Authored By Louis Stevens
Explaining the Sell Off From $70/share
To explain the big sell off, allow me to start with articulating the Chipotle thesis.
The Chipotle thesis is very straightforward:
- Chipotle offers a product with a compelling value proposition, which I've believed to be the best in the QSR space, via its burritos and bowls. We (as in you the reader and me as a team) actually got some data recently substantiating this perspective, and we will review it later in this note.
- It offers this product presently at 3.5k locations in North America, and it has set a goal of 7k locations over time in North America alone. It has also begun expansion into the Middle East, Europe, and, over time, it could certainly expand into APAC, as Guzman Y Gomez (GYG) has demonstrated expansion in this region would be possible via its own success in the region (starting in Australia). To this end, the long run total location count could very well be in excess of 7k by quite a wide margin.
- It presently generates ~30% restaurant level margins, and, with more Chipotlane (drive-thrus), this could mature into 30%+ over time, which provides ample room for a 20% operating margin and, deducting taxes, a 15% net margin (free cash flow margin). In Q2'24, it achieved these margin levels for the first time since its ecoli-pocalyse in 2015, in which it caused customers to get sick. The fallout of this event caused Chipotle's profit margins to crater to below 0%, and it has been gradually rebuilding its margin structure ever since (May be worth noting for Crowdstrike).
- It has $2.5B in cash and $0 in debt and devotes huge sums of money to buy backs each quarter, which poises it to grow free cash flow per share at rates above its top line growth in the decade ahead. Chipotle's share buy backs are an important ingredient in the company's long term return profile, especially now that the stock has fallen to an extent that the share buy backs will more materially impact free cash flow per share growth (fcf/share grows faster when the share variable is reduced faster, and this can be reduced faster via share repurchases at lower valuations. When companies like Costco, Chipotle, or Waste Management trade at 50x earnings or more, their share repurchases have negligible impacts on the growth of free cash flow per share).
So Chipotle is a straightforward, compelling thesis. From here, we simply need to perform a valuation in which we conservatively project free cash flow per share out ten years and invest based on that projection. Easy.
All of that said, the stock just fell from ~$70/share to ~$50/share, and I believe such a decline warrants an explanation before we perform our brief valuation exercise and conclude this review of Chipotle.
When The Highest Valuation Ever Meets The Best Quarter Ever
In late June, I referred to the QSR (quick service restaurant) space as a "den of unmitigated speculation," with the king of the space, Chipotle, having found itself trading at its highest valuation in its corporate history.
Yes, Chipotle traded at a valuation higher than even when it had only 1k stores twenty years ago while its sales grew ~30% and its growth runway was massive (meaning that it was far easier to assume 20%+ growth annualized for the decade ahead, whereas today it's virtually impossible to assume that due to Chipotle's growth runway shortening).
Chipotle's PE Ratio Hit 70x As Its Net Margins Hit Their Highest Level Ever = Highest Valuation Ever
The combination of its highest margins alongside a 70x PE made it the most expensive it had ever been in its company history, as it faced a growth runway just a fraction of what it was in bygone years.
This represented an unwarranted level of exuberance, bordering on outright insane speculation (I'd say it was the latter frankly).
And I noted as much in late June.
So the decline was bound to happen in due course, even with fantastic execution from the business and a lot of luck.
And, indeed, Chipotle executed to perfection. In fact, Q2'24 was the company's best quarter in its company history with 18% growth atop 30% restaurant level margins, which fed into 20% operating margins and a 15% net margin, its highest ever.
Chipotle Achieves Its Highest Net Margin Ever
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This represented phenomenal business performance and execution by the Chipotle team over the last decade since the ecoli-pocalypse cratered these margins to ~0% on average.
Second quarter highlights, year over year:
- Total revenue increased 18.2% to $3.0 billion [Incredible]
- Comparable restaurant sales increased 11.1% [Industry leading for companies of Chipotle's scale]
- Operating margin was 19.7%, an increase from 17.2% [Best ever]
- Restaurant level operating margin was 28.9%, an increase of 140 basis points [Best in a decade]
"The second quarter was outstanding as successful brand marketing, including the return of Chicken Al Pastor, drove strong demand to our restaurants. Our focus and training around throughput paid off as we were able to meet the stronger demand trends with terrific service and speed driving over 8% transaction growth in the quarter."
