Z. Christopher Mercer, ASA, CFA, ABAR, Founder and CEO of Mercer Capital, maintains a business valuation-themed blog at ChrisMercer.net. This guest post first appeared on Chris’s blog on December 30, 2015.
When I see stories in the financial press I often think of what lessons business owners can learn from the experiences of others. Perhaps there is a lesson to pay attention to basics in the emerging situation at Chipotle Mexican Grill, Inc. (CMG). This post about Chipotle will come in three sections.
- The first section addresses Chipotle’s performance between 2012 and mid-October 2015, or the period ending just before an outbreak of E. coli in Chipotle stores located in the northwest.
- The second section addresses performance since the initial E. coli announcement, which has been followed by other, similar announcements regarding other stores around the nation, as well as the announcement of a class action lawsuit on behalf of E. coli victims.
- The third section examines the traditional valuation relationships between expected growth and risk to examine the current pricing of Chipotle in that light.
Chipotle’s Performance Through Third Quarter 2015
Chipotle’s performance, both as a company and as a stock, can be described as phenomonal for the period beginning 2012 through the end of the third quarter 2015. Sales grew at 20.6% compounded over the period (Line 1 in figure below), with earnings per share growing an even faster 26.7% (Line 8). Fueled by this rapid growth, the stock price grew at a 40% compounded rate from year-end 2012 to September 30, 2015, or from $297.46 per share to $750.25 per share (Line 6). Chipotle’s equity market capitalization rose from $9.45 billion to $23.40 billion (Line 7). That’s a lot of market capitalization! The analysts and investors loved the stock, because the price/earnings multiple increased from 34x trailing earnings to about 50x trailing earnings by the end of 2014 (Line 9).
This growth was fueled by a growth in the number of stores of 12.1%, with the store count increasing from 1,410 to 1,931 (Line 3). Chipotle was opening stores at the rate of more than three every week during the period. In spite of this rapid growth in the number of stores, average sales per store rose 6.8% (Line 2). This meant that same-store sales (for stores open more than a year) were rising at even more rapid rates.
The train was running at a very rapid pace and hoping for no sharp curves ahead. Unfortunately, we never know about most of the the curves in life until they happen. When I talk to business owners, I talk about addressing known risks while they are addressable. These risks include concentrations of all types. They also include regulatory change, potential industry and competitive threats. And, for restaurants and other food-related companies, risks also include the danger of E. coli, listeria, and other potential contaminants. That’s just an aside.
Assume that Chipotle’s discount rate was 15% during this period from 2012 through September 2015. With risky and rapid growth like described above (and shown in the table below) it should have been at least that high. Go with me for now, because the selection of the discount rate doesn’t impact the inferences of analysis below very much. Using the Gordon Model and LTM earnings for simplicity (V = CF / (R – G)), Chipotle’s perpetual growth rate assumed by analysts had to be on the order of 12% to 13% to justify its stock price over the period (Line 12). This is in line with the growth rate of 12.1% in the number of stores during the trailing periods (Line 3).
There was not much room for risk in the stock’s price. The chart is shown below for reference.
Performance from Mid-October to Year-End 2015
The initial E. coli announcement occurred about October 15, 2015. We have measured the stock’s performance from October 13th, before the announcement. The closing price that date was $750.42 per share, and equity market cap stood at $23.42 billion (Line 2 in the figure below). That is in line with pricing a couple weeks before at September 30, 2015.
The stock has experienced an almost steady decline since October 13th following a series of announcements about new E. coli issues and other issues. At the close of business December 29th, Chipotle shares traded at $489.94 per share, representing a 34.7% decline from October 13th, and a 28.4% decline from year-end 2014.
Equity market capitalization declined $8.12 billion from October through year-end. That’s a lot of market capitalization! Recent investors have to be hurting, and any short sellers should have made out like bandits. The stock’s price has been taken down to below its price of $532.78 per share on December 31, 2013, so more that two years of growth have been lost.
