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Beware of Valuation Risks on Red Hot Chipotle Stock

Valuation risks on Chipotle stock will eventually rear their ugly head

Shares of fast casual Mexican eatery Chipotle (NYSE:CMG) have been on fire ever since February 2018, when the company brought on new CEO Brian Niccol from Taco Bell and began down a recovery path defined by three big growth initiatives: menu innovations, unique marketing, and digital business expansion. These three growth initiatives have paid off in a big way, and since February 2018, Chipotle stock has rattled off a 225% gain as customers have come flying back into stores.

Beware of Valuation Risks on Red Hot Chipotle Stock
Source: Northfoto / Shutterstock.com

That’s a huge gain. To put it in perspective, the S&P 500 is up less than 10% over that same stretch. But, while management continues to do everything right to secure a healthy long-term growth trajectory for the restaurant chain, investors should be aware that, at current levels, Chipotle stock has large valuation risks.

That is, because Chipotle has been so good for so long, investors are expressing abundant optimism with respect to management’s ability to continue to drive big growth for a lot longer. This has led to aggressive buying, and has left Chipotle stock with one of the richest valuations in the entire restaurant category.

But here’s the problem — the restaurant industry is tough. It’s fickle, as consumers bounce from restaurant to restaurant without much thought or consideration. It’s dynamic, as what works in drawing those customers to stores today, may not work tomorrow. And it’s fiercely competitive, with hundreds of chains across the U.S. competing for the same consumers.

In a tough, fickle, dynamic, and fiercely competitive industry, premium valuations are not warranted. But, Chipotle stock features a premium valuation. Ultimately, that means that at current levels, CMG stock offers investors more risk than reward.

Chipotle Stock Is on Fire

Make no mistake about it. Chipotle is on fire today because management is doing everything right.

That is, management is making sure Chipotle stays relevant everywhere. On the food front, Chipotle has wholly embraced vegetarian and paleo options to account for the fact that more consumers than ever are choosing these diets. They are also rolling out multiple new menu options, including carne asada and queso blanco.

On the digital front, Chipotle is aggressively expanding its footprint both through its own channels and third-party delivery channels. On the marketing front, Chipotle is running a bunch of on-trend promotions like a TikTok dance challenge during National Avocado Day, Meatless Monday promotions during National Vegetarian Month, and free delivery Sundays in September for the back-to-school season.

Big picture: Chipotle is doing everything right to stay fresh and relevant to the consumer. So long as Chipotle continues to execute on this front, sales and profit trends will remain robust.

CMG Stock May Not Be On Fire Forever

Chipotle won’t stay fresh and relevant to the consumer forever. That’s just nearly impossible to do in the fickle, dynamic, and fiercely competitive restaurant industry.

Consumer tastes and preferences simply change far too often, far too quickly, for anyone to stay on top forever. Arguably, the only restaurant chain that has been able to do this is McDonald’s (NYSE:MCD), and that’s a function of industry-low prices and industry-best convenience (there’s a McDonald’s seemingly on every street corner).

Chipotle isn’t the lowest priced player in the QSR world — they are cheap, but not the cheapest. Nor are they the most convenient — service is quick, but lack of drive-thrus is a problem from a convenience standpoint. As such, while Chipotle is on fire today thanks to various menu options, digital, and marketing initiatives, those growth initiatives won’t power high single-digit comparable sales growth forever. Instead, growth is big right now because Chipotle finds itself on the right side of a few macro consumption trends, such as alternative diets.

But, those macro trends will change with time, and Chipotle won’t always find itself on the right side of the trend. As such, today’s high single-digit comps will slow over time, and such deceleration could spell a problem for CMG stock.

Chipotle Stock Isn’t Priced For Any Cooling

Chipotle stock trades at 46.8-times forward earnings. The market average multiple is 16-times forward earnings. The average multiple in the consumer discretionary sector is 21-times forward earnings, and the average restaurant stock multiple is 27-times forward earnings.

In other words, at current levels, CMG stock trades at: 1) a 275% premium to the market, 2) a 185% premium to the consumer discretionary sector, and 3) a 120% premium to its restaurant peers. Bulls say this premium is warranted because of Chipotle’s bigger profit growth prospects — adjusted EPS rose nearly 40% last quarter.

It is, but to a degree. Aggressively, let’s assume Chipotle continues to open about 150 new stores every year, and continues to comp in the mid-single-digit or better range into 2025. That should power consistent about 10% revenue growth. Margins will run higher with positive comps, and buybacks will remain in the mix. So, EPS growth should run north of 20%, paving runway for EPS to hit $45 by 2025.

Let’s throw a restaurant sector average 27-times forward earnings multiple on that. We arrive at 2024 price target for CMG stock of $1,215. Let’s discount that back by 10% per year. We arrive at a 2019 price target of $750.

Thus, at $800, Chipotle stock is priced for perfection … and then some. That’s a dangerous place to be in the restaurant industry.

Bottom Line on CMG Stock

Valuation risks on Chipotle stock will eventually rear their ugly head, and when they do, this stock could find itself in a “look out below” situation, considering just how stretched the valuation is today.

As of this writing, Luke Lango was long MCD. 


Article printed from InvestorPlace Media, https://investorplace.com/2019/10/beware-of-valuation-risks-on-red-hot-chipotle-stock/.

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