Chipotle Mexican Grill (CMG) - Setting up for Disappointment
Investors in Chipotle Mexican Grill (CMG) were met with an unpleasant surprise in February when for the first time in its history as a public company, the restaurant chain reported earnings that did not beat consensus expectations. Earnings came in at $0.54 per share compared with estimates of 0.55. While the miss was minimal, the long-term consequence could be far reaching due to the high level of confidence the street has in management. The stock is currently trading at 43 times 2008 consensus expectations of $2.68 and at over 34 times 2009 consensus expectations of $3.38. Wachovia noted that this was a very large premium over industry peers which trade at an average multiple of 16.8.
Whenever making judgment calls on stocks with high multiples, it is important to understand exactly why that multiple is so high. Often, the company’s growth rate is expected to rise sharply which makes current valuations irrelevant. If a company is earning $1.00 or so for this year and next, but will bring additional capacity online in 2010 to begin earning $5.00 per share, investors should assume they are holding an asset that is worth much more than current earnings levels. Another key variable that plays into a stock price is risk, or more specifically the perceived level of risk in future earnings streams. All other things equal, a stock with less perceived risk (strong confidence in future earnings) should trade at a much higher multiple than one with the same consensus expectations but more uncertainty as to whether those expectations will be realized.
Looking specifically at Chipotle, it appears that the valuation is high due in a large degree to confidence in the company’s management. Since the restaurant chain was able to grow so quickly and effectively under current management’s guidance, the perception is that this trend will continue indefinitely. At the same time, management is sending signals to the street that growth trends will be under pressure for at least the next several quarters. Despite the veiled warnings, investors still appear optimistic that growth trends of the past will continue.
The macro environment that Chipotle faces (along with the rest of the industry) is not exactly a rosy picture. There are two major factors which should cause investors concern. The first issue faced by retail chains in general is the pressure on consumer spending. This is not a new issue as many are aware that slumping home prices, a leveraged American public, and declining employment statistics will likely put pressure on spending. The perception, however, is that Chipotle will emerge from this environment unscathed due to their quality of food and the need for a busy but health conscious public to find fast food at reasonable prices that is good for their health. But when the credit cards become maxed out and consumers are forced to tighten budgets, eating out anywhere will likely cease to be an option for many.
Secondly, the biofuel initiatives among other things have led to soaring commodity costs which directly affect Chipotles bottom line in the form of higher food costs. Not only are flour and corn products more expensive, but cattle and chicken farmers are facing rising feed costs for their livestock which translates to higher meat and poultry costs. Management has addressed this concern and believes that their price increases in markets where they are introducing naturally raised beef will offset the higher food costs keeping margins at a steady level. However, there are some concerns with cheese costs as well as the company no longer has fixed contracts in place and is at least temporarily paying high spot market prices for its dairy. It seems unreasonable to assume that 3% higher menu prices in a few markets will be effective in stabilizing margins across the whole company in this inflationary environment.
I am certain that I will receive a high degree of criticism for this post given the strong investor base and positive sentiment on the company. I want to clarify that I think management has done an exceptional job in building this chain and I think that the company will survive the current economic difficulty and continue for years as a healthy business. But my perception of the stock price is that it is not fully incorporating the risks in the market and the likely decline in growth trends. At the end of the day, the stock is simply a financial asset which prices the expected future returns of the company. With those returns likely to fall below expectations, and with the stock still pricing in a positive outlook, I would consider adding short positions opportunistically.
FD: Author does not have a position in CMG
Additional Reading:
Zachstocks - CMG, Does the Growth Justify the Price?
