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The inevitable Chipotle (CMG) tumble has finally begun. I wrote my first article detailing just how overvalued Chipotle was on March 20th of this year. Since then, shares have fallen over 23% and reached a (slightly) more normalized valuation of 29x projected 2013 earnings.

Although I'm a big fan of Chipotle's burritos, I still can't say the same for its stock. A number of macro headwinds which could negatively impact Chipotle's bottom line are in the midst of unfolding. That combined with several industry specific patterns that aren't going its way, makes the stock appear grossly overvalued.

Rising Commodity Costs

As I mentioned in my first piece, food costs are rising, and fast. Chipotle has temporarily been able to stifle this macro economic set back by raising prices (throughout 2011, thus still showing an impact in 2012's YOY earnings). However, because of lower same store sales, it's clear that Chipotle realizes it cannot continue to pass these commodity costs off to consumers for much longer.

By not continuing to raise prices in 2012, Chipotle suffers from the risk of severely decreasing margins in the following year (2013). Here's a quote from the Q2 conference call:

In terms of full year inflation, while costs have been relatively stable overall so far this year, the recent extreme weather will likely put pressure on our food costs later in the year and into 2013.

Even Chipotle's management is starting to admit that rising food costs have the potential to be a real problem. Chipotle's two choices in this scenario are 1) pass the cost to consumers (and lose customers) or 2) let margins contract several hundred basis points.

Chipotle loses no matter how you slice it.

Growth Projections Are Still Too High

Expectations (earnings wise) have been lowered slightly after Q2's disappointing report, but Chipotle is still priced for perfection. Although multiples have come down a significant amount since March, they remain far above the industry standard (for example McDonalds (MCD) trades at a forward P/E of 14.9). Revenue estimates (for 2012) have stayed flat at $2.75 billion, representing projected growth of 21.1% yoy.

But theses estimates will be even harder to achieve after a $16 million revenue miss in Q2. Momentum of same store growth is stalling, which bodes very poorly for these elevated expectations in the back half of the year.

Same Store Sales Are Falling

As predicted, same store sales rose under 10% (8.1% in Q2) for the first time in the past 5 quarters. What's even scarier is that management isn't predicting this number to bounce back to double digits any time soon. In fact in its Q2 press release Chipotle guides for "mid-single digit comparable restaurant sales growth for the full year."

If Chipotle can't figure out a way to have same store sales bounce back there is no way they will be able to meet expectations.

The reason behind falling same store sales is Chipotle's newer (and less profitable) locations just aren't delivering. As stated in Part I, Chipotle doesn't include new stores in this metric until after they've been opened for 13 months. This means that all the new locations (built about a year ago) that are finally being included in same store sales are dragging down Chipotle's numbers.

If the stores opened 13 months ago have been unable to produce high enough results to satisfy Wall Street, then I doubt the locations being built now will be able to either. In fact I see this as the beginning of a much bigger trend; Chipotle is has overextended.

Remember, because of the 13 month rule, same store sales are a lagging indicator. The damage has been done for the past 13 months but we are only being able to see the results now. If the restaurants opened in mid 2011 are underperforming, then the one's built in mid-late 2012 (presumably in even worse locations) will under-perform even more drastically.

I see Q2's disappointing same store sales as the tip of the iceberg. Unless Chipotle can raise prices again in 2012 without consumers minding, delivering 10%+ same store sales growth is not feasible.

Yum!'s Cantina Bell

Don't rule out Taco Bell (YUM) just quite yet. In the past several weeks Taco Bell has rolled out its new Cantina Bell menu, which is a new direct competitor to Chipotle (and for a cheaper price).

Thus far, the Cantina Bell Menu (designed by Chef Lorena Garcia) has received rave reviews. Taco Bell's CEO was on CNBC just last week saying how the Cantina Bell has been one of the most well received products in the companies history.

Because of how similar of a demographic the new Cantina Bell Menu and Chipotle cater too, this has the potential to impact Chipotle's sales as well. If anything this could also be looked at as a catalyst to hinder Chipotle's rising prices (which have now been undercut by a similar quality product).

Valuation

I strongly believe that expectations for Chipotle are still too high (outlined above), but let's assume they aren't for now. Even so, Chipotle's valuation is stretched to say the least. Shares currently trade at 23x 2014 earnings projections of $13.42 per share. That's increase of 97% from 2011 earnings ($6.81 per share), even if we do see earnings double in the next 3 years, I still wouldn't buy Chipotle.

In that time period the competitive landscape has huge potential to change (which we already are starting to see with Cantina Bell) and Chipotle is going to have a hard time to adapt. By maintaining such a high focus on quality, Chipotle will have to figure out a way to cope with rising food prices, other than simply passing it on to its customers.

Conclusion

Despite falling about $100 per share since my first article, I'm still not a Chipotle bull. Macro headwinds and increased competition are gong to make it a difficult environment for any business like Chipotle's to succeed. That combined with what still seems to be a ridiculous valuation, gives Chipotle more downside potential at current levels.

Source: Chipotle Due For A Serious Correction: Part II