue. Once it reaches 7,000 locations, there's no reason to think this business can't start printing $20 billion in annual sales if it only raises prices by a small amount each year. At 15% margins, that would equate to $3 billion in annual earnings compared with less than $1 billion over the past 12 months.
But what about valuation?
Right now, with the stock down 15% in 2022, Chipotle trades at a market capitalization of $41 billion. With a trailing net income of $808 million, the stock has a price-to-earnings ratio of 51, which is more than double the average S&P 500 multiple of 20. Compared with its current earnings, Chipotle stock looks expensive.
If you are going to invest in the stock, you need to be confident that the company can grow its store count for the foreseeable future and keep expanding its profit margins. At $3 billion in earnings based on my 7,000 store location estimate, that would bring Chipotle's P/E down to 13.6, which is well below the market average. But remember that the company is still many years out from hitting this earnings target.
