It’s been a disastrous start to the year for the restaurant industry group, as several restaurant stocks have seen their share prices halved, while a couple of names are still down 70% year to date. Fortunately, Chipotle (CMG) has managed to evade the carnage in the sector through its massive digital presence and the ability to quickly pivot to open up a drive-thru option (“Chipotlanes”) at both new and existing stores, with 100 installed year to date. However, while the company is expected to post outstanding earnings growth in FY2021 as dine-in headwinds decrease, the valuation is beginning to get stretched, with Chipotle valued at over 6.5x price-to-sales. Therefore, I believe investors would be wise not to chase the stock here above $1,315.
Chipotle released its Q2 results last month and reported quarterly revenue of $1.36 billion, down 5% year over year, with same-store sales down 9.8% in the quarter. While this was a disappointing result for investors after several quarters in a row of revenue growth, it was quite impressive considering the challenging operating environment restaurants are facing due to COVID-19. On the positive side, digital sales were up 216% year over year and made for over 60% of total sales, and the company finished the quarter with over $930 million in cash and short-term investments, leaving Chipotle in much better financial shape than some of its peers. This solid balance sheet allowed the company to open another 37 stores during the quarter, while a few of the industry’s smaller names are clinging to life. Notably, most of the new stores have a drive-thru “Chipotlane” built into them, providing a more comfortable way for consumers to shop if they aren’t interested in paying delivery fees.
(Source: Author’s Chart)
Fortunately, while same-store sales slipped considerably in Q2, we saw them bounce back in June, increasing by 2%. As of the earnings call in late July, same-store sales in July were tracking at 6.4%, suggesting that we’re continuing to see substantial growth despite the massive headwinds from COVID-19. It’s worth noting that this same-store sales growth has occurred despite 30 stores remaining closed as of quarter-end and only about 85% of stores offering limited in-restaurant, patio dining options, with the remainder of business coming strictly through delivery channels. However, the most impressive stat in the quarter was the news that Chipotle has hit the 15-million mark for enrolled Rewards Members, an incredible feat considering that this was launched just 16 months ago. While it’s still early, the company has seen higher order frequency among members versus non-members and is beginning to leverage its installed base using promotions.
However, while sales were only down 5% and the company continuing to see massive traction on the business’s digital side, earnings did take a beating, with annual earnings per share (EPS) sliding by 90% year over year. This massive drop was due to a mix of lower margins and lower sales, with the margin crunch attributed to higher delivery fees associated with the shift in the sales mix. The other headwinds in the quarter were higher marketing and promotional spending, higher beef prices, and increased costs directly related to COVID-19. The good news is that while quarterly EPS fell off a cliff, it’s barely put a dent in the long-term earnings trend. We can take a closer look at the growth metrics below:
(Source: YCharts, Author’s Chart)
While weaker sales and margins are expected to weigh on FY2020, with estimates for a 23% drop year over year ($10.76 vs. $14.05), FY2021 earnings growth is set to hit a new all-time high, with estimates currently pegged at $20.85. This suggests that the weak FY2020 earnings are merely an aberration in the long-term earnings trend here, and there’s no reason to get hung up on the dismal FY2020 performance. If this weakness occurred in the absence of a global pandemic and the company was clearly losing market share to a competitor or its offerings weren’t resonating, this would be a different story. However, given the unprecedented situation we’re in, I don’t see any point in putting much weight into the FY2020 annual EPS, nor attempting to guess where the long-term trend is headed based on this figure.
(Source: YCharts, Author’s Chart)
If we take a look at the earnings trend above and focus on the FY2021 and FY2022 figures, analysts are clearly bullish long term on Chipotle. Based on the current FY2021 estimates, annual EPS is expected to grow by 48% from FY2019 levels ($20.85 vs. $14.05), with over 90% growth from FY2020 levels ($20.85 vs. $10.76). I believe the former figure is more important, as it’s not all that relevant how much annual EPS is growing following a near-25% decline in the prior year and easy year-over-year comps. However, the other impressive thing about this earnings trend is that we should see an earnings breakout year in FY2021, with annual EPS coming out of a massive range to hit a new all-time high. Generally, this is a very much bullish development, and this might be why Chipotle has been performing so well. While an earnings breakout year doesn’t preclude sharp pullbacks, it does suggest that the company has a better chance of being bought.
