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How Many Burritos Does it Take?

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Over the past three months, the debate over the valuation of Chipotle Mexican Grill (NYSE: CMG) has heated up.  While shares of Chipotle are down over 10% from the all-time high of $442.40 in April, recent analyst commentary seems to indicate that shares may be due for further correction based on valuation concerns.  Is Chipotle's growth story coming to an end, or are multi-bagger returns ahead for investors?  In part 1 of this analysis, lets focus on the bear argument and the current valuation of Chipotle's shares.

The core of most compelling bear arguments for Chipotle is centered on valuation.  Most investors recognize that Chipotle runs an excellent business, but have difficulty accepting the company's current valuation.  With a market capitalization of $12.1 billion, a TTM P/E ratio of 52.6, a P/S ratio of 5.0 and a TTM Free Cash Flow Yield of just 1.7% (all as of July 12, 2012), investors clearly have high expectations for the company going forward. Compared to the S&P 500's average P/E ratio of 15, shares of Chipotle are selling at a significant premium to the overall market.   In the case of high growth companies, such a premium is often warranted. The big question is whether it is appropriate for Chipotle to be trading at a price that is over three times more expensive than the market average on a P/E basis.

The Growth Story To Date

Chipotle has had an impressive run since its launch in 1993.  19 years and 1262 store openings later, Chipotle has become recognized as one of the creators of the "fast casual" dining category.   The rise to 1262 stores (as of March 31, 2012) has yielded some pretty impressive growth statistics:

<table> <tbody> <tr> <td><strong>Year</strong></td> <td><strong>Restaurants</strong></td> <td><strong>% Growth</strong></td> <td><strong>Revenue (in billions)</strong></td> <td><strong>% Growth</strong></td> <td><strong>Diluted EPS</strong></td> <td><strong>% Growth</strong></td> </tr> <tr> <td>2005</td> <td>500</td> <td> </td> <td>0.625</td> <td> </td> <td>1.43</td> <td> </td> </tr> <tr> <td>2006</td> <td>573</td> <td>14.6%</td> <td>0.820</td> <td>31.2%</td> <td>1.28</td> <td>-10.5%</td> </tr> <tr> <td>2007</td> <td>704</td> <td>22.9%</td> <td>1.085</td> <td>32.3%</td> <td>2.13</td> <td>66.4%</td> </tr> <tr> <td>2008</td> <td>837</td> <td>18.9%</td> <td>1.332</td> <td>22.8%</td> <td>2.36</td> <td>10.8%</td> </tr> <tr> <td>2009</td> <td>956</td> <td>14.2%</td> <td>1.518</td> <td>14.0%</td> <td>3.95</td> <td>67.4%</td> </tr> <tr> <td>2010</td> <td>1084</td> <td>13.4%</td> <td>1.836</td> <td>20.9%</td> <td>5.64</td> <td>42.8%</td> </tr> <tr> <td>2011</td> <td>1230</td> <td>13.5%</td> <td>2.269</td> <td>23.6%</td> <td>6.76</td> <td>19.9%</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td><strong>CAGR</strong></td> <td><strong>16.2%</strong></td> <td><strong> </strong></td> <td><strong>24.0%</strong></td> <td><strong> </strong></td> <td><strong>29.5%</strong></td> <td> </td> </tr> </tbody> </table>

The combination of rapid expansion and same store sales increases have fueled impressive bottom line growth of almost 30% per year over the past 6 years. Still, even assuming that the company can maintain EPS growth of 30% going forward, many will argue that a PEG ratio of 1.78 (current P/E ratio of 52.6 divided by the 29.5% average EPS growth noted above) is still far too expensive. While there are many opinions regarding what an appropriate PEG ratio should be, a PEG ratio of 1.0 for Chipotle would translate into a decline in share price to around $215 per share. Clearly, that is a dramatic decline from the July 11th closing share price of $390.47.

How Many More Burritos Can Be Sold?

The second half of the valuation bear argument is that double digit location and same store sales growth cannot continue forever.  Chipotle has already opened stores in the largest metropolitan areas in the country and has presumably chosen its 1262 favorite locations for its restaurants already.  While the company plans to open an additional 155 to 165 locations in 2012 (of which, 32 were opened in Q1), it will get harder and harder to maintain that growth rate over the next 5-10 years due to a combination of market saturation, competition and the law of large numbers.  Maintaining the 16.2% CAGR of restaurant locations would result in 2,600 locations in 5 years and 5,500 locations in 10 years.  The current analyst sentiment is that the U.S. market may accomodate somewhere between 3,000 and 3,500 Chipotle locations; based on this current assessment of the total market opportunity, the compounded rate of growth will have to decline at some point as Chipotle matures.  Slowing growth typically leads to P/E compression, which again points to downside risk in the company's share price.  

Don't Forget About Competition

While Chipotle may have helped form the fast casual restaurant category, it did not take long for a wide range of competiton to join the party.  There are a number of competitors, including fellow purveyors of burritos such as Qdoba (owned by Jack in the Box (NASDAQ: JACK)) and Baja Fresh as well popular restaurants such as Panera Bread (NASDAQ: PNRA) and Pei Wei Asian Diner (owned by PF Changs (NASDAQ: PFCB)).  Plus, Yum Brands' (NYSE: YUM) Taco Bell chain has recently announced its own gourmet menu that could (at least in theory) compete with Chipotle.   While there is plenty of room in the restaurant industry for each of these companies, it certainly makes the conclusion that Chipotle can march into the future with 3,000 locations, double digit same store sales growth and stellar earnings growth far from a certainty.  

How Can This Stock Beat The Market?

With a stock that is considered expensive based on historical performance, is likely to experience a slowdown in growth in the future and is faced with heavy competition, how can anyone expect Chipotle to outperform the market from here?  The bears argue that it can't be done based on the valuation data described above.  

This analysis has clearly focused on the bear argument that Chipotle's stock is too expensive.  As with most investments, there are two sides to the story.  Stay tuned for part 2 as I turn the focus to the bull argument that Chipotle will continue to outperform the market.

BrewCrewFool owns shares of Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill and Panera Bread. Motley Fool newsletter services recommend Chipotle Mexican Grill, Jack in the Box, Panera Bread, and Yum! Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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