-Brian Niccol, CEO, Chipotle
Chipotle's Comparable Sales Growth
However, while we did get the execution, the luck has not been in Chipotle's favor lately.
As a result of difficult seasonality trends and near term investments, the company guided for near term margin pressure, which sent shares careening downward after an initial 15% pop after hours on the day of Chipotle's earnings.
"Before I go through the individual P&L line items, I want to give an overview of what to anticipate. We expect our margins will be under pressure for the next couple of quarters. Most, if not all of this pressure is seasonal, temporary, or it's an investment that we can offset through efficiencies, and we believe our industry-leading margin structure is still intact."
-Jack Hartung, CFO, Chipotle Q2'24 Earnings Call
Quantifiably, restaurant level margins are set to decline to 25%, which puts downward pressure on net margins as we discussed earlier, and lower net margins result in an elevated valuation (as price remains static but earnings in price to earnings declines, leading to a greater overall result, i.e., higher price to earnings ratio or higher valuation).
"Based on these expectations provided, we anticipate restaurant level margin to be around 25% in Q3."
-Jack Hartung, CFO, Chipotle Q2'24 Earnings Call
So while the company reported its best quarter ever:
- It had a valuation that not even the best quarter ever could justify.
- Things started to go a little bit wrong in Q3'24 for the company.
And these factors caused the stock price to precipitously decline.
And, of course, this highlights the importance of valuation and investing with a margin of safety.
A margin of safety shields our investment operations against the inevitable periods when things go wrong.
Margin of safety is defined as:
- Using conservative assumptions about future growth and margin levels in the process of underwriting an investment such that everything can go wrong in the future for the company, and the investment will still generate desired returns.
A margin of safety is created by using conservative assumptions about a company's forward growth rates and margin levels and investing only when the investment makes sense based on those conservatively assumed growth rates and margin levels.
If the investment thesis does not work with conservative assumptions about growth and margins, then we simply do not invest. Instead, we wait until the market offers us the stock at a price such that the thesis works with the aforementioned conservative assumptions.
Importantly, time and business progress must be considered in the process of underwriting an investment.
That is, while an investment thesis may not make sense at $100/share in 2020, it may, indeed, make sense at $100/share in 2025, after five years of valuation compression by way of the company growing sales and profits.
Datadog has been an example of this dynamic in that, in 2020, at 50x sales, it simply did not make sense as an investment, but at $70/share in 2023, it made more sense.
As we can see in this simplified hypothetical example, at $100/share in 2020, the valuation was 20x earnings, which may not have been attractive for us; however, at $100/share in 2025, it was 5x which would almost certainly be attractive enough.
We can think of it as a triangulation process in which our conservative assumptions, the company's stock price, and forward returns converge to create an attractive setup, and sometimes, or rather often, this process requires time and patience.
We will perform this triangulation process later today in our Chipotle valuation exercise, but, before we do that, I'd just like to touch on some recent data I came across which supported by long held thesis that Chipotle offers the best taste-adjusted calorie/dollar value of all fast food offerings in America presently.
The Best Taste-Adjusted Calorie/Dollar
In the past, I've shared that Chipotle offers the best calorie/dollar value in fast food, and this has mostly just been based on my intuition.
However, Goldman Sachs recently performed a survey in which it asked participants to rate the value proposition of various fast food offerings, and Chipotle was far and away the most differentiated in terms of its perceived value it offered to consumers.
I was excited to see this because I've long believed that Chipotle has effectively a monopoly product offering, a hidden monopoly if you will, hidden by the fact that there is nominally a lot of competition, but in reality very little, if any, competition. (Hidden monopolies, such as Facebook, is a very important concept in investing. While there's almost infinite competition for our attention, there's only one Facebook.)
And the chart above reflects this long held perception that I've incorporated into my Chipotle thesis.