- The problems erupted while Chipotle was growing very rapidly. Management may not have been paying attention to quality control as much as was needed.
- Senior management was incentivised for growth for growth’s sake, rather than for returns to shareholders.
- Chipotle was a “Wall Street Darling.” Prior to the E. coli announcement, there were 18 buy recommendations out on the stock, and 12 neutral opinions. There were no sell recommendations. Arands notes that now, there are 15 buy recommendations and 17 holds. There is only one sell recommendation at this time. Is Chipotle still a darling?
- Chipotle was an expensive stock. Arands noted: “It began the year on a lofty 40 times forecast per-share earnings — more than twice the historic average for U.S. stocks overall. (In the past, as a rough rule of thumb, U.S. stocks have tended to trade on around 16 times forecast earnings.) Genuine growth stocks can justify higher ratings, but it is hard to see why a simple burrito chain with brick-and-mortar economics would merit so high a rating. You have to run really hard to keep up with a rating of 40 times earnings.”
Chipotle is having problems addressing the damage to its brand because the Center for Disease Control and Prevention (CDC) is investigating another round of E. coli outbreaks at Chipotle stores. Until the company receives a clean bill of health from the CDC, it will be in limbo, and sales will be under pressure from lots of negative press and social media coverage.
Getting the green light from CDC is critical, because management expects same store sales to be down between 8% and 11% for the fourth quarter 2015, which would be the first down same store sales report in about a decade. Declining same store sales, unless reversed quickly, will lower sales and earnings potentially. It is not known (by me at least) what impact this crisis will have on new store growth. Certainly there are lots of stores in the pipeline that are coming on stream in the midst of all of the bad news.
Expected Growth, Risk and Value
It goes without saying that Chipotle has been recognized as a riskier stock after the E. coli outbreak. We assumed a discount rate of 15% in the first table to examine the implications for the markets’ assumption about expected perpetual growth for Chipotle. In the table above, we see that the perpetual growth rate embedded in Chipotle’s stock price of $750.42 per share at October 13, 2015, was 12.8% (Line 8).
Assume that the appropriate discount rate for Chipotle is now 20% and not 15% (Line 7). The embedded expected perpetual growth rate to justify the stock price of $489.94 per share is 16.5% (Line 8). The implication is that the expected long-term growth for Chipotle has increased to support the current pricing of $489.94 per share. This is simply not realistic. The market will rationalize pricing with expectations for risk and growth over time.
Look at one further implication of this analysis. If the discount rate is 20% as assumed above, and the expectation for perpetual growth remains unchanged from the 12.8% pre-E. coli (which is not a likely assumption), the implied price/earnings multiple for Chipotle would be 13.8x, and not 29.2x as seen on Line 5 above.
If the p/e were 13.8x and earnings per share are unaffected by all of this (including declining same store sales), then the implied price for Chipotle is about $232 per share. That is substantially below yesterday’s price of $490 per share. That’s a lot of potential downside exposure for Chipotle shares.
This analysis, by the way, in no way represents investment advice or a recommendation of any kind. As in numerous other posts, I simply do the valuation math and observe the implications.
Chipotle shareholders had a great ride for a long time. The company has now hit a major fork in the road that is slowing the growth machine down. It remains to be seen what the ultimate impact of this E. coli problem will be on Chipotle. In the short run, it has been nothing short of disastrous as measured by lost share price and equity market capitalization.
Will the Chipotle shares find a bottom in the near-term, or will they continue down? I don’t know, but the analysis above suggests there is potential for a good deal more downside in the shares. As I put the finishing touches on this post, the share price has dropped further to $484.10 per share, or another 1.2% from the close yesterday (December 29th). [Ed. Note: Since the blog post was published, Chipotle’s daily closing share price declined to a low of $404.90 on January 12, 2016, before ending at $482.12 on February 12, 2016.]
The message for business owners is, as always, to focus on minimizing risks while balancing that risk minimization with realistic growth potential. As noted at the outset, a focus on basics is always good.