Chipotle Mexican Grill: A Fantastic Company At A Bad Price (NYSE:CMG)

I would venture to say that, purely from a business perspective, Chipotle Mexican Grill (NYSE:CMG) is the highest quality restaurant operator on the planet. Or at least it’s the highest quality publicly traded one. The company has demonstrated time and time again the ability to grow revenue, profits, and cash flows, all at a rapid pace. Even though consumers are finally pushing back against price increases at other chains, all of the evidence suggests that they still have no problem paying the price here. The company achieved comparable restaurant sales growth even during the pandemic, and it actually benefited from the pandemic in a way that most other companies did not.

If I made a comprehensive list of all the great achievements seen by the business over its life, that alone would probably comprise a standalone article. But you get the point. The behemoth, which has gone from a marginal player in the restaurant industry to an enterprise with a market capitalization of $87 billion, is truly special. And based on all the data currently provided, it looks as though growth will only continue. This is because of continued investments in expanding its physical footprint, combined with innovative strategies aimed at boosting sales. Because of this, I think it’s difficult to be bearish on the business. At the same time, there’s also no denying that the restaurant operator is priced at a level that you would expect for such a high-quality firm. As a value investor, I cannot bridge the gap between the price and value of the business. But I can understand why some investors might prioritize the quality and growth prospects over its valuation.

A great firm at an awful price

The financial track record achieved by Chipotle Mexican Grill has, quite frankly, been astonishing. It’s one thing to see attractive growth and strong margin expansion when you are talking about a small player with tremendous growth opportunities. But it’s another when we are talking about one of the largest restaurant operators in the world. From 2019 to 2023, revenue at the company expanded from $5.59 billion to $9.87 billion. That’s an annualized growth rate of 15.3%. This expansion was driven by two primary factors. The easiest of these to cover is store growth. At the end of 2019, Chipotle Mexican Grill had 2,622 locations. By the end of 2023, the number of locations had expanded to 3,437. That’s a rise of 31.1%, or 7% annually.

The other big contributor has been expansion in comparable store sales. Even during the pandemic year that was 2020, comparable sales expanded by 1.8%. All combined, during the past five years, comparable sales grew by a whopping 57.2%. More detailed data involving this has only been made public from 2022 through the present day. But from 2022 to 2023, for instance, the company benefited from a 5% rise in transactions and from a 2.9% increase in average check size. That check size increase was because of a 5.2% increase in menu prices. Though, there was an offsetting decline in the mix of products sold. In 2022, the average check size jumped by 7.1%, driven by a 12% increase in prices. And even during that difficult time, transactions expanded by 0.9%.

When I said earlier that Chipotle Mexican Grill benefited from the COVID-19 pandemic, I mean that quite literally. Management took that opportunity to significantly increase prices as other companies, both in the restaurant industry and outside of it, hiked their own prices in response to inflation. But like some other players that I have seen, Chipotle Mexican Grill increased prices by far more than what inflation warranted. To see that this is undeniably true, we need only look at the firm’s margin expansion over the past few years. Back in 2019, the company spent about 33.1% of its revenue on food, beverages, and paper products. In every year since then, there has been a drop in this. In 2023, the company spent only 29.5%. While this may not seem like much, the difference over those five years, when applied to the revenue generated in 2023, accounted for an extra $355.4 million in pre-tax profits for the business.

This was not the only area of improvement that the company saw. Even though the cost of Labor has shot up in recent years, Chipotle Mexican Grill has been successful in pushing its labor costs down from 26.4% of revenue to 24.7%. Using the 2023 figures again, that’s another $167.8 million in pre-tax profits on the bottom line. Occupancy costs declined from 6.5% of sales to 5.1%. That’s another $138.2 million in benefit to shareholders if we keep revenue constant. Meanwhile, general and administrative costs fell from 8.1% of sales to 6.4%. That represents $167.8 million in benefit to shareholders. To be clear, not every cost item saw improvement. The company has a category called ‘other operating costs’. Back in 2019, this accounted for 13.6% of sales. By the end of last year, it had fallen to 14.5%. But if you move forward just to the year 2020 as the starting point, it would have represented a decline from 17.2% of sales.

