Chipotle: 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 Chipotle's bottom line in the form of higher food costs. Not only are flour and corn products more expensive, but also 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 fact that 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.

CMG Notes

Disclosure: Author does not have a position in CMG.

Comments

[Alan Brochstein]

Zach, I read all of your articles and usually find myself in agreement with you, even on the ones we miss (WFR). In this case, I haven't followed CMG very closely, though I did recently add it to the 100 stocks on my focus list.

I think that Chipotle offers one of the very best values in dining. While it is clearly "fast-food" in terms of delivery and pricing, the quality and nutritional value are on a totally different level. When I talk to people about the restaurant, I am shocked at how many people have never eaten there before (despite liking burritos).

While your concerns about price inputs and the macro headwinds may be valid, I think the bigger picture suggests that there is tremendous long-term growth potential here. I liked it enough to add it to my focus list at what happened to be the low for the last 9 months. Now that I know the story a bit better, I sure hope it gets back to 90. I doubt it, though!

[gpb]

I worked for Chipotle and in my 35 year career in food, I have never worked for a better company. they are closed 5 days a year , unheard of in the industry. they do not advertise in the traditional media and yet the word of mouth is unbelievable. there mission statement is built on "food with integrity. I no longer work for them but I own the stock and will continue to invest in their futur and mine.

[poorboy]

Don't know if I can totally agree on Chipotle being nutritional. A burrito with the bare minimum is at least a 1,000 calories with usually 39 grams of fat. They are healthier fats though and if Chipotle eaters actually knew the amount of calories they were eating, they could plan their daily intake accordingly. It is not low calorie food but I'd rather eat this than a Big Mac or Whopper.

[springpanda]

Great food, reasonable price, fresh and healthy Mexican cuisine, and both management and their employees are quality in a relentlessly competitive industry. The overspent and indebted U.S. consumer has begun changing its behavior (people who have never budgeted before are learning). CMG is on my 5 stock list for short sale. There is a reason institutional ownership is lacking. Watching to see if the enthusiastic diners will push up the price, so I might take a short position while munching a homemade burrito.

[Zachary Scheidt]

I have to say I agree with you guys on the quality of the food and respect for the company. Considering shorting the stock is not a reflection of my view of management or the company as much as it is a reflection on my view of the price that investors have placed on the stock.

I have to say, just writing about the restaurant makes me hungry though. I'll always be a fan of the food.

Good luck guys and thanks for the comments!
Zach
zachstocks.com

[Ceviche Fund Partners LP/Dan Jacome]

"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."

Are you kidding me, this is s great analysis! Great work. I am a CMG bull but I totally see your side of the story.

I think if you have a longer term view, CMG has a ton more room for growth, but as you say, the market will eventually pay a lot less for that growth as comps get harder and harder to beat as 2008 progresses.

You'll recall that a lot of people dismissed CMG in early 07 and then CMG came and crushed bears as it doubled its EBIT margin and cranked out on the top line, as well. So you are dead-on: the high PE comes from investor belief in current management to execute on another blockbuster year....

With EPS on Wed, we're long the common and would suggest hedging with puts.