Chipotle Mexican Grill, Inc. (NYSE:CMG) has seen some optimism lately. Chipotle stock has rallied 29% since early February. Of course, that optimism is relative: CMG stock had hit a five-year low before that rally.
Indeed, Chipotle stock still is down about 57% from its all-time highs reached in 2015. And yet, the stock still really isn’t that cheap. At $320, CMG stock trades at a whopping 38x 2018 earnings per share estimates. Those estimates came in sharply after a disappointing fourth-quarter earnings report — the same report that sent CMG plummeting to the multi-year low.
And yet Chipotle has retraced all of its losses. The hiring of a new CEO has sparked optimism toward a potential turnaround. But a new CEO alone doesn’t fix the problems here. Competition in the “fast casual” space remains intensely difficult. Fast-food rivals are improving their quality — and keeping prices low. Chipotle’s brand still needs to be fixed, and an increasing bent among consumers for “independent” and “unique” offerings provides another headwind.
There is a case for some sort of turnaround at Chipotle. But it’s difficult to argue, at 39x EPS, that a good deal of success isn’t already priced in. That seems to leave a “heads I win some, tails I lose a lot” type of bet for Chipotle stock. After the past few years, that bet hardly seems attractive.
Chipotle Stock Becomes a Turnaround Play
Simply based on 2017 numbers, Chipotle seems like a growing company. Comparable sales rose 6.4% in 2017, and generally accepted accounting principles EPS soared to over $6 from below $1.
But 2017 growth benefited from a comparison to a disastrous 2017. Chipotle’s revenue declined in 2016, for the first time ever. Restaurant-level margins fell by more than half, to 12.8% from 26.1% the year before. Over two years, same-restaurant sales still have declined 15%. EPS has dropped by more than 50%. Restaurant-level margins have fallen over 900 bps.
In a sense, that’s good news. Investors should look forward, not backward. And simply getting Chipotle back to where it was suggests impressive growth potential. Simply moving 2017 restaurant-level margins back to 2015 levels — which themselves were down from 2014 — combined with a lower tax rate, gets EPS to the range of $11-$12.
And there’s potential for growth as well. Chipotle is guiding for comp growth in 2018 in the low single digits. It’s planning to open 130-150 stores in 2018, which would add about 6% to its store count. If Chipotle can just get back to what it was in 2014-2015, there’s a reasonably simple path for EPS to double from 2017’s $6.17.
That’s part of why the new CEO has sparked enthusiasm toward Chipotle stock. There is a turnaround play here. The new CEO, Brian Niccol, had great success at Yum! Brands, Inc. (NYSE:YUM) unit Taco Bell. He’s already started to make changes: Chipotle’s head of marketing departed this week. Fresh eyes and better performance means a real shot at turning the business around. And a turnaround here likely means as much as 100% EPS growth over the next few years.
The Problems with Chipotle Stock
The catch is that Chipotle stock already is pricing in a good deal of success. The 100% EPS growth from 2017 levels still suggests a price-earnings multiple around 19x. CMG stock did trade as high as 40x+ earnings before its food safety issues, but it’s unlikely to see that multiple again. Something in the 25-30x range — still aggressive — suggests 30-50% upside in CMG stock.
That’s a nice number. But it also is the upside over three years in a scenario where the turnaround takes hold. Given the risk and time required, that’s not a particularly impressive return. And the risks here are real.
For one, it’s not clear that all of Chipotle’s problems stem from bad press surrounding food safety, and the resulting hit to its image. “Fast casual” growth across the board has slowed. Zoe’s Kitchen Inc (NYSE:ZOES) has seen a major slowdown. Chipotle rival Qdoba, sold by Jack in the Box Inc. (NASDAQ:JACK) in December, saw its growth decelerate sharply in 2016 and turn negative in fiscal 2017, according to the JACK 10-K. (Note too that Qdoba sold for less than 0.4x revenue; Chipotle trades for more than 2x its sales.)
It’s possible that fast food players are taking share back. McDonald’s Corporation (NYSE:MCD), Burger King owner Restaurant Brands International Inc (NYSE:QSR), and Yum! all have seen improved revenue trends of late. Whether it’s improvements in fast food, or the increasing price gap, it does seem like fast casual as a whole has lost its mojo, so to speak.
And as one of the giants in fast casual — indeed, as one of the companies that created that category — Chipotle is hardly immune to those pressures. That in turn means a turnaround for Chipotle might not be as easy as simply fixing what broke over the past few years.
Yet, again, investors are pricing in an extremely healthy probability of the turnaround being a success. At 38x EPS, there simply isn’t much room for error.
There is a path for Chipotle to rebuild its brand, and its profits. There’s probably enough of a chance that a short of Chipotle stock — still a popular trade — itself is too risky. But a bet on Chipotle is a bet that an awful lot of things go right. And with the stock up 30% in a matter of weeks, the rewards no longer seem to justify that bet.
As of this writing, Vince Martin has no positions in any securities mentioned.