Throughout the 1990s shares of Wal-Mart (NYSE: WMT) and Microsoft (Nasdaq: MSFT) exploded higher year after year. Investors realized that these firms had so powerfully revolutionized their respective industries, that they could maintain solid growth far into the future.
Trouble is, investors didn't benefit. Shares of Wal-Mart fell more than 25% from their 1999 peak over the next decade, while shares of Microsoft lost half of their value. In hindsight, it would have been wise to sell these two stocks prior to another decade of solid sales and profit growth. Simply put, their valuations had become so extended that the company's financial performance needed a decade to catch up.
That's worth thinking about as investors continue to snap up shares of Chipotle Mexican Grill (NYSE: CMG), an extremely well-run company in the midst of robust growth, which is accompanied by too-rich valuations. Shares may be peaking now, with 20% to 30% downside ahead, and possibly more if the bull market finally comes to an end.
Although Wal-Mart and Microsoft delivered very strong growth in the decade spanning 2000-2010, the rate of growth began to slowly decelerate. That led investors to continually re-rate the stock with lower price-to-earnings (P/E) ratios and price-to-sales (P/S) ratios. Before I talk about the likelihood of Chipotle's eventual sales growth slowdown, let me first pause to explain just how great this company is.
|On top of its current 1,595 store base, Chipotle aims to expand that by roughly 12% this year, adding another 180-190 stores.|
Chipotle has re-written the playbook on fast-casual dining. An emphasis on fresh ingredients and an efficient food preparation system enables the restaurant chain to charge prices well above fast-food operators, which leads to industry-leading store-level economics. On a company-wide basis, Chipotle routinely generates operating margins of around 16%. In comparison, Darden (NYSE: DRI) and Brinker International (NYSE: EAT) have never once exceeded 10% operating margins.
And Chipotle has done a remarkable job of generating cash while investing in new store growth: free cash flow has risen in nine of the past 10 years, to a recent $329 million.
Chipotle finished 2013 on such a strong note, with same-store sales rose 9.3% in the fourth quarter, that the near-term strength should be quite impressive as well. "This is impressive performance in an absolute sense but even better on a relative basis with widespread retail and restaurant softness at the end of 2013," note analysts at Merrill Lynch.
On top of its current 1,595 store base, Chipotle aims to expand that by roughly 12% this year, adding another 180-190 stores. Yet Chipotle is bumping up against a challenge that almost every retailer -- from Office Depot (NYSE: ODP) to The Gap (NYSE: GPS) -- must eventually face: saturation. Early in a retailer's growth cycle, it's easy to spot ideal locations in towns and cities that sport the perfect demographics. Eventually the low-hanging fruit is gone. In recent quarters, Whole Foods (Nasdaq: WFM) has seen a slowdown in comps, simply because its niche is becoming saturated.
It should be noted that 2014 and 2015 growth forecasts are based on continued very strong same-store sales growth, which is plausible but not a certainty. More to the point, even as Chipotle ramps up a second dining concept based on Asian food, analysts increasingly realize that "laws of bigness" are starting to take root with the core Mexican food franchise.
How will this stock react to the prospect of maturation and saturation? We already know the answer, as a growth scare in 2012 led to a sudden plunge in the stock.
The fact that shares have more than doubled since the end of 2012 tells you that investors no longer expect any sort of sales growth deceleration. And they've pushed shares up to levels that already discount financial results well into the future.
Analysts at UBS have extended their earnings model out into 2018, and see sales hitting $6.3 billion by then. That means that Chipotle is valued at three times projected 2018 sales, while Darden and Brinker, on an average basis, trade for one times projected 2014 sales. Sure, Darden and Brinker won't grow at the pace of Chipotle in coming years, but even moderate growth will push their 2018 P/S ratio below 0.75, or just one-fourth of Chipotle's projected 2018 multiple.
What about profits? Chipotle earned $384 million in 2013, and should earn $750 million by 2018. That means that Chipotle is valued at 24 times projected 2018 profits, which is astonishing. That kind of multiple would be justified if Chipotle was positioned to boost profits at a 25% annual clip for the next five years. But as we saw with Wal-Mart, Microsoft and so many other once-great growth stocks, such sustained growth is nearly impossible to achieve.
Risks to Consider: As an upside risk, Chipotle could look to sharply boost prices to maintain growth well in excess of the store count expansion, but that runs the risk of alienating price-sensitive customers.
Action to Take --> Analysts at UBS gave a "neutral" rating and a base case $530 price target, though they note an upside scenario of very strong same store sales that justifies a target price of around $600. They also add a downside scenario of just $375 if both same store sales slow from the recent pace and the slate of new store openings in 2015 is lower than consensus forecasts.
This is not a call to short this stock. Too many have been burned going against this stock before. But if you own Chipotle, you need to know that the share price reflects a perfect future of sustained strong growth and there is no margin for error, let alone any case for upside. If you've been debating purchasing this stock, you'll find lower-risk higher-reward stocks elsewhere.