The impact this has had for shareholders cannot be understated. I would argue that this margin expansion might be even more important for shareholders than the firm’s physical location expansion. Obviously, operational improvements driven by economies of scale certainly would have contributed to this bottom-line expansion as well. For instance, the company has been investing heavily and expanding its Chipotlane concept. This is essentially a Chipotle Mexican Grill location that has a drive thru. Based on estimates, these increase sales on a per-location basis by between 10% and 15%. This is actually much lower than what other restaurants experience. Most quick service restaurants, for instance, generate somewhere around 70% of their sales because of their drive thru capabilities.

A surge in digital sales has also helped the company. Because of the COVID-19 pandemic, the company went from getting about 10.9% of its revenue from digital sales in 2019 to getting 46.2% in 2020. Since the pandemic ended, this number has been on the decline, eventually dropping to 37.4% by the end of 2023. While third-party delivery sales in this category do hurt margins to an extent, having customers order online and coming in store to pick up their food seems to be very high margin. But even in spite of the decline that we have seen, the data shows that margins continue to march higher.

The end result of all of this has been a significant expansion of the firm’s bottom line. From 2019 to 2023, net profits for the business jumped from $355.8 million to $1.23 billion. Operating cash flow grew from $721.6 million to $1.78 billion. If we adjust for working capital, this increase was from $853.1 million to a whopping $1.69 billion. Meanwhile, EBITDA for the business grew from $692.3 million to $1.92 billion. We can also express these figures from a margin perspective. From 2019 through 2023, the company’s net profit margin nearly doubled from 6.3% to 12.4%. Its adjusted operating cash flow margin rose from 15.3% to 17.1%. And its EBITDA margin expanded from 12.4% to 19.4%.

To be clear, 2023 is not the end of the record for the company. Impressive results have continued into 2024. Revenue of $2.70 billion in the first quarter of 2024 came in 14.1% above the $2.37 billion generated one year earlier. The company benefited from an increase in the number of locations in operation from 3,224 to 3,479. It also benefited from a 7% rise in comparable store sales growth, driven not only by a 5.4% jump in transactions, but also by a 1.6% rise in average check size.

This expansion on the top line has been accompanied by improved profitability as well. The company’s net income in the most recent quarter was an impressive $359.3 million. That’s 23.2% above the $291.6 million reported one year earlier. Operating cash flow grew from $455 million to $569.2 million. On an adjusted basis, its expansion was from $393.7 million to $478.3 million. And lastly, EBITDA for the business grew from $452.6 million to $530 million. The charts throughout this article demonstrate margin expansion during this time as well. Even though labor costs for the company grew from 22.7% of sales to 24.4%, while general and administrative expenses rose from 6.3% to 7.6%, the company’s net profit margin expanded from 12.3% to 13.3%. Adjusted operating cash flow grew from 16.6% of sales to 17.7%, while the firm’s EBITDA margin grew from 19.1% to 19.6%.

When it comes to the current fiscal year, management has big plans. They expect to add between 285 and 315 locations for the year. At the midpoint, that’s an increase of 300. That would take the number of locations in operation up to a whopping 3,737 for a year-over-year increase of 8.7%. As I mentioned earlier in this article, the company continues to expand its Chipotlane concept. In 2023, the company added 271 locations to its system. 238 of these, or about 87.8%, had a Chipotlane. For this year, that number is expected to be at least 80%, as is expected to be the case in subsequent years as well.

Clearly, we are talking about a very high-quality business that has been able to defy the fickleness and price consciousness of consumers. Recent news reports have suggested that perhaps consumer discontent is growing. And that is something that investors should pay attention to since it could result in shares plummeting pretty quickly. But until we see it show up in the data, it’s difficult to guess what the outcome would be. At some point in time, the company would hit a breaking point. After all, you wouldn’t expect this to continue to the point where the company is generating almost 100% profit margins with a burrito costing $1,000.

Even though I am not sold on the idea that we are at that breaking point, I cannot personally rate the company a ‘buy’. Yes, we have a high-quality operator that is adored by its customers. At the same time, however, shares are incredibly expensive. As you can see in the chart above, the firm is trading at very lofty multiples. In the table below, I then compared it to five similar firms. On a price to earnings basis, three of the five companies were cheaper than it. But when it came to the other two profitability metrics, Chipotle Mexican Grill was, hands down, the most expensive of the group.

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Takeaway

Long term, I fully expect that Chipotle Mexican Grill will do just fine from an operational standpoint. Whether the company will continue to generate strong returns for investors or not is a different story. I do think the company would be larger and more profitable 10 years from now than it is today. But given how expensive shares are and my view that a breaking point for consumers exists somewhere, I think that rating the company a ‘hold’ is the most sensible approach.