(Source: YCharts, Author’s Chart)
The key to making sure that an earnings breakout is sustainable is keeping a close eye on quarterly revenues and making sure revenue is also expected to hit new all-time highs. A new all-time high in annual EPS absent record revenues or significantly higher margins suggests that the breakout is less sustainable, as it’s likely due to one-time items or cost-cutting. In Chipotle’s case, there’s a lot to like here, as revenue briefly dipped to $1.36 million in Q2 but is expected to hit a new all-time high in Q3 of $1.58 billion. Meanwhile, Q3 and Q4 estimates are also projecting new all-time highs, telling us that the trend is clearly up for revenues. This is despite some minor margin compression due to third-party delivery fees, and some continued softness until we see complete migration by consumers back into the “dining room” at restaurants. Based on the strong recovery expected in quarterly revenue, this suggests the earnings breakout above is likely sustainable, a bullish sign long term.
(Source: YCharts, Author’s Chart)
So, why not buy the stock here if annual EPS and annual revenue are expected to hit new highs in FY2021? Unfortunately, I believe some of this is already priced in. This is because Chipotle is now trading for more than 6.5x price-to-sales. As the chart below shows, the 5.5x price-to-sales zone has been a tough spot for Chipotle previously, as the stock has peaked at this level on three occasions. Given that we’re now 20% above this level, I would argue that valuation is becoming a headwind above $1,300.
If we take a look at Chipotle’s valuation relative to its peers, we can see that most quick-service restaurants tend to have a ceiling near 5.50x price-to-sales (red line), and while they sometimes trade above this area, their rallies are ephemeral. As the 10-year chart shows, Dunkin’ Brands (DNKN) peaked at 7.7x sales, Shake Shack (SHAK) peaked at 7.80x sales when I noted it was getting risky, and Starbucks (SBUX) peaked at 5.0x sales. If we average out the peak between these three names, we have an average peak revenue multiple of 6.8. Given that Chipotle is currently trading just shy of this figure at ~6.57x sales, the valuation is no longer even remotely attractive here.
Some investors might argue that valuation is meaningless, stocks can grow to the sky, and Chipotle is going much higher. While this could work out, the technical picture is also suggesting things are a little riskier, as the company is more than 40% above its weekly moving average. As we can see, this has led to short-term and medium-term tops twice in the past three years, and the reward-to-risk has been terrible in prior signals.
If we examine this further below, I have shown a green shaded area to show the 6-month forward reward (draw-up) and a red shaded area to show the 6-month forward risk (draw-down). Like the two prior occasions show (August 2018 and May 2019), the reward-to-risk was balanced at best in May 2019 and very poor in August 2018 with a nearly 30% drawdown. Given that we’re now more extended than these two occasions, I would argue that new purchases up here carry elevated risk. This is because the best case is a slow grind higher or consolidation, and the worst-case is a severe correction to reset the current overbought condition. Therefore, I see no reason to pay up for the stock at current levels.
Chipotle has seen a sharp rebound from the challenging March and April performance, and the stock is set to post new all-time highs in annual EPS in FY2021, thanks to its significant digital presence. Unfortunately, while the projected earnings breakout next year is a long-term bullish development, I believe some of this is priced in already, given that the stock is trading at over 60x FY2021 annual EPS and over 6.5x sales. Based on this, I believe investors would be wise not to chase the stock above $1,315, and I would view any rallies above $1,335 before year-end as an opportunity to book some profits.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: Taylor Dart is not a Registered Investment Advisor or Financial Planner. This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Taylor Dart expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.