Shares of Chipotle Mexican Grill, Inc. (CMG) have risen sharply in the last two quarters.  And why not?  The company continues to roll out new stores and has managed to grow profitability even in one of the worst economic periods in modern history.  Commodity prices that had once hampered margins have backed off significantly, and the casual dining firm recently posted yet another quarter with double digit revenue growth.

Many consumer discretionary stocks have climbed in recent months as the late winter panic led to low prices that were eventually bought on the assumption that things just weren’t as bad as expected.  As the market began picking up momentum, professional money managers and amateur individual investors alike began searching for strong companies worthy of investment capital.  Chipotle was one of the obvious choices due to its strong balance sheet, reliable earnings growth, and the household familiarity with the company.

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But at some point investors need to take a step back and question at what price each investment should be considered attractive.  It appears that at a price near $80, CMG is beginning to push the limits on valuation and could be setting investors up for a disappointing second half.  Part of this concern stems from the company’s most recent quarterly report.

On the surface, the first quarter was a great victory for Chipotle.  The company posted revenue of $354.5 million which was 16% higher than the first quarter last year.  Comparable stores saw sales up 2.2% annually and operating margins were 23.5% (more than 2% higher than last year).  The earnings number came in at 78 cents per share, a healthy 50% increase and management reported that there were 26 new stores opened during the quarter.

Barclays noted particular surprise at the increase in margins as management had issued guidance for a full 2% decline in margins for the full year.  But the details show that much of the margin growth was due to two things:  First there was an increase in menu prices which was initiated in Q4 2008, and secondly the marketing and promotional spending was much lower.  Management explained that the majority of marketing spending would take place in Q2 and Q3 as a new advertising campaign was kicked off.  So we can expect to see these margins contract to some degree for the rest of the year.

The menu price increase baffles me a bit.  While 2008 had management concerned over commodity price increases, that worry has largely gone away as can be seen by the decline in food costs.  But still, the menu prices remain higher than last year which likely has a negative effect on traffic.  While management has been able to make up for this fact through expense control, there is uncertainty as to how long this leverage will be available.  You can only cut costs so far before it begins to effect the way business transpires.

Chipotle is making some very sound financial decisions with its available cash.  The company has spent $50 million since October buying back class B Shares, and still has plenty of cashflow to pour into new restaurant openings.  Guidance is for an additional 120 to 130 restaurants for the full year and still at the end of the first quarter CMG had $204 million in cash on their books.  An excellent approach to debt management has certainly put CMG in an advantageous competitive position.

Despite the strong business, I am hesitant to endorse a purchase of CMG at this price.  The market has largely thrown caution to the wind, but that can only last for so long.  If we get a downdraft in the coming weeks, sellers will likely target consumer discretionary names with relatively high multiples.  This puts a target square on the back of CMG.  In fact, it may be prudent to set up a modest short position in the stock ahead of this potential scenario.  I admire Chipotle’s management, growth prospects, and food but I am uncomfortable with the price of the stock at this point.

FD: Author does not have a position in CMG
CMG Notes
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