Here’s How Mounting Expenses Can Impact Chipotle Mexican Grill’s Valuation

Chipotle Mexican Grill (NYSE: CMG) has been a work in progress for more than a year now. After an E. coli outbreak in its food last year, the company is still struggling to grow its sales and attract customers to its stores. Further, it is spending heavily on marketing, promotional discounts, and a food safety program to entice customers back to its restaurants.  In Q4 2016, the company registered a 12% year-on year increase in operating expenses on the back of this spending.  While we expect a meaningful decline in the company’s operating expenses as its revenues grow over our forecast period and it achieves economies of scale, there can be a significant downside to our price estimate, if these expenses continue to grow for a longer period.

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We expect a steady decline in Chipotle Food, Beverage, and Packaging Expenses (as a % of revenue) as the prices of its extensively used commodities such as rice and meat decline and the company is able to pass on the price increase in other commodities (such as avocados) to its consumers. However, with stricter food safety norms and an inability to hike prices of its final products (in an attempt to lure customers) if this number does not decrease as per our expectations, there can be a nearly 15% downside to our price estimate (if these expenses remain at around 34% of revenues over our forecast period).

Similarly we expect the company’s general administrative and other expenses to steadily decline from around 7.5% of revenues in 2017 to nearly 5% of revenues by the end of our forecast period.

As the company’s revenue growth outpaces the growth of partial fixed costs we expect the general administrative expenses (as a % of revenue) to decline over our forecast period. However, if the company is not able to grow revenues significantly over our forecast period and marketing expenses mount, there can be a downside to our price estimate.

Chipotle’s troubles appear to be far from over. While its Q4 2016 results showed signs of improvement with positive comp sales, it appears that the company will take a long time to recover from its E. coli scandal. Its activist shareholder Bill Ackman who is also the company’s second largest shareholder has signaled that he might sell his stake.  This could indicate that Ackman is not confident of the company turning around in the near future. While Chipotle has taken several initiatives to recover from the scandal and drive growth, its future still appears to be uncertain.

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