Chipotle Mexican Grill (NYSE:CMG) has always had plenty of detractors on Wall Street. Many investors are skeptical of Chipotle stock's perennially high earnings multiple. Most notably, prominent hedge fund manager David Einhorn warned investors about Chipotle's high valuation in late 2012 and declared, "Taco Bell has started to eat Chipotle's lunch."
Boy, was he wrong. In the two-and-a-half years since Einhorn's original presentation, Chipotle stock has more than doubled. Meanwhile, shares of Taco Bell parent Yum! Brands (NYSE: YUM) have posted an uninspiring 18% gain during that same time frame.
This week, another Chipotle bear came out of the woodwork. Ivan Feinseth, chief investment officer of Tigress Financial Partners, stated that Chipotle's valuation was "stratospheric" -- and recommended that investors buy Yum! stock instead. (Sound familiar?) But a closer look shows that Chipotle stock is probably still undervalued.
The bear case
Valuation has always been the bears' chief argument against Chipotle stock. Today, the shares trade for 46 times trailing earnings. That represents a considerable premium to the market, which has an average earnings multiple of about 19.
This high earnings multiple is a tribute to Chipotle's earnings growth. However, bears don't believe that growth is sustainable. Feinseth expects that same-store transaction growth will slow from 11.3% in 2014 to 7.7% this year.
Feinseth also revived the margin worries that have hounded Chipotle from time to time. He pointed to rising food costs and the cost of Affordable Care Act compliance as key margin headwinds for 2015.
Earnings will keep growing anyway
While Feinseth maintains a bearish attitude toward Chipotle, it's worth pointing out that most restaurant chains would be ecstatic about a year with 7.7% same-store transaction growth. Combine that with Chipotle's steady expansion -- it plans to add 190-205 restaurants in 2015, increasing its restaurant count by about 11% -- and you have a recipe for strong revenue growth.
Furthermore, while Chipotle will face significant food inflation this year -- especially for beef -- it will continue to see a year-over-year benefit from last year's broad menu price increase through the first half of 2015. This will offset cost inflation, pushing Chipotle's profit margin higher.
By the second half of the year, it is quite possible that Chipotle will have raised its prices for beef entrees again. The company stated on its most recent earnings call that it is considering a "targeted price increase" for its steak and barbacoa entrees later this year. That could allow Chipotle to continue offsetting the cost pressure on its business in the second half of 2015.
Longer-term, beef prices are unlikely to stay near today's historic highs. Cattle herds are starting to grow again, so prices are likely to stabilize this year and could start falling in 2016 or 2017. This will provide a significant margin expansion lever for the next few years.
Don't underestimate the long-term growth potential
Chipotle's strong sales growth and its stellar margin profile create a formidable long-term earnings growth engine. Since its IPO in 2006, Chipotle has grown EPS nearly tenfold.
Chipotle is a more mature company today, so earnings growth won't be quite so fast in the future. But analysts do expect Chipotle to grow EPS by about 20% annually for the next few years. If that trend holds, EPS would rise more than sixfold over the next decade. From that perspective, Chipotle stock seems undervalued, if anything. A pricetag of $655/share doesn't seem like much to pay for a company could be producing EPS of nearly $100 a decade from now.
Does Chipotle retain this level of growth potential? I certainly think so. Chipotle set a long-term goal of operating 4,000 restaurants in the U.S. at the time of its IPO. Beginning five years ago, it successfully piloted smaller "A Model" stores, expanding the number of areas where it can operate successfully. This increased its long-term growth potential.
Furthermore, Chipotle has added a handful of stores outside the U.S., which could provide the seeds for a major international expansion a few years down the road. It has also piloted two new restaurant concepts: ShopHouse Southeast Asian Kitchen and Pizzeria Locale. If these new concepts succeed, they could double (or even triple) Chipotle's ultimate unit growth potential.
The bottom line is that Chipotle will be multiples of its current size in a decade or two. While Chipotle stock might look expensive compared to more mature restaurant stocks like Yum!, its massive growth potential probably merits an even higher valuation.