Chipotle: Fully Valued Heading Into Q3 Earnings

Just over ten months ago, I wrote on Chipotle (NYSE:CMG), noting that relatively aggressive pricing could hurt demand and that any rallies to $1,640 before year-end 2022 would present profit-taking opportunities. And while the stock slid ~18% following a rally to ~$1,640 in December 2022, the stock has been one of the better performers in 2023, up 28% year-to-date which has crushed the S&P-500's (SPY) 13% return. However, with the stock recently losing its 200-day moving average and approaching a more difficult setup in Q3, it's harder to argue for paying up for the stock ahead of its results on October 26th. Let's take a closer look below:

Recent Results & Q3 Outlook

Chipotle released its Q2 results in late July, beating earnings by ~3% with quarterly earnings per share of $12.65 (+36% year-over-year), and posting solid results across the board. This included 47 new restaurants that were opened, 13% revenue growth in the period to a record ~$2.51 billion, and a 230 basis point improvement in restaurant-level margins which came in at 27.5%. Meanwhile, the company reported ~4% traffic growth, a clear outlier vs. the industry where traffic has been consistently negative since January. Finally, the company reported double-digit comparable sales growth in Q2, one of the better metrics reported among its peer group, with this translating to 2-year stacked comp sales growth of 22.6%.

Digging into the results a little closer, Chipotle enjoyed lower food & beverage costs of 29.4% (down 100 basis points), with the benefit of higher menu pricing and lower avocado prices more than offsetting higher beef, dairy, salsa, beans, and rice costs. Meanwhile, labor also dipped 50 basis points year-over-year, with the benefit of sales leverage, partially offset by wage inflation. The result was that Chipotle's restaurant-level margins improved 300 basis points on a two-year basis, with this being one of the best quarters for restaurant-level margins to date, despite peers struggling to hold the line. Finally, regarding development, the company opened 47 new restaurants in the period (including 40 Chipotlanes), with its Chipotlanes continuing to outperform, and not surprisingly, Chipotle continues to aim for ~80% of new restaurants in this new format.

Industry Wide Trends

Moving over to industry-wide trends, one positive for the industry has been the cool down in commodity inflation, with several restaurant brands actually expecting commodity deflation in the back half of the year in some areas of their market basket. And while Chipotle in a less favorable position given that it has seen had to combat rising beef prices (beef and veal accelerated to up 21.6% in September vs. ~16.0% in August), it benefited from Chicken Al Pastor which was added to its menu in May, shifting some of its guests from more expensive beef into chicken.

Simultaneously, it was benefiting from mid-single-digit menu pricing to help combat higher beef prices and lower avocado prices. However, with it won't have the same benefit in Q3/Q4 with the LTO taken off the menu in late August, and Chipotle won't have the same benefit of pricing given that pricing was rolling off to just ~2.5% effective pricing as of August. These factors could affect its ability to meet Q3 earnings per share estimates of ~$10.70 unless it leans on share repurchases to improve its per share growth.

Meanwhile, from a top-line standpoint, sales estimates are sitting at ~$2.48 billion for its upcoming Q3 results, implying a ~12% increase in sales year-over-year. And while there's an outside chance of Chipotle meeting this figure, industry-wide traffic trends suggest this won't be an easy feat, with August and September being poor traffic months for casual dining and quick-service, with further evidence of this from the below OpenTable Seated Diners chart, showing that traffic levels worsened as Q3 progressed and spent only a couple of days in positive territory. And while some investors might argue that measuring casual dining/fine dining statistics is less helpful for a brand like Chipotle and they might also argue that Chipotle has been much less sensitive to traffic headwinds evidenced by its positive traffic in Q2, I'm less confident that it can buck this trend in Q3/Q4, with minimal help from pricing and traffic at its consistently worst levels of the year industry-wide.

Digging into company commentary a little closer, Chipotle seen a positive progression over the past year in regards to its guests and their spending habits, with the following take-aways:

Q2 2022: "lower income consumer is slowing down, but higher income consumer is strong, and we over-index to higher income consumers"

Q3 2022: "we're seeing a widening of trends by income level, with lower income consumer further reducing frequency, but higher-income households are increasing purchase frequency"

Q4 2022: "we continue to see the higher-income consumer, the individual that earns over $100,000, coming more often... and we made the decision not to chase people with discounts, and we think the same thing would have happened regardless of pricing (discussing low-income consumer)"

Q2 2023: "so, we're not seeing any weakness in the lower-income consumer, if anything, they've continue to improve, and that's why we had such a strong traffic performance in the quarter.. both the lower-income and higher-income consumer are both showing really good strength".

This above trend would suggest that Chipotle is far less sensitive than the peer group and that looking at industry-wide traffic trends may be less helpful for predicting Chipotle's upcoming results. This is because Chipotle indexes to higher-income consumers that are spending similarly or more, and even its lower-income guests seem to have gravitated back judging by its commentary, somewhat out an outlier vs. other retail brands. However, this commentary was provided early in the quarter (late July) when industry-wide traffic was enjoying a recovery, but it rolled over almost immediately judging by traffic trends and has stayed negative since, and the company will not have the benefit of pricing (~5.0% in Q2 vs. ~2.5% in Q3) if the company isn't able to buck this trend. Therefore, I would argue that the setup to beat is much more challenging in Q3 than it was in Q2, suggesting a higher probability of Chipotle missing top and bottom line estimates of ~$2.48 billion.

