2 Measures Say Chipotle is Undervalued

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Disappointing means very different things to investors these days. I understand that an earnings miss causes investors to panic, and in particular when a stock is perceived as overvalued. This has been the theme now for two straight quarters with Chipotle (NYSE: CMG). Last quarter, Chipotle delivered earnings that by all accounts were better than analysts expected, yet the stock sold off. In the company's most recent earnings, the stock sold off again by delivering on the company's guidance.

Earnings:

Many people must have assumed that Chipotle was overvalued prior to this most recent earnings release. However, this begs the question: What measures were investors looking at to believe that the company was overvalued? Before we get to how much Chipotle should be worth, let's look at how the company performed in the last quarter. Sales increased 18.4%, and comparable sales were up 4.8%. Chipotle also delivered almost 20% EPS growth and impressive cash flow. In fact, the company's operating cash flow jumped by more than 30% year-over-year. Chipotle grew new restaurants by 2.58% and expects to open about the same amount of new stores next quarter. While it's true that Chipotle's projections for next year probably disappointed some people, by multiple measures I would question the idea that Chipotle is overvalued.

Undervalued Based on Operating Margin:

I've looked at Chipotle's valuation before and found that the company produced more net income per employee than competitor Yum! Brands (NYSE: YUM). However, over time things change and after two big drops in the stock, I wanted to make sure that Chipotle's performance hadn't dropped off as well. One way to measure a company's efficiency is by operating margin. To get a good cross section of other fast growing restaurant companies, I wanted to compare Chipotle to the previously mentioned Yum! Brands and other fast growers like Buffalo Wild Wings (NASDAQ: BWLD) and BJRI Restaurants (NASDAQ: BJRI). YUM of course competes directly with Chipotle with their Taco Bell chain. Buffalo Wild Wings offers a fast growing chicken wing and beer joint, and BJRI offers a smaller restaurant chain that is just getting started on the west coast. What all of these companies have in common is that they are all expected to grow earnings by at least 13%, they all have solid revenue growth, and each represents competing restaurants that customers can choose from. Take a look at how each of these companies perform when it comes to operating margin and let's see what this might tell us about Chipotle's valuation:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Operating Margin</strong></p> </td> <td> <p><strong>Chipotle vs Competition</strong></p> </td> <td> <p><strong>Chipotle's Relative P/E Ratio</strong></p> </td> </tr> <tr> <td> <p>BJRI Restaurants</p> </td> <td> <p>6.79%</p> </td> <td> <p>147.42% more</p> </td> <td> <p>61.51</p> </td> </tr> <tr> <td> <p>Buffalo Wild Wings</p> </td> <td> <p>7.39%</p> </td> <td> <p>127.33% more</p> </td> <td> <p>46.44</p> </td> </tr> <tr> <td> <p>Chipotle</p> </td> <td> <p>16.80%</p> </td> <td> <p>0.00%</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p>YUM Brands</p> </td> <td> <p>18.80%</p> </td> <td> <p>10.64% less</p> </td> <td> <p>17.23 </p> </td> </tr> </tbody> </table>

If you look at the comparison of the four companies, Chipotle is outperforming two of its three competitors by a wide margin, and only trails YUM by a small amount. If we use a weighted average of these relative P/E ratios, we find that Chipotle should trade for 41.32 times projected earnings. Since analysts expect earnings for 2013 of $10.41 this would indicate a price of $430.14.

Undervalued Based on Free Cash Flow:

It should be no secret that Chipotle is a cash flow machine. Since most restaurants require few employees and generate tremendous sales, free cash flow is a natural consequence. Looking at Chipotle's free cash flow performance versus its competition, the difference is astounding.

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Free Cash Flow Per $1 Sales</strong></p> </td> <td> <p><strong>Chipotle Versus Competition</strong></p> </td> <td> <p><strong>Chipotle's Relative P/E Ratio</strong></p> </td> </tr> <tr> <td> <p>BJRI Restaurants</p> </td> <td> <p>N/A</p> </td> <td> <p>N/A</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p>Buffalo Wild Wings</p> </td> <td> <p>$0.03</p> </td> <td> <p>566.67%</p> </td> <td> <p>136.2</p> </td> </tr> <tr> <td> <p>Chipotle</p> </td> <td> <p>$0.20</p> </td> <td> <p>N/A</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p>YUM Brands</p> </td> <td> <p>$0.10</p> </td> <td> <p>100.00%</p> </td> <td> <p>38.56 </p> </td> </tr> </tbody> </table>

BJRI reported negative free cash flow so we can't get a comparison that way, but you can see that Chipotle is destroying their competition when it comes to free cash flow. In fact, using a weighted P/E ratio again, Chipotle should trade for about 87.38 times earnings. Even if you cut this assumption in half, the stock still should trade for 43.69 times earnings relative to its competition. At 43.69 times earnings on 2013 projections, the stock would trade for $454.81.

Conclusion:

There is far more to valuing a company than just the P/E ratio. I made the mistake originally of looking at just P/E relative to their growth rate and thought that Chipotle was overvalued myself. However, the more I looked at how much more efficient Chipotle is in generating sales and profits, the more convinced I became the stock was not overvalued. After the two recent drops in the price, investors are being given a prime opportunity to load up on this burrito maker. As we have seen, by two measures relative to its competition, Chipotle should trade for at least $430. With analysts expecting growth of over 21%, it doesn't hurt that Chipotle also has the highest growth rate of the group either. Use this information as a starting point for your own research and see if the “business of good food” could be good for your portfolio.


MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of BJ's Restaurants, Buffalo Wild Wings, and Chipotle Mexican Grill. Motley Fool newsletter services recommend BJ's Restaurants, Buffalo Wild Wings, and Chipotle Mexican Grill. 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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