Chipotle Mexican Grill - Growth Has Come To A Standstill

Jul.22.12 | About: Chipotle Mexican (CMG)

Shares of Chipotle Mexican Grill (CMG) had a terrible Friday as shares of the Mexican style restaurant chain fell 21.5% to $316.98, an impressive $86.88 price drop compared to Thursday. The reason, a disappointing revenue release and a cautious guidance for the remainder of the year.

Second Quarter Results

Let's quickly run through the highlights of the earnings report to see why investors are disappointed. Chipotle reported a 20.9% increase in second quarter revenues to $690.9 million, driven by a 8.0% comparable restaurant sales growth. Both figures came in below analysts consensus of $707.3 million in quarterly revenues, and comparable sales growth of 10.1%.

The company experienced a healthy margin expansion after price hikes near the end of last year. Operating margins increased 340 basis points to 29.2% which resulted in a 61% increase in net profits to $81.7 million. Diluted earnings per share rose a similar 61% to $2.56, beating analysts consensus of $2.30

Growth is slowing down

Investors are disappointed with the growth of the franchise. In the first quarter of this year Chipotle reported a 25.8% annual growth rate in revenues which has now fallen to 20.9%. The real disappointment comes from the comparable sales growth which came in at 12.7% for the first quarter and dropped to 8.0% in this quarter. The significant decline is a reflection of lower consumer confidence in recent months as the US is approaching its "fiscal cliff", with measures which include automatic budget cuts which full put more pressure on the economy and consumer confidence.

To keep up a steady growth rate, more growth has to come from new store openings which require significant capital expenditures, rather than organic growth. The company opened 55 restaurants in the second quarter compared to 32 in the first quarter, bringing the total new openings to 87 so far in 2012. The company reiterated its target to open between 155-165 stores in 2012.

Outlook

Besides disappointing second quarter revenue growth, the full year 2012 outlook scared investors as well. While the target number of restaurant openings and a 39% effective tax rate are no surprise, the full-year comparable sales growth rate of "mid single digit" is. Given the 10.2% in same store sales growth for the first six months of 2012, the full year target implies no same store sales growth for the remainder of 2012.

Chipotle admitted that April started fine but that a revenue slowdown emerged in May and June. While Chipotle blames the overall economic circumstances including lower consumer spending as main reasons behind the slowdown, the company admitted in the press conference that it does not know the exact reasons behind the slowdown. Analysts point towards Yum! Brands (YUM) whose Taco Bell unit introduced a new upscale menu recently in order to compete with Chipotle. The Taco Bell unit reported 13% same store sales growth for the recent quarter as it offers new Dorito shell tacos and fresh-focused menus.

CFO Jack Hartung comments on the slowdown. "The slowdown is attributed to the tough comparison compared to last year, a decline in consumer spending and ramped up advertising by competitors. Furthermore it is possible that maybe that's causing people to visit other restaurants, but we just don't know."

Furthermore the company warned that extreme weather might put pressure on food costs which may impact margins in the second half of 2012 and into 2013.

Other premium priced food and beverage companies had a rough day on Friday as well. Whole Foods Market (WFM) fell 7.2%, Starbucks (SBUX) fell 4.1% and Panera Bread (PNRA) fell 3.8% as investors fear that consumers are not willing to pay premium prices for food and beverages anymore as consumer confidence among high-income classes has fallen significantly in recent months.

Valuation

For the first six months of 2012 Chipotle reported net income of $144.3 million, or $4.53 per diluted share. Despite the warnings about the revenue developments into the second half of 2012 and food cost inflation, earnings per share for the full year of 2012 between $9 and $10 should be attainable. This values the company around 35 times full year 2012 earnings, even after the freefall on Friday. This valuation is still not justified as organic growth will come to a complete standstill in the second half of 2012 and margins might come under pressure amidst flat selling prices and food cost inflation.

Strong competition in food industry and the introduction of Taco Bell's menu will put more pressure on the growth profile of Chipotle. This quarter report also highlighted that new store openings are saturating the market with lower average revenue growth per restaurant.

Investment Thesis

I have been short since the stock traded around $380 per share and I will not reconsider my thesis unless significant new news hits the wires or shares correct further to $250 per share. Despite the 22% drop on Friday I feel investors are underestimating the impact of the organic revenue slowdown and food cost inflation in the second half of the year.

Disclosure: I am short CMG.