Finally, while the Q3/Q4 results could come in softer than some investors hope, the FY2024 outlook isn't much better, with Chipotle likely having to lean on price again if it wants to hold the line on margins. This is because nearly one-sixth of its system looks like it will be exposed to a $20.00 minimum wage in California (one of its core markets where it has ~14% of its restaurants) and this is occurring at a time when pricing is less of an available lever after raising prices nearly 30% over the past three years already. In summary, both the near-term and medium-term outlook look challenging, and the risk to taking additional price (above the recent October price hike) is that we could see its less affluent customer that was bouncing back drop in frequency and looking for trade-down options even if they may not be as healthy/fresh. Let's dig into the valuation and see if these risks are priced into the stock:

Valuation

Based on ~27.6 million shares and a share price of $1,780, Chipotle trades at a market cap of ~$49.1 billion and an enterprise value of ~$51.0 billion. This continues to leave Chipotle as one of the highest capitalization names, just shy of Starbucks (SBUX) and McDonald's (MCD) which hold the #2 and #1 spots, respectively. And while the company has rightfully commanded a premium multiple for its domination of the burrito space in North America and near ~400% growth in its store count since 2007, the stock's premium multiples are getting more and more difficult to justify in the current interest-rate environment. Meanwhile, headwinds for the company include a weaker consumer, rising wage rates in one of its key markets (California), and that it has already raised prices multiple times in recent years, meaning that using this tool hold the line on margins could be riskier in the future with the possibility that it could price some loyal customers out.

The latter has been a worry for several years and, understandably; the bulls have become de-sensitized to this topic given that Chipotle continues to consistently grow sales, with most guests having no issue forking over more each year for its entrees/sides. However, we've finally reached a potential tipping point where even some more affluent customers are trading down on groceries as pointed out by Walmart (WMT), and for its younger customer base, the restart of student loans won't help. And with Chipotle's prices now sitting ~25% above year-end 2020 levels following its most recent price hike taken in October combined with nearly all consumers continue to get hit from multiple angles (rising gas, utilities, mortgage/rent costs) and less benefit from the wealth effect from 2010 to 2020, it's tough to be optimistic about traffic in Q3/Q4 and Chipotle's ability to beat estimates yet again.

So, based on the higher interest rate environment, headwinds on wage inflation and the fact that Chipotle now has the scale that it can't grow units at double-digit levels each year, I think a more conservative earnings multiple for the stock is 33.0x, a 40% discount to the 55x multiple it's enjoyed over the past 15 years. If we multiply this figure by FY2024 earnings estimates of $52.50, Chipotle's fair value comes in at $1,730 per share (18-month price target). Hence, I see Chipotle as fully valued heading into its Q3 earnings and I think Chipotle may need time to grow into its valuation, potentially leaving the stock in a more volatile range over the next 12-18 months compared to the ~24% annualized return investors have enjoyed since the stock went public. Hence, if we were to see the stock rally near the top of its range on a surprise beat in Q3 and vault back above $1,950 before year-end, I would view this as an opportunity to book more profits.

On the downside, it would take a lot to become interested in Chipotle, given that I am looking for a minimum 20% discount to fair value for large-cap growth stocks to ensure a margin of safety. And if we measure from a more conservative fair value estimate off $1,730, Chipotle's ideal buy zone wouldn't come in until $1,385, significantly below current levels and in line with where the stock bottomed in mid-2022. So, while there's no question that Chipotle is one of the better names to purchase on corrections for investors looking for growth in the Retail/Restaurant space, it's hard to argue that it's anywhere near the best value here, even if the sector is down substantially from its highs.

Summary

Chipotle has overcome more significant challenges in the past and emerged stronger, and I have little doubt that the company will continue its impressive growth over the next several years and continue to command a premium vs. its peer group. That said, the premium currently sits at a significant spread compared to other quick-service options like Restaurant Brands International (QSR) with less sensitivity to wage increases in California and other states because of its franchised model, and while CMG may be cheap relative to its average multiple enjoyed in the 2009-2020 period, this was a period marked by double-digit unit growth, ultra-low interest rates (little competition for stocks), and a stronger consumer overall. And with the current environment being far different, it's hard to argue for paying anywhere near the same multiple for the stock, let alone even half the multiple.

Obviously, I could be wrong and Chipotle may once again beat its estimates with it just coming off a beat in Q2 despite the consumer's wallets similarly strained in the previous period. However, the difference in Q3 vs. Q2 is that there's the added impact from rising gas prices, the company won't benefit from carrying mid-single-digit price in the period, and there's clear evidence that traffic has worsened industry-wide, and it'd be shocking if this didn't creep into Chipotle's quarterly results. In summary, I see Chipotle as an Avoid ahead of its Q3 results and I would view any rallies above $1,950 before year-end as profit-taking opportunities.