If you own Chipotle (NYSE: CMG), chances are it's the best-performing stock in your portfolio. Shares in the burrito roller have blazed a trail all the way to the $400 mark, scorching competitors and the market along the way. The stock is worth more than 10 times its value in November 2008, when it bottomed out at under $40, and its share price has soared with the recent bull market, up 25% in just the last three months. Strangely, that surge came without any major news about the company except a poorly received earnings report in early February.
Unlike the volatility the stock showed through 2011, its rise in the last few months has come with no significant dips. Many before have tried to call Chipotle's top, suggesting the stock is overpriced, but the market continues to push it higher. Is it time for a pullback? Let's look at each side of the debate.
This burrito is just too hot
Naysayers like to argue that Chipotle shares are simply out of control for a company eyeing 20% long-term growth. Unlike the tech sector, for example, the restaurant industry tends to be less prone to big pops and drops. Chipotle is not going to come out with a game-changing, revolutionary product the way Apple had with the category-killing iPad. Restaurants can only grow so fast. To open new locations, management needs to find real estate, build it out, and hire and train new employees. To speed the expansion process, some restaurant chains turn to franchising, but Chipotle's stores are all company-owned, so that is not currently on the table.
For the bears, the argument boils down to valuation metrics. Chipotle's P/E ratio has jumped from the 20s during 2009 to near 60 today. In other words, share appreciation is vastly outpacing earnings growth. Based on valuation per restaurant, individual Chipotles are worth about $10 million, even though they make only an average of close to $200,000 in profit a year. The critics balk at those numbers, especially as they claim that the company has no true economic moat. Anyone can come along and open a similar, or better, Mexican fast-casual chain, they believe.
Finally, the demon of multiple compression lurks for Chipotle shareholders. As a recent Wall Street Journal article points out, the larger a company gets, the harder it is for it to maintain a torrid growth rate. In Chipotle's case, a 10% share appreciation over the next 10 years would make its stock worth $1,032. At an imagined P/E ratio of 15 then, that would require earnings to grow 26% per year, faster than they are growing now.
Throw some more guac on there
For Chipotle bulls, the proof is in the pudding. Its burritos win rave reviews, the service is fast and efficient, and it's hard to find a location without a line during lunchtime. Its popularity is obvious.
But it's still just a restaurant, and, as the bears argue, anyone could copy this concept. While opening a Mexican fast-casual restaurant may not be rocket science, competitors such as Qdoba, Baja Fresh and California Tortilla have tried -- and failed -- to match Chipotle's high standards.
In addition to advanced cooking methods such as sous vide that keep food quality high, the company has employed a clever approach to solving that bugaboo of the service industry: employee turnover. Instead of searching for outside talent, the fast casual chain decided to promote from within and offer development bonuses, two tactics that helped slash turnover for hourly managers by 64%. Managers, for example, receive a $10,000 bonus for successfully bringing a line worker up to management. It's innovative approaches like these that have raised the industry bar, and a recent Slate article described Chipotle as an unsung restaurant equivalent of Apple, inventing new ways to delight customers with exacting business acumen.
So the Chipotle team seems to have proven their skills at managing food quality and labor, which are the key drivers of success in the restaurant business, but it's the company's market opportunities that really have investors' mouths watering. The burrito chain opened its first international location in London last year, and is planning a second in the British capital as well as one in Paris in 2012. Last year also saw the company's first ShopHouse location open, a fast-casual Southeast Asian concept offering items as curries and Bahn Mi sandwiches delivered in a Chipotle-style assembly line. The company expects to open another ShopHouse later this year.
Considering the success that chains like McDonald's (NYSE: MCD), Yum! Brands (NYSE: YUM), and Starbucks (Nasdaq: SBUX) have found abroad, it's no surprise that investors see Chipotle as the next American food concept that will win foreign fans. And with only about 1,200 locations now, the company could easily grow to 10,000 or more one day. (McDonald's, by comparison, has over 30,000 restaurants worldwide.) Chipotle also shares two key characteristics with these three operators that have made them so successful abroad: operational excellence and an in-demand product.
Foolish bottom line
I'm not going to be foolish enough to call the top on Chipotle, as many others wrongly have. But the growth we've seen in the last few months or even the last year is not sustainable, barring a significant strategic shift such as a move to franchising, which I don't see. Still, even with its lofty multiple, I would expect Chipotle to continue to beat the market in the future. The multiple compression referenced in the Wall Street Journal article seems exaggerated. Considering the P/E ratios of more mature peers like McDonald's (18), Yum! Brands (25), and Starbucks (31), it's clear that there are growth opportunities aplenty in the restaurant industry. There's no reason why Chipotle's P/E should shrink all the way to 15, even 10 years from now.
Based on the company's future growth opportunities and its savvy management, I've decided to give the Chipotle a bullish CAPSCall. I see its steady growth continuing for years to come.
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