In many respects, the restaurant industry is where seemingly great ideas, great managers, and even great dishes go to die. Foodie trends come and go, the competition is ruthless, and customers grow weary of the same old shtick -- no matter how much cheese or bacon is layered on top. (OK, bacon gets a pass.)
So, with that in mind, why would an investor even consider a fast casual chain like Chipotle Mexican Grill (NYSE:CMG)? The answer to this is simple: In the end, quality tends to shine, even in the restaurant biz. And Chipotle is all about high quality, from its customer service to its coveted carnitas.
I've described why I think Chipotle is a stellar company before, but let's evaluate whether this is the right time to load up on shares.
The 7 questions you need to answer ...
In a busy burrito assembly line, Chipotle's "expeditor" is the person who makes sure the customer's order is properly put together. Dining in? Check. Side of guac? Check.
This quality assurance process focuses on the customer, but there's no reason we can't apply the same idea in investing. Checklists keep our approach consistent from one stock pick to the next. In that spirit, let's evaluate the ingredients that matter most to potential Chipotle investors, one by one.
Here are the seven key questions every shareholder needs to consider:
1. Is Chipotle profitable? Yes, Chipotle's net profit margin doubled between 2006 and 2013 from 5% to 10%. At this point, net margins are 25% higher than the restaurant industry average. What's more, the company's expansion efforts during the last seven years have boosted earnings per share from $1.28 to $10.47, an increase of 818%.
2. What is the outlook for earnings? Chipotle is on fire in this category. Earnings per share grew 24% during the second-quarter of 2014 and management expects 40% year-over-year earnings growth in the latter half of the year.
3. Who are its competitors? Everyone. And no one. At the same time. Rival chains like Taco Bell's Cantina Bell have yet to win the hearts of too many Chipotle die-hards. There are numerous upstarts -- including regional chains and even food trucks -- that offer new and enticing alternatives, but they will have difficulty in topping Chipotle's speed and value.
4. Who runs Chipotle? Co-CEOs Steve Ells and Monty Moran share responsibilities, with Moran primarily focusing on operations and Ells playing the visionary role. As earnings rise and new concepts like ShopHouse and Pizzeria Locale take root, both execs look like virtuosos in the fast-casual business.
5. Is the balance sheet in good shape? Chipotle has virtually no debt and has complete control of one of its most important assets -- real estate -- since it owns all of its restaurants.
6. What are some reasons it could falter? I dove into the most pressing challenges Chipotle faces in a recent article. Namely, the brand could suffer if Chipotle fails to live up to its "Food With Integrity" promise or allows its people-centric culture to slip. But management discusses how they are addressing sourcing and morale-boosting strategies on every conference call -- a good sign of transparency.
7. Does it have room to grow? This burrito is hardly overstretched. I think management is underestimating its potential Mexican restaurant count of 4,000 U.S. stores, which would be 138% more than the current footprint of 1,681. For comparison's sake, Yum! Brands' has 18,000 domestic restaurants and McDonald's has more than 14,000. I don't think it's hard to imagine Chipotle's total restaurant empire reaching 10,000 restaurants in the U.S., including Pizzeria Locale and ShopHouse, with more overseas.
All this ... at a price you want to pay?
Based on its restaurant economics and growth trajectory, it's safe to say Chipotle's one of the best investment opportunities in the business. But there's one last question we need to answer: Is the price right?
On this issue, there are a many different ways to peel back the onion layers, and I think all of them would make a value investor's eyes water: At $660, Chipotle's stock is not the cheapest ticket in town.
Still, Chipotle qualifies in my mind as a "buy" candidate due to the long runway of opportunity that lies ahead. And let's put a few things into perspective before gawking at the share price.
First off, the restaurant industry is currently priced at 28.4 times earnings versus Chipotle's spicy P/E of 58.1. But no one else measures up in terms of growth: Chipotle's five-year average revenue growth stands at 19.3% versus the industry's 6.2%. That's three times the growth at two times the valuation.
Second, I've found that Chipotle hardly ever looks "cheap" by traditional measures because it is absolutely thumping its competitors year-after-year. And the market respects such a high-performing restaurant company.
Finally, here's a hypothetical. Let's say Chipotle's earnings keep a growth pace of roughly 20% per annum through 2024. In a detailed analysis, my colleague Adam Levine-Weinberg makes a convincing case for the shares potentially reaching $2,500 if that were to occur. This would nearly quadruple the stock price in merely a decade.
The takeaway for investors
The bottom line is that it's all about the long game. There's reason to believe Chipotle is worth its weight in salt if you peek 10 to 20 years into the future and see the optional growth outlets in its new restaurant concepts, catering, coffee, and perhaps even breakfast.
As I pointed out earlier this year, I think this is one stock where portion control is absolutely critical. If you bite into Chipotle's share in easily digestible amounts over time, I think you'll satisfy your appetite for market-beating returns as this budding restaurant empire continues to take shape.