Beyond the CEO: Assessing Chipotle’s (NYSE:CMG) Fundamental Strengths

Introduction and recent developments

Since our last review of Chipotle (NYSE:CMG) in May 2023, the stock increased by 30%. Because we believe that a leading company with a high valuation multiple needs time to prove its strength, we urged investors to hold and not trade these shares at that time.

After six years at Chipotle, Brian Niccol, the company’s president and CEO, left in August 2024. Investors were surprised by this, and the stock crashed soon after. Since its peak in 2024, it has fallen 20%. As a result, we believe the time has come to evaluate the company’s stock and prospects.

The impact of the CEO’s departure

First, given that Chipotle’s stock has outperformed the industry over the past five years, we think the CEO has done a great job and his resignation cannot be seen as a cause for concern. Prior to the CEO’s departure, the company grew comp sales by 11% in Q2 2024. Thus, we should still give the CEO credit for bringing Chipotle this far despite the upcoming hurdles the company faces -could meet or any unfinished business.

However, we think the most important concern is whether Chipotle can maintain its growth momentum following the departure of its CEO, given that the company trades at a forward P/E of 50x. The company has performed admirably over the past few quarters, with EPS growing in the high-teens. Analysts anticipate that EPS will continue to expand in adolescents in the next three years. (see graphs below)

International expansion strategy

In our view, the market’s high expectations are based on Chipotle’s international expansion to more than 28,000 stores, rather than its US expansion to 7,000 stores, as we determined when we previously used the DCF model to value the stock. As a result, inventory performance must be closely related to how well the company is expanding globally.

Management said on the Q2 earnings call that it believes Chipotle’s early success in penetrating 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 company, which has 30 locations in the UK and 7 in France as of 2023, has announced its intention to expand across Europe. Europe seems to be expanding faster than Canada. Given that we found Chipotle reviews to be more positive in France and the UK than in Canada, this is likely a result of consumer experiences. (see graphs below)

Canadian stores often have lower ratings than those in the UK and France, according to Google reviews. Our investigation into the bad reviews led us to conclude that food quantities were likely the issue, which management addressed on the Q2 earnings call.

Management wants to address this issue by investing more in food ingredients, which could ultimately lead to a reduced margin at the restaurant level. In Q3 2024, management expected restaurant-wide margin to decline to 25% as the company also faced other challenges, such as rising labor costs.

Economic risks and industry trends

We recognize the challenges ahead and believe that following the Fed’s interest rate cut in September, there may be additional risks. Given that historically high interest rates have suppressed demand for durable goods. Lower interest rates will likely promote the purchase of more durable products. This will likely push back consumption of non-durable goods by consumers as their savings have declined.

We believe the market is concerned that Chipotle may face short-term difficulties as a result of the overall downturn in the restaurant industry. Retail sales of food service and beverage establishments in the US have fallen in recent months, as can be seen.

Additionally, the National Restaurant Association reported that customer traffic is down across all sectors and that the problem has gotten worse recently. As of June 2024, McDonald’s ( MCD ) and KFC were observed selling $5 menu items. Chipotle’s grocery investment signals the start of an industry-wide price war. Investors are alarmed by this because Chipotle will likely suffer more than companies that use franchise models like McDonald’s. It doesn’t seem beneficial to Chipotle because the franchisor can pass on the operating costs to its franchisee.

However, we believe 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 eating movement is gaining momentum and that we believe its health appeal can be the catalyst for long-term change in the restaurant business.

While we think 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 3,500 locations to date, Chipotle is still well below the top 10 companies in the US. (View chart below.) Because of this, we believe Chipotle is still in its early days as it disrupts existing chains both domestically and abroad, and we conclude that given the size of its current chain, it is unlikely that Chipotle be significantly affected by the likelihood of an industry downturn. Additionally, given that the food portion issue can be resolved and the company’s goal of expanding internationally is still on track, we believe Chipotle’s long-term growth prospects remain intact.

ASSESSMENT

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

Based on the sensitivity analysis below, we infer that given that the anticipated lower Fed interest rate may also lower its WACC, it appeared to be more upside than downside. Chipotle is a strong growth stock, so changes in WACC will have a significant impact on its valuation. Based on our sensible table below, we believe that if Chipotle can maintain low-teens growth in EPS even after temporarily narrowing its restaurant-wide margin to 25% in Q3, the market is likely to give it a valuation bigger. We continue to maintain our Buy rating.

Conclusion

We believe that when investing in fast-growing stocks like Chipotle, investors often become uneasy because the departure of the CEO is sometimes interpreted as a warning sign. However, we believe that Chipotle is still in the early stages of changing 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 WACC and growth assumption have a significant impact on stock valuation. We tend to maintain our buy rating as we believe that Chipotle has demonstrated its potential in the global market and that the CEO’s departure may not affect the expansion plan.