Risks for Chipotle Shareholders in 2014 and Beyond

Chipotle Mexican Grill (CMG 4.13%) has tremendous growth opportunities ahead of it. While the ability to double the number of locations in the United States, expand internationally, and venture out into new restaurant concepts has excited investors in recent years, it is important to give serious consideration to threats to the company's ongoing success. As the closure of more than 10% of Jack in the Box's Qdoba locations during the second half of 2013 illustrates, fast casual burritos are no guarantee of success.

Competition is everywhere
Chipotle faces obvious direct competitors in the fast casual burrito market including Qdoba and privately held Moe's Southwest Grill, but the competition is far broader than just burritos; Chipotle is competing against Panera (PNRA) and every other fast casual chain for a share of a finite (albeit growing) consumer market. 

Several quick serve restaurants, including Five Guys Burgers and Fries and Jimmy John's, are opening new locations faster than Chipotle. While burgers and sandwiches are nothing new to the array of quick serve options, Noodles & Company (NDLS 6.67%) became an immediate hit following its IPO thanks to its role in adding pasta to the array of fast casual options. Chipotle's success has bred an array of company's striving to be (and often labeled as) "the next Chipotle." While none has quite earned that title quite yet, it is clear that companies will not stop trying to duplicate Chipotle's success by carving out market share in the fast casual market. There are thousands of local, regional, and national fast casual restaurants looking to compete with Chipotle across the country.

The impact that competition can have on Chipotle is enormous.  The perceived threat from the introduction of the Cantina Bell menu at Yum Brand's Taco Bell in 2012 led to a well-publicized short position in Chipotle from well-known investor David Einhorn. Einhorn's short position was based on the premise that competition from Taco Bell and others would derail Chipotle's growth. The corresponding fall in share price was dramatic as illustrated below:

CMG Total Return Price data by YCharts

In just three months, Chipotle shares fell $200 primarily based on the fear of perceived competition. Fortunately for shareholders, this premise was quickly dismissed and the company's shares rebounded to new all-time highs and have more than doubled since the lows of 2012.

Premium valuation comes with risk
The dramatic fall and recovery in Chipotle's share price is a perfect illustration of the volatility that comes with a high-growth stock that commands a correspondingly high valuation. While valuation is a risk for investors rather than to the company itself, it is critically important for investors to recognize that money can be lost over the short term even while the company continues to succeed operationally. With that in mind, it is helpful to see the range of valuation multiples that Chipotle has traded over the past five years:

CMG P/E Ratio (TTM) data by YCharts

Given that many of Chipotle's closest competitors are either privately held or part of a larger organization of restaurant concepts, the comparison to Panera is useful. The chart above illustrates that while Panera has been valued at a trailing earnings multiple between 20 and 35 times earnings over the past five years, Chipotle has been more volatile; Chipotle's valuation has ranged from 20 times earnings to more than 60 times earnings. Presently, Chipotle trades toward the higher end of this range, placing additional risk on investors in the event that negative news appears in the near future.

To put this valuation in perspective, here is a brief comparison of Chipotle, Panera, and Noodles & Company:

Source: Yahoo! Finance-January 12, 2014

The growth opportunity and proven track record of both Chipotle and Noodles & Company has resulted in significant valuation premiums. If the outlook for the future changes due to competition, the economy, or some other major change to the investment thesis, the downside risk to either company is tremendous. Consider this illustration of what each company's share price would be if the market determined that all three should be valued at 25 times forward earnings:

This scenario is essentially what happened to Chipotle's shares late in 2012 as described above. If there is reason to believe that Chipotle's growth target in the United States is 2,000 locations rather than 3,000 (or more) or that international growth and opportunities from ShopHouse and Pizzeria Locale won't materialize, investors could be in for a repeat of this shock. 

Investing is a balancing act
For a growth company like Chipotle, a well informed investment takes into account the strengths and weaknesses of the company. While Chipotle's operational strengths outweigh its weaknesses at this time, the competitive environment will change over time. With the stock trading at a premium valuation, there's also the potential for sharp declines at the first sign of any bad news; investors must understand this and be comfortable with the risks prior to making an investment. Investors with a long-term perspective and the diligence to monitor the competitive environment will continue to find Chipotle to be a compelling investment even at the current valuation.