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Morningstar | Chipotle Caps off a Strong 2018 While Building New Sales Layers, but Reflected in Market Prices

Chipotle's fourth-quarter update offered the clearest evidence to date that it has corrected organizational issues that led to underwhelming customer experience the past several years while taking steps to reclaim its mantle as one of the industry's leading innovators (and reinforcing the brand intangible asset behind its narrow moat). Comps of 6.1% (2.0% traffic, 3.3% price, 0.8% mix) were the clear highlight of the quarter, not only because it puts Chipotle among industry leaders, but also because it reveals more about the efficacy of CEO Brian Niccol's recent priorities. With October-November comps running at about 4%, December-implied comps came in around 10%. We attribute this acceleration to several factors, including streamlined operations, the effective "For Real" advertising campaign, a free-delivery bowl promotion in late December, and improved mobile app functionality/awareness.

More important, we believe there is evidence that these trends will continue into 2019. Backed by its second make lines, Chipotle is seeing greater success with digital orders (up 66% to 12.9% of total sales) and delivery than many of its peers. We also see the "Chipotlane" mobile order/pickup lane format as a natural extension of its digital efforts, and believe these locations could be a material revenue driver. As it optimizes mobile order/delivery and rolls out a national loyalty program in 2019, we believe Chipotle will also be positioned to introduce new products that stimulate consumer curiosity without adding undue operational complexity.

Based on Chipotle's top-line momentum and realistic guidance calling for mid-single-digit comps, we're planning roughly a 10% increase to our $425 fair value estimate. While we believe Chipotle's current initiatives will likely result in medium-term outperformance--and likely keep the stock trading at lofty multiples for the foreseeable future--we believe they are fully priced in and would wait for a more attractive entry point.

In addition to mid-single-digit comps, the rest of Chipotle's detailed 2019 guidance strikes us as reasonable. This includes 140-155 new restaurant openings (weighted toward the back half of the year and including roughly 30 Chipotlane format openings), food costs of 33% of revenue, labor costs in the low 27% range, other operating costs of 14% (including 3% allocated to marketing and promotional activity, roughly in line with 2018), an effective tax rate of 27%-30%, and capital expenditures of $300 million. While we believe these assumptions may put Chipotle's 2019 restaurant margins around 19% (versus 18.7% in 2018) and adjusted EPS below consensus expectations calling for roughly $12 per share, we believe the market will look past these results as long as top-line trends persist and signal future operating leverage potential.

Looking beyond 2019, we expect average annual comps of 5% from 2020 to 2023 due to new menu innovations, guest experience improvements, and second assembly line delivery/catering orders. Taken together, we expect high-single-digit revenue growth over the next five years. Coupled with wage rate inflation across much of the U.S. the next few years, food safety initiatives, and additional labor and restaurant investments to augment the consumer experience, we expect restaurant margins and operating margins will recover to the low to mid-20s and the low to midteens, respectively, over the next five years, but still a shade below the mid- to high 20s and high teens posted just a few years ago.