"And one of the things that I keep an eye on closely is, are we gaining market share? And what's great to see is we're gaining market share every month, okay? So as we stay focused on executing Chipotle's core business, we see the results not only in the comp and transactions that we're delivering, but also the market share gains that we're making."
-Brian Niccol, CEO, Chipotle Q2'24 Earnings Call
It makes sense that Chipotle would continue to gain market share via its differentiated offering.
Runway For Growth
Chipotle's runway for growth has been a question mark in my mind over the years, and we've gradually received more data on the topic in the last two years.
In the early 2020s, Chipotle raised its guidance for total location count in North America from 6,000 to 7,000, and it, in recent years, announced its expansion into Europe and the Middle East.
"I also wanted to share an update on our partnership with the Alshaya Group. Our first restaurant in Kuwait has been open for several months and continues to have strong performance."
-Brian Niccol, CEO, Chipotle Q2'24 Earnings Call
"The good news is that the feedback from guests is that the culinary experience is right on par with North America, which is fantastic to hear. It also tells me that when we execute our culinary and delivering an exceptional experience for our guests, Chipotle's brand resonates across geographies.
We look forward to opening our second restaurant in Kuwait as well as expanding into Dubai with the Alshaya Group later this year."
-Brian Niccol, CEO, Chipotle Q2'24 Earnings Call
Considering Chipotle is a basic rice, chicken, and beans concept, which is a combination of food that all of earth enjoys, I believe it will have far greater universal appeal globally than even I have expected in the past.
If KFC and McDonald's can take the world by storm, I believe a basic rice, chicken, and beans concept, delivered in certainly a unique, differentiated, and compelling fashion, can as well.
By now, we have the necessary data to make assumptions in our valuation model, so let's perform our valuation exercise, then conclude this review of Chipotle's Q2'24 and the thesis broadly.
Valuation Exercise
"Earnings per share adjusted for unusual items was $0.34, representing 36% year-over-year growth. The second quarter had unusual expenses related to unrealized loss on investment and an increase in legal reserves, which negatively impacted our earnings per share by $0.01, leading to GAAP per share of $0.33."
-Jack Hartung, CFO, Chipotle Q2'24 Earnings Call
We will project free cash flow per share in a moment; however, it's worth considering that on an annualized basis, at $49/share, Chipotle trades at 36x price to earnings, which is a 2.8% yield, and the $.34 in earnings represents Chipotle achieving my long-held target for its margins of 15%.
Chipotle Achieves Our Target 15% Net Margins (Awesome)
This is far more palatable relative to its yield at $70/share; however, is it enough?
Let's investigate via the valuation exercise below.
And below we can see the results:
Notably, I assumed a reduction in share count of 15%, which I believe is achievable considering the business has $2.5B in cash on its balance sheet, $0 in debt, and $1.8B in annualized free cash flow that it devotes to buy backs.
"Our balance sheet remains strong as we ended the quarter with $2.5 billion in cash, restricted cash and investments with no debt. During the quarter, we repurchased $151 million of our stock at an average price of $63.52."
-Jack Hartung, CFO, Chipotle Q2'24 Earnings Call
That said, at its current valuation, it may struggle to reduce its share count by 15% over 10 years (it's difficult to make this assumption due to the variability of the price at which it will buy back shares, hence the margin of safety discussion from earlier).
(That said, we're supposed to be using conservative assumptions, right!?)
Stick with me.
Let's now turn total returns.
As we can see, total returns are relatively tepid at just 9% in the above scenario.
This corroborates my unwillingness to buy at in any significant degree at these levels.
Chipotle will begin to get more attractive via either: 1) the passage of time and its business growth catching up to its valuation or 2) a further decline in its stock price.
(Recall the above-had triangulation discussion).
Concluding Thoughts
To close, Chipotle is doing better than ever, and it will certainly be at the top of LAS' buy rating list should the market broadly sell off or should the stock itself sell off.
Otherwise, I'll be patient in rating the business a buy and allow its business progress to catch up to its valuation such that it becomes a more attractive risk/return setup where returns are higher than risk (I would say they're about equal presently. Chipotle's just not that risky as the best QSR spot in America at the moment).
Disclosures:
L.A. Stevens has not rated Chipotle.
