Chipotle Mexican Grill stock (NYSE:CMG) has managed to sustain a hefty valuation against all market hurdles. The company’s shares not only swiftly rebounded from the initial COVID-19 market crash in 2020 but also withstood much of the turbulence that most stocks encountered in 2022.
Investors’ enthusiasm for Chipotle can be likely attributed to their eagerness to capitalize on the company’s ambitious expansion plans, signaling an optimistic outlook for its earning potential. This is further reinforced by the significant institutional ownership of the stock. That said, with interest rates moving gradually higher, investors’ ever-bullish sentiment on Chipotle could alter. Accordingly, I am neutral on the stock.
Why is CMG Stock a Wall Street Darling?
Chipotle Mexican Grill has evolved into one of Wall Street’s darlings, as illustrated by the stock’s mighty trading pattern and its continuously rich valuation. Shares are currently trading at a forward P/E of about 39, which is obviously a very expensive multiple, especially in the current market environment.
The question arises as to why investors are willing to pay a premium for Chipotle’s stock. In my perspective, the answer lies in the company’s favorable position. After having already cemented its presence in the global QSR (Quick Service Restaurant) industry, Chipotle is now ready to start achieving tremendous economies of scale. And most importantly, Chipotle has reached this position without franchising a single location!
To better illustrate this point, let’s break down the journey of a QSR chain into two phases. The first phase involves cementing your position in the QSR space. This is a costly process that involves a company opening a bunch of corporate-owned locations that will serve as proof of concept for future franchisees. I recently wrote an article explaining why Shake Shak (NYSE: SHAK), which is currently navigating this phase, has a hard time reaching profitability due to how expensive this process is.
Then, there is a QSR chain’s maturity phase, in which a company starts shifting its location mix to franchisee-owned locations. McDonald’s (NYSE:MCD) and Domino’s Pizza, Inc. (NYSE:DPZ) are two great examples of QSR companies reaching a peak maturity phase, with 95% and 99% of their restaurants being franchised, respectively.
This is where the real profits can be made, with both companies making bank from high-margin royalties on franchise-attributed sales, rental revenues from franchised locations, and the distribution of ingredients to franchisees, without actually taking on all the hurdles that come with operating the restaurants.
Chipotle’s magnificence lies in that the company has managed to complete the first phase without franchising a single location! No other company in the space has ended up with more than 3,000 locations without franchising a single restaurant apart from Chipotle.
The company has achieved incredible menu optimization efficiencies that have allowed it to be quite profitable while actually operating its own restaurants, making investors eager to witness the company’s future profitability as it scales up from this point. This is pretty much why renowned investors on Wall Street can’t get enough of Chipotle’s stock. Legendary investor Bill Ackman, for instance, has been accumulating Chipotle’s stock since 2016 via Pershing Square Capital Management. The fund now owns about 4% of the company.
Is Chipotle’s Earnings Growth Fast Enough?
As mentioned, Chipotle’s rich valuation essentially reflects investors’ expectations for rapid earnings growth. Indeed, Chipotle has sustained robust revenue growth over the years, resulting in gradually expanding margins and, thus, even stronger earnings growth.
Over the past five years, revenues and net income have grown at a compound annual growth rate of 14.0% and 38.5%, respectively, which reflects both a satisfactory pace of top-line growth and Chipotle’s gradual margin expansion.
In 2022, Chipotle’s bottom-line growth remained at superb levels, with the company’s operating margin expanding to 13.4%, up from 10.7% in 2021. Consequently, net income grew by 37.7% to a record $899.1 million, sustaining its exciting pace of growth. Based on these metrics, if Chipotle were to sustain such a pace of earnings growth in the next few years, its steep forward P/E of 39 appears rather reasonable.
Another signal that Chipotle’s valuation is reasonable relative to its future earnings growth is that over the past few years, the company has been repurchasing a fairly notable amount of stock, even at higher forward P/E ratios than the current one. Last year, the company repurchased about $929.1 million worth of stock, which was modestly higher than its net income for the year.
I find it unlikely that management would allocate capital toward buybacks instead of further restaurant openings if they weren’t confident that their stock is indeed undervalued relative to its future earnings growth.
Is CMG Stock a Buy, According to Analysts?
Turning to Wall Street, Chipotle Mexican Grill has a Strong Buy consensus rating based on 17 Buys and five Holds assigned in the past three months. At $1,850.71, the average CMG stock forecast implies 12% upside potential.
Conclusion
Chipotle is well-positioned to sustain exciting earnings growth, as the company has cemented its position in the QSR industry quite competently. No franchisee has ever joined the Chipotle family, leaving ample room for the company to pursue this avenue if it ever wishes to. In the meantime, its earnings can keep snowballing as the company achieves economies of scale through growing same-store sales and new location openings, which expand its margins.
Regarding its valuation, it appears that Chipotle’s steep P/E can be justified given its rapidly improving profitability and management’s guidance. That said, I would remain cautious as rising rates have changed investors’ appetite for highly-valued equities. Chipotle has been an exception so far, but if macroeconomic pressures persist, it may eventually see investors’ willingness to pay a premium multiple subside.
