Beyond The CEO: Evaluating Chipotle’s Fundamental Strengths (NYSE:CMG)

Introduction and Recent Developments

Since our last assessment of Chipotle (NYSE:CMG) in May 2023, the stock has increased by 30%. Because we believe that a leading company with a high valuation multiple takes time to demonstrate its might, we urged investors to hold and not trade this stock at that time.

After six years at Chipotle, Brian Niccol, the company’s chairman and CEO, departed in August 2024. Investors were taken aback by this, and the stock crashed shortly after. Since its peak in 2024, it has declined by 20%. As a result, we believe the moment has come to assess the stock and the company’s prospects.

Impact of CEO Departure

First off, given that Chipotle’s stock has outperformed the industry over the previous five years, we believe that the CEO has done a great job, and his resignation may not be viewed as a cause for concern. Before the CEO’s departure, the company increased comp sales by 11% in Q2 2024. Thus, we should still give the CEO credit for bringing Chipotle thus far, despite whatever future obstacles the company may encounter or any unfinished business.

Still, we believe that the most important concern is whether Chipotle can maintain its growth momentum in the wake of the departure of its CEO, considering that the company is trading at a forward P/E of 50x. The company has been performing admirably over the last several quarters, with EPS growing in the teens. Analysts anticipate that EPS will continue to expand in the teens over the next three years. (see the below charts)

International Expansion Strategy

The market’s high expectations, in our opinion, are based on Chipotle’s international expansion to over 28000 stores rather than its US expansion to 7000 stores, as we determined when we previously utilized the DCF model to assess the stock. As a result, stock performance needs to be closely linked to how well the company expands globally.

Management stated on the Q2 earnings call that they think Chipotle’s early success in breaking into the Canadian market supports the scalability of its business model. After entering the Canadian market in 2021, Chipotle has grown to 47 locations at a rate of 15.6 locations annually. The business, which has 30 locations in the UK and 7 in France as of 2023, had proclaimed its intention to expand throughout Europe. Europe appears to be expanding more quickly than Canada. Given that we discovered that reviews of Chipotle are more positive in France and the UK than in Canada, this is probably the result of consumer experiences. (see the below charts)

Stores in Canada often have lower ratings than those in the UK and France, according to Google reviews. Our investigation into the bad reviews led us to the conclusion that the food quantities were probably the problem, which the management had rectified at the Q2 earnings call.

The management wants to address this problem by investing more in food ingredients, which could eventually result in a reduced restaurant-level margin. In Q3 2024, the management expected its restaurant level margin to drop to 25% because the company also faced other challenges, such as rising labor costs.

Economic Risks and Industry Trends

We recognize the challenges that lie ahead and believe that, following the Fed’s September interest rate reduction, there may be additional risks. Considering that historically high interest rates have suppressed the demand for durable goods. The reduction in interest rates is probably going to promote the purchase of more durable products. This will probably push away consumers’ consumption of non-durable products because their savings have been declining.

We believe that the market is concerned that Chipotle may face short-term difficulties as a result of the general downturn in the restaurant industry. Retail sales of food service and drinking establishments in the US have been declining over the last few months, as may be observed.

Additionally, the National Restaurant Association reported that customer traffic was down across all sectors and that the problem had recently gotten worse. Beginning in June 2024, McDonald’s (MCD) and KFC were observed to sell $5 menu meals. Chipotle’s food investment signals the start of an industry-wide price war. Investors are alarmed by this, since Chipotle is probably going to suffer more than businesses that use franchising models like McDonald’s. It does not appear beneficial for Chipotle because the franchisor can pass through the operating costs to its franchisee.

However, we believe that one of the main reasons Chipotle has outperformed the market over the past five years is that it appeals to consumers as a healthier alternative to more established fast-food chains like McDonald’s. We explained in our Strong Buy recommendation of Sweetgreen (SG) that the healthy diet movement is gaining traction and that we believe its allure for health can be the catalyst for long-term change in the restaurant business.

Although we believe Sweetgreen offers the best value when it comes to health, Chipotle is already quite competitive when it comes to typical fast food chains like McDonald’s and Domino’s (DPZ). With over 3500 locations as of right now, Chipotle is still much below the top 10 businesses in the US. (View the chart below.) Because of this, we think Chipotle is still in its infancy as it disrupts existing chains both domestically and abroad, and we conclude that, given the size of its current chain, Chipotle is unlikely to be significantly impacted by the likelihood of an industry downturn. In addition, given that the problem with food portions can be resolved and the company’s goal to expand internationally is still on track, we believe Chipotle’s long-term growth prospects remain unchanged.

Valuation

This time around, we valued the stock using a new methodology. Rather than using the bottom-up approach to value the stock based on the number of stores, we assume that the company will maintain its 12.3% free cash flow margin as is and will grow at a rate of 10% over the next ten years, then 3% after that. Given the size of the retail base and the value proposition presented to customers, we expect that the current impact on the firm’s bottom line will be temporary in Q3, 2024. We believe the company will likely maintain its momentum both domestically and abroad to offset its restaurant-level margin pressure short term. Since the company’s revenues are already growing at a 15% annual rate, we believe our 10% CAGR is acceptable. This implies a 44% upside to $78 per share, based on an 11.7% WACC assumption. (see the below chart)

Based on the sensitivity analysis below, we deduce that considering that the anticipated lower interest rate from the Fed can also lower its WACC, there appeared to be more upside than negative. Chipotle is a strong growth stock, so changes in WACC will have a significant impact on its valuation. Based on our sensitive table below, we believe that if Chipotle can maintain growth in the teens in EPS even after temporarily lowering its restaurant-level margin to 25% in Q3, the market is likely to give it a higher valuation. We so continue to maintain our Buy rating.

Conclusion

We believe that when investing in fast-growth stocks like Chipotle, investors often become uneasy since the CEO’s departure is sometimes interpreted as a warning sign. Nonetheless, we believe Chipotle is still in its early stages of upending the conventional fast food chain market. Thus, the current difficulties are unlikely to have a significant effect on the company’s long-term prospects. We are cautiously optimistic because the WACC and growth assumption have a significant impact on the stock valuation. We tend to maintain our Buy rating since we believe Chipotle has demonstrated its potential in the global market and the CEO’s departure might not hurt the expansion plan.