Chipotle Mexican Grill (NYSE:CMG) has had its shares of volatility. The stock is currently trading near $325, about 35% more than its previous year low of $236. These lows came after teh shares had reached highs above $400. The recovery was partly fueled by the stock repurchasing program to the tune of $200 million, which reduced the number of outstanding shares as well as improved earnings. Despite the steady climb higher in the past six months, many investors fear that the shares are poised for a big correction.
We believe the shares are fairly priced based on our current assumptions, and if growth outpaces our assumptions, there could be additional upside to its valuation.
Underlying our assumptions are:
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(a) Margins will stabilize and remain around current levels
(b) Growth will moderate as the company expands
Even after taking these factors into account, we have a price estimate of near $345 for Chipotle Mexican Grill, about 5% above the current market price.
In addition to its traditional restaurants, the company has plans to open more ShopHouse Kitchen although it is still not sure how many of these will open eventually. Thus, we will only consider traditional Chipotle restaurants in this article.
Profitability of Restaurants
The average sales per restaurant stood at $2.1 million in 2012.  The company reported EBITDA margin stood at 19.7%. Once we adjust for non-cash items such as stock-based compensation and losses on disposal of assets, we come up with margins in excess of 22% or about $450,000 cash generation from a single store.  These figures are pretty high for a company-operated store.
Can It Be Sustained ?
We think so. Over the years, the margins have expanded as the restaurant has been able to successfully leverage its sales growth to offset increases in fixed costs such as labor or occupancy.
Going forward, we expect the same store sales growth to slow down since growth over a bigger base is more difficult to achieve and as more Chipotle restaurants open up, some cannibalization could kick in. Therefore, we do not expect the future same-store sales growth to replicate its past growth and this supports our view for margins around current levels going forward.
Also, it is important to determine how much of pricing power the brand possesses. More specifically, if food prices were to spike, how much of that can be passed on to consumers. The cost of food, beverage and packaging (as a percentage of revenues) has remained in a range of 30.5-33.0%. The years in which the food costs were relatively lower were 2009 and 2010, as commodity prices plummeted after the 2008 crash. 
Despite the fact that the commodity costs were relatively higher in 2011 and 2012, Chipotle was still able to contain the food costs, and we think that’s a good measure of the company’s pricing power and cost controls. Going forward, it wouldn’t be unreasonable to assume that the cost of raw materials will remain at similar levels relative to sales.
As a result, if the fixed and variable cost components can be kept within a reasonable range, the company should be able to sustain the current level of profitability.
Scope of Expansion
As of December 31, 2012, it had 1,410 stores – almost all of them in the United States. In 2013, the company will add 165-180 new stores. Although its store tally is significantly smaller than larger chains such as McDonald’s (NYSE:MCD) or Wendy’s, its higher menu prices and more selective menu limits the potential number of restaurants it can operate without branching into new restaurant concepts, which the company is testing. 
Also, Chipotle emphasizes using locally grown crops and naturally raised meat as a key selling point. Setting up the necessary supply chain is no easy feat for the company when it expands into new markets. In certain markets such as overseas, the supply chain might not be economically feasible since sourcing such ingredients could prove to be more expensive. These are the reasons why we estimate the rate of expansion to slow down to about 120-130 restaurants annually.
On the other hand, if the current rate of expansion continues and the company can successfully add about 160-170 restaurants annually, there could be further 10% upside to our current valuation.
Given the above considerations, we believe the stock’s rally looks more or less justified. Chipotle shares tumbled last year after it earnings missed expectations, and this shows how sensitive investors are to small changes in its outlook. However we believed and wrote in the past that this was an overreaction and that the company’s outlook is solid in our view.Notes: