Don't Make My Mistake with Chipotle

By Chad Henage - June 22, 2012 | Tickers: BWLD, CMG, YUM | 0 Comments

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I made a huge investing mistake with Chipotle (NYSE: CMG) over the last few years. I actually owned Chipotle a few years ago, and after watching the stock jump from about $56 (where I bought) to $125 (where I sold) I saw a high future P/E and sold. This was brought to mind again, when I read a Fool article by Jeremy Bowman. His premise was that Chipotle stock seemed to have gone up into thin air. He noted that even though the company beat earnings, the stock still gave back 3% on an up day in the market. His comment that, “investors seem to have come back to their senses,” struck me as particularly interesting. I've made the same mistake in assuming that Chipotle was overvalued. Let's see who needs to come to their senses.

One of my first posts on The Motley Fool Blog was about Chipotle. The stock was selling for about $350 at the time, and I thought the stock was “..Too Stuffed.” My main point was the future P/E ratio at the time was over 40, and analysts were expecting growth of just over 20%. Anytime a PEG ratio gets to 2 or more, I start to get nervous. However, I try not to get stuck in an opinion for too long. The market has taught me over and over again to look at more than just the P/E ratio. A few months later, I was looking to find a reason that Chipotle might not be overvalued. When you approach a stock from the perspective of disproving your original theory, you find things you didn't expect. In my March post, I found that one primary reason Chipotle is valued more highly than some of their competition is the company generates significantly more free cash flow than other restaurants. When I read Jeremy's article, I wondered if there were other measures in which Chipotle might be ahead of their competition.

Pre-Tax Margin

First, let's look at pre-tax margins. This measure will tell us how much the company keeps of each dollar it sells after everything but taxes are taken out. Chipotle's pre-tax margin has risen from 13.44% to 15.4% in the last few years. By comparison, Buffalo Wild Wings (NASDAQ: BWLD) pre-tax margin has grown from 8.4% to 9.3% in the last three years. Based on pre-tax margin, Chipotle keeps much more of each dollar of sales relative to this competitor.

Net Income Per Employee

My theory is, part of the reason Chipotle's pre-tax margin is so high is because of the efficient use of employees. For this test, I want to use a more established company as the competitor. Let's compare Yum Brands (NYSE: YUM) and Chipotle's net income per employee. In theory, this makes sense as Yum Brands owns Taco Bell, and this is a direct competitor to Chipotle. Take a look at the numbers:

It turns out my theory is exactly right. Chipotle's more efficient restaurant design is the reason the company keeps so much more of each dollar of sales. Chipotle's standard restaurant employs just a handful of employees to prepare the food, and take orders. Chipotle's competitive advantage over Taco Bell is two fold. First, the meals are priced higher since the food quality is higher. Second, Chipotle's menu isn't as diverse, which allows ordering and receiving food to happen nearly as fast as Taco Bell. In short, diners get a higher quality meal than they could at Taco Bell, for a little more money, in about the same amount of time.

The point of us looking at these two tests of Chipotle is to say don't assume that a high priced stock when it comes to P/E, is overvalued. For instance, YUM Brands sells for a forward PEG of 1.42 versus Chipotle's forward PEG is 2.03. This indicates a premium for Chipotle of 43%. However, each Chipotle employee is producing 145% more net income than each YUM Brands employee. Theoretically, this means that Chipotle could sell for 145% of the PEG that YUM Brands sells for. That would indicate a forward PEG for Chipotle of 3.48. With a 22.3% expected growth rate, this would equate to a stock price of over $680. Just think about that number the next time you hear someone say that Chipotle is overvalued. I'm a big fan of using the P/E ratio to begin to gauge a company, but Chipotle's efficiency is being undervalued. There's a word I bet you never thought would be applied to Chipotle – undervalued.

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