Chipotle Stock: Growth-Stock Value Investing

There are two main ways that you can get a fair (or better) price on a stock with a strong growth profile. You can either purchase a stock when the general economy is in a recession, or you can purchase an otherwise fast-growing company during good/ordinary economic times when it is presented with a solvable crisis that makes the stock temporarily cheap.

On August 5, 2014, I gave an example of the latter when I wrote “Target: Blue-Chip Value Investing in Action” in which I discussed how the temporary problem of the hacking scandal led to a slightly distressed stock price that provided a good deal for investors with a 5+ year time horizon. Since that date, Target has delivered 23.37% annual returns compared to 8.00% annual returns from the S&P 500.

Warren Buffett created the fiction of thinking about twenty punch cards that investors are permitted to have over the course of a lifetime to encourage my disciplined thinking. My corollary would be this: Think about whether a news item that is currently weighing down the price of a stock will be something that will be talked about five, ten, fifteen years from now. If you can’t imagine yourself referencing this event in 2021, 2026, or 2031, then you should probably treat the opportunity as a moment to purchase the stock (the only event that meets this moniker among large-cap firms is the BP Gulf Oil Spill, and even that acknowledgement triggers a second-level analysis: How deep is the impairment compared to the decline in the stock? If the permanent impairment is less than the cheapness of the stock, then you may still be getting a good deal).

At the end of 2015, the best growth stock opportunity on my mind is Chipotle. It is a beautiful firm with no debt, no pension obligations, no preferred stock, and no equity dilution during its time as a publicly traded company (it had 32.54 million shares outstanding at the time of its IPO release from McDonald’s in January 2006, and it has 31.1 million shares outstanding today). It doesn’t pay a dividend, and has built new stores with existing cash flows. And the amount of money in the bank has grown from $323 million to $604 million in the past three years. It really has grown the old-fashioned way, making the analysis of the company easy because you don’t have to measure whether the equity dilution is worth it due to superior growth (because there is no equity dilution at Chipotle weighing on returns).

The problem has been that everyone else in the investor community has known that Chipotle is great. I’ve written before that I would love to write more about growth stocks; it’s just that the lofty valuation usually precludes me from doing so. When Chipotle IPO’d in 2006,the P/E ratio was over 40. It remainder over 40 in 2007. It finally came down to a zone of reasonable between 2008 and 2010, but since then, the P/E ratio of the stock has been between 39x earnings and 43x earnings. That puts me in a hard position to analyze a company, as it requires everything to go right in order for that type of valuation to make sense.

And things have largely gone right since Chipotle’s IPO. Look at how profits have grown every year–Chipotle made $1.28 per share in 2006, $2.13 in 2007, $2.36 in 2008, $3.95 in 2009, $5.64 in 2010, $6.76 in 2011, $8.75 in 2012, $10.36 in 2013, $14.13 in 2014, and $17.05 in 2015. The valuation has been high, and from 2006 through 2015, Chipotle has delivered on the promise created by such a lofty valuation. That is 38.22% annual earnings growth delivered through actual honest-to-God business expansion rather than financial engineering. You had foot traffic at existing stores growing by 8%, the store count rising by over 10% per year, and price hikes in the 8% range. When a highly profitable business replicates its business model in new locations, good things tend to happen.

However, I had been hesitant to cover Chipotle much extensively because of its high P/E ratio and my general disfavor for restaurant stocks. As far I can tell, McDonald’s is the only restaurant company that has survived the 40+ year test of time. It is a brutal industry, subject to intense competition and the changing tastes of customers, and that gives me caution. But if the price is right, and if you recognize the shortened time frame, then it can be wise to consider another industry participant.

After news of the E. coli outbreak at many locations has forced Chipotle to close some locations and generate substantial headline risk, the price of the stock has collapsed from a high of $758 in August to $489 now. That’s a wild change in valuation–back in August, Chipotle was trading at $758 against $17.05 per share in profits for a P/E ratio of 44.45. Now, the stock is way down to $489 per share against an expected $19 per share in 2016 profits for a P/E ratio of 25.73.

That’s the kind of deal you could get on Chipotle in 2009. And even with price decline from this summer, Chipotle has still delivered 28.87% since the summer of 2009 when Chipotle traded at a similar valuation. And if you measured it from the summer of 2009 through the summer of 2015, the annual returns from Chipotle have been 39.30% (septupling your money in six years, compared to the current valuation that only quintuples your money in six years).

It may take a few months. It may take a year. It may take your tears. The unknown of when the price will improve, as well as the patience to ride it out, is the edge possessed by individual investors that do not have short-term oriented clients to satisfy. But the 25x earnings valuation of Chipotle is something that has caught my attention, given the debtless balance sheet of the firm, and the general likelihood that the store count will be noticeably higher five years from now and Chipotle during ordinary times has foot traffic growth that rivals Starbuck’s.

Chipotle has the balance sheet strength and management strategy to ride out this storm. The earnings have grown every year since the IPO, and even with this E. coli outbreak, Chipotle is still expected to deliver double-digit growth between 2015 and 2016. Just as Target customers moved on and got over the electronic hacking scandal, people who want to eat at Chipotle will continue to do so after enough time passes from the current E. coli outbreak (as one of my friends joked, it’s healthier to eat Chipotle with E. coli than White Castle or McDonald’s as is).

This is straight out of the investment tradition of Peter Lynch. His book “One Up on Wall Street” highly favored strong firms that had solvable problems. And thus, the opportunity is that the valuation is low, and will compensate you well for the patience to await better days ahead. I can’t think of an easier no-brainer than a company with no debt that has grown profits every year of its existence and is expected to grow profits from $445 million in 2015 to over $500 million in 2016 even after accounting for the effects of E.coli closures. People with balance sheet literacy can see that it is a fantastic firm still in the rolling-out-stores stage of expansion in which existing stores are also performing admirably well.

Absent a deep recession in the next few years, I imagine people will be looking back at Chipotle in 2015 at $489 per share and wonder why they didn’t load up. The fundamentals of the business remain strong even during the troubled times, and will perform better ahead. The possibility of an expanding P/E ratio will interact favorably with double-digit earnings growth. The only real caveat is that you will have to sell at some point within the next ten years, as this is not an industry where you want to buy-and-forget it (given that McDonald’s is the only American firm in the history of the industry to prove itself worthy of that moniker, although the Dairy Queen business under the Berkshire umbrella may be a close second).