One of the great success stories of 2007 is Chipotle Mexican Grill (CMG) which is up 157% for the year. The company has revolutionized the idea of fast food and developed a very loyal customer base that drives stability and growth. One of the primary reasons it has been so successful in retaining customers is the commitment to healthy ingredients and respect for the process by which it raises meat, poultry and dairy products. In keeping with the trends that made such successful food and beverage retailers as Ben & Jerry’s and Starbucks, The company has nurtured a culture that spans beyond the eating experience to a way of life.

It seems quite odd that such a firm would have been incubated by a behemoth such as McDonalds (MCD). However, while the culture is very dissimilar to that of the Golden Arches, management was able to learn from some of its parent company’s strengths. These strengths manifest themselves through operating efficiency and disciplined growth as Chipotle continues to beat guidance numbers and improve the profitability of the firm. Despite food cost increases including scarcity of avocados this year, operating margins continue to trend higher as evidenced by a 23.0% margin in the Q3 report versus 21.5% in the year ago quarter.

The most recent quarterly earnings release uncovered the typical positive surprises as earnings beat consensus numbers at $0.62, with comparable restaurant sales up 12.4%. The comp store sales increase number has become an increasingly important metric as the installed base of restaurants open for one year now exceeds 500 stores. Looking to new locations, CMG opened an additional 28 new stores with the majority being placed in markets the company already has a presence in. New stores in existing markets should benefit from existing customer knowledge and loyalty and need fewer promotional resources to drive sales. As far as new markets are concerned, the company has targeted Salt Lake City, Birmingham and Philadelphia as the newest additions to cities it serves.

Presently, the company operates all of its restaurants within the US and believes the potential for domestic stores is around 3,000 locations. Since current restaurants only comprise a quarter of that level, there is significant room for growth before the company runs into restrictions. Management expects 130-140 new openings for 2008 and that is on top of expectations towards the high end of 110-120 locations in 2007. While domestic growth is still the primary focus, the company will open its first non US store in Toronto, Canada next year. This will likely give management a chance to test out its ability to manage currency risk and international regulatory issues which could be beneficial if international growth became more of an objective in the future. While no plans have been announced beyond the single Toronto store, this is likely a test for management to gain experience for further growth long-term.

Chipotle’s balance sheet is quite healthy with $167m in cash at the end of the quarter. Typically companies with such strong cash positions would begin to talk about share repurchase plans or dividends to investors. However, CMG cannot use cash in this manner at the present time as that would jeopardize the tax-free status of the company’s spin-off from McDonalds. Instead, the company will use the cash to fund new store openings and continue its aggressive growth strategy. Additional capital can be spent for measures that drive efficiencies such as a new hand-held POS system which allows staff to charge customers while they are standing in line which decreases the wait time and bumps up the number of customers able to be served during peak lunch hours.

Despite the impressive cost saving efforts, and robust growth plans, most analysts do not recommend purchases of the stock. There is an incredible amount of respect for management and the strength of the Chipotle brand, but since the stock is trading at 54 times next year’s consensus numbers, there is little room for any error. If any important metric were to slip or the growth rate was called into question, it is likely that the stock would take a significant hit. One has to look no further than Crocs (CROX) to note how vicious a sell-off can be when a momentum name stumbles.

Despite my recommendation to buy the stock in June and again in August of this year, I am now suggesting that investors take a careful look at their own investment style to consider if this name is right to hold. For those who wish to invest in quality companies with strong management and hold those positions indefinitely, there is nothing wrong with CMG’s long-term prospects. However for those who are opportunistic traders, I would suggest moving capital out of this name as the likelihood of the stock increasing 157% next year is very poor. I would expect the stock to be range-bound for the next several quarters as fundamentals catch up with the stock price and therefore the risk/reward ratio for owning this well oiled machine is not favorable to me at this time.

CMG Notes

FD: Author does not have a position in CMG