Seeking Alpha
Long/short equity, research analyst, dividend investing, tech
Profile| Send Message| ()  

Chipotle (CMG) is a fast-casual chain of Mexican restaurants that have been growing rapidly in the past few years. The company reported third-quarter 2012 earnings Friday that were a tremendous disappointment to investors. The stock declined more than 15% on Friday and has now dropped nearly 40% in the last three months. Investors only have to look back to April when Chipotle was trading at $442 and how the stock has now plummeted $200.

The most famous Chipotle bear is hedge fund manager David Einhorn, who accurately bet against Green Mountain (GMCR). Einhorn has a very analytical approach to investing and I have agreed with him in the past, notably in my bearish stance toward Green Mountain. Einhorn utilizes less financial analysis with Chipotle, but his arguments are still very valid. Chipotle is a growth story and I want to dedicate this article to the issue of the company's income statement.

Chipotle reported 18.4% revenue growth this quarter with same-store sales rising by 4.8%. These are excellent numbers for this economic environment, but represent declines of 3.1% and 3.5%, respectively. This is a precipitous decline in growth for a company that has been trading at a multiple of around 60. Such a high multiple is quite rare for retailers, as they typically trade in the teens or twenties because of their relatively low margins and usually average growth rates. Chipotle is growing at a decent clip and is still riding the expansion phase of the business cycle; however, the P/E of 60 was clearly too high. Now that the market has reached a consensus that Chiptole's P/E was unreasonable, an even more alarming issue is on the horizon.

CFO Jack Hartung mentioned during the conference call that Chipotle intends to increase prices in 2013 if costs continue to grow. Hartung discussed margin contraction as follows:

Well, at that level, Larry, with inflation, margins are going to be under pressure. So food costs are going to rise in the fourth quarter. They're going to rise again next year. So that, all by itself, is going to have a negative hit on our margins... Now keep in mind, eventually, it would be our intent to pass on the higher cost of doing business, especially inflation, through a menu price increase, but we're going to be patient at that… And then there will be the opportunity sometime in the future when we decide, okay, the economy seems to be picking up, consumers seem to be confident, others have increased price then it looks like it's an okay time to raise prices, we can recover that margin back. So longer term, Larry, our margins as they are today are sustainable. In the short term, I would expect there to be some pressure.

The focus from the earnings report and conference call has been on the slowing growth, and things could get far worse next year if Chipotle does increase its prices. I do not believe that the competition from Yum's (YUM) Taco Bell poses a real threat currently, but the danger grows for Chipotle as the price difference between the companies grows. Competition from Taco Bell was one of Einhorn's main points and this will become a larger issue going forward. I believe Chipotle is making a tremendous mistake if it believes that a price increase would be digestible by its consumers next year. The cheapest burrito is currently pushing $8 in the Northeast (without guacamole), and I believe Chipotle will face resistance once a meal breaks the $10 barrier. In essence, the price increase will slow momentum and the company's growth will decline further.

Do not fall into the value trap of investing in Chipotle at these "depressed levels." The company has authorized a $100 million buyback plan, but that represents less than 1.3% of the company's outstanding shares. Chipotle could very easily rebound five percent in the near term as it has many bulls who are supporters of the stock; however, any such rally will likely be short-lived. I expect to see Chipotle trading at a P/E closer to that of Yum's 21, which would result in a share price close to $180. Even if Chipotle were to trade closer to Starbucks (SBUX), that would still result in a 10% decline in value.

If you are interested in purchasing a fast food company, I would look at McDonald's (MCD), which also recently missed earnings targets. McDonald's is trading at a forward P/E below 15 and offers a respectable 3.3% yield.

Disclaimer: Please refer to my profile for the disclaimer.

Source: Sell Chipotle - Einhorn Was Right