Barrons with a piece on cooling trends at CMG
Daniel Jacome with a bullish view on CMG
Chipotle just for fun. AAA. favorite growth metric: chipotle unit volumes have grown for 12 quarters sequentially to an annual rate of $1,734,000 per unit up sharply from under $1,500,000 per unit in 2005. while the sequential growth is enviably over due to slow down sharply..(or is it?) the unit economics near $1,734,000 annual sales equate to >40% ROI. thus even if there is some demand softness it clearly pays for Chipotle to raise expansion plans from 130-140 in 2008 towards an eventual clean cut goal of 200 units annually. the uniformly priced upfront menu prices all entrees for $6-ish. Chipotle’s market share gains with its stellar upfront $6-ish per entree menu( $6-ish per entree occurs atleast suburban real estate locations florida’s orlando to miami. The quality perception by the loyal fan base, repeat customers 30 to 50 times a year..is the $6 entree may have a value of up to $12 per entree in casual dinning format. so the loyal repeat customers have a value perception of a $12 entree priced for $6 , half price. The core customer base is Colledge stuntents. BBB. MACRO ENVIRONMENT Regarding consumer slow down. i agree. this is dangerous threat. Lets look at what bellweather MCDONALD’s has fully disclosed in DECEMBER, JANUARY, FEBUARY RESULTS. McDonalds same store sales bottomed out in December and upticked nicely in January and Ramped up bigtime in Febuary. see wachovia’s MCD SSS FEB ‘08 report early march. the next mcdonalds monthly sales report is due in *1 to 2 days*. Whats more McDOnalds said consumer are stress ed but this is cutting into McDonalds sales by only 1% to 2% and that during the worst the “Dollar Value ITEMS” barley upticked from 13% of overall sales to 14% of overall sales. This suggest that these type of operators McDonalds, Burger King, a $6 per entree CHipotle have proven to be more *low priced* consumer staples then consumer discretionary. CCC. COMMODITY 1 & COMMODITY 2 Commodity 1 - input cost trend is horrible. Commodity 2 - realestate and construction market favorable soemwhat.. due to industry downcycle and spare capacity. ( perhaps somewhat a buyers market). Commodity 1. McDonalds has reported that some input cost have risen 10% in the past year. So this is a lingering problem for a few quarters. But commodity cycles come and go and Chipotle is still the smooth Pac-Man marketshare operator.
April 6th, 2008 at 1:51 pm“Looking specifically at Chipotle, it appears that the valuation is high due in a large degree to confidence in the company’s management.” this is probably not what sets the valuation. during the past 15 months the unit economic model has upticked from 39% ROI to about a 44% ROI. thats solid cause for optomism
April 6th, 2008 at 9:04 pmand chipotles says locations are easier to come by. they are in opportunitic position to take advange and move in on other players expansion turf as the industry cuts back new unit growth. If you have picked up some concrete inside information that SSS are going down the tubes then i wont argue with that but for now i believe the same store sales are still relatively robust. Thats why 3 houses have upgraded Chipotle in past 30 days. the new Jefferies report pratically glowed.
On Mar. 31, New York-area Chipotle restaurants hiked prices almost 10%. A spokesman for the chain, which offers Mexican fare, said the price rise, the first in more than three years in that region, was due to higher food costs. “Even with the new prices in New York, Chipotle remains a great value,” he said in a statement.
April 8th, 2008 at 5:53 pmBoris,
Thanks for the comments! I’m not sure we’re that far apart on fundamentals for the company, we just come to different conclusions as to the stock price. I don’t think SSS have to decline in order for the stock to sell off. But a 10% hike in NYC is actually a bit concerning. This could have the effect of raising sales (inelastic demand) or could be disastrous if demand is actually elastic and people refuse to pay more.
The fact that 3 houses upgraded the stock doesn’t do much to give me confidence. Often these guys are actually very accurate at determining sales and earnings figures but can totally miss the boat as far as predictions on how the stock will react. If analysts (and by extension their clients) are bullish, that may be a sentiment metric that a good trader would fade.
Only time will tell. But it will certainly be an interesting stock to watch over the next several quarters and I believe the fate of CMG will be highly correlated to many consumer dependent sectors of our market.
Thanks for reading and for participating in the dialog!
Zach
April 8th, 2008 at 6:37 pmi will be happy if “well oiled machine” as you phrased it Chipotles *A* shares reach $140 by year end. A breakout to new highs and besting 1000 sites by the end of next year would be nice. if they can open >200 new sites in 2009 that would be fantastic. The consumer and commodity macro factors will probably influence the color of the price escalation.
April 10th, 2008 at 9:03 pmQuestion. You posted that some premium is warrented. Jeffries just said Chipotle is best of breed. this might be a mini-mcdonalds growth story in the making. Also monthly sales at Mcdonalds, extra fuel sensitive Cracker Barrel and others are reporting monthly sales, keep watchers abreast of the situation, and there has been some stablization in the “consumer staple” restaurant monthly sales. and I just dont see what tired hamberger trick Burger King has that Chipotles doesnt other then a lower valuation. What does the fair value for CMG look like today and in 1 year? There has been a dip of $14 bringing it down to the 50 MA. also a final thought.. in Atlanta there are about a dozen sites. but this growth story implies there is room for 4 dozen sites. 50 sites? is that possible? there are 50 in Denver and 50 in Chicago.
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April 25th, 2008 at 1:52 pm[…] He looked at the increasing costs associated with the food that Chipotle served and provided great insight into a short position that paid off well. Now, shares are starting to bounce on the recent market uptick and estimates […]
July 19th, 2008 at 12:34 am