Deconstructing Chipotle's Earnings Growth

| About: Chipotle Mexican (CMG)

Earnings growth is one of the most important metrics for investors. It is the fuel for growth stocks and is often the single largest factor in a company's valuation. Only when you understanding what drives earnings growth can you assess whether, and for how long, that growth can be sustained.

Earlier this month I analyzed the earnings growth of AutoZone, Inc., a distributor and retailer of automotive parts. This analysis can be accessed here. Chipotle Mexican Grill (NYSE:CMG) is another retail stock that has achieved incredible earnings growth over the past several years. It has also seen large price swings when the growth trajectory was questioned by investors. The shares peaked at $440 in April 2012, only to fall more than $200 six months later. The shares are now trading over $300, as investors are once again betting that Chipotle can continue to grow earnings despite the pricing and cost challenges in the restaurant space.

The chart below illustrates Chipotle's year-over-year earnings growth using a four-quarter rolling average. This approach smooths out the data and also accounts for seasonal effects.

Chipotle's earnings growth peaked as the country emerged from the recent recession. It slowly dropped from the 60% range and normalized at around 20%. In the last several quarters, earnings growth has picked up once again. Analysts are currently projecting FY12 EPS of $8.76 and FY13 EPS of $10.26, or around 17% growth. So are analysts being too conservative, reasonable, or too aggressive?

Chipotle's Earnings Growth

As I mentioned in my previous article, earnings growth typically results from revenue growth, cost reductions, and/or share repurchases. Quite often, these growth drivers vary over time. For example, a young company may generate earnings growth by rapidly grabbing market share to increase revenue. Then, as the company matures, it may streamline its cost structure and achieve growth through increased margins. For established companies, earnings growth may be propelled by using free cash flow to buy back shares.

For Chipotle, I examined these factors to determine the role they each play in driving earnings growth. Turning first to revenue, Chipotle achieves growth by opening stores at a rapid pace and also by increasing sales per store. Chipotle's store growth has been around 13% annually over the past three years. For FY13, the company plans to open between 165-180 stores, which would maintain this growth rate for another year.

The chart below shows the actual earnings growth rate starting in FY10 Q1 compared to the growth rate that would have been achieved without any new store openings. Note that profit margins were held constant in these calculations. As the chart shows, new store openings have been the company's most significant and consistent earnings driver. They now account for more than 17% of the company's earnings growth.

Another growth component is the increase in sales per store. The chart below shows the yearly earnings growth that would have been achieved if sales were held constant at the levels achieved in 2009. Although not as significant as new store growth, the increase in sales per store has consistently generated 10% earnings growth throughout most of the time period. Last quarter, however, the growth rate started to decline, so that's certainly something to watch going forward.

Chipotle reports its operating costs in two categories. The first category comprises restaurant operating costs, such as food, packaging, labor, and occupancy costs. These costs tend to be volatile as a percentage of revenue. For example, this was Chipotle's primary growth driver during 2010, but actually hindered growth by the end of 2011. In 2012, the growth rate picked up again as margins improved.

The other category of Chipotle's operating costs includes G&A, depreciation, pre-opening costs, and losses on assets. These costs tend to run around 10%-11% of revenue, so they do not change the growth trajectory as much as the other factors. Nevertheless, these costs generated more than 5% earnings growth from 2010-11. The first and third quarters of FY12, however, show that investors should not count on earnings growth from the management of these costs in the near term.

Share repurchases are another common way that companies have achieved earnings growth over the past two years. Chipotle has roughly the same number of shares outstanding as it did at the end of FY09. Recently, however, Chipotle approved another $100 million in share repurchases. If Chipotle bought back $100 million in shares this quarter at the current price, the repurchase could add roughly 4% to earnings growth in the next year. It is more likely, however, that these shares will be bought back over time, so the repurchase may not have much of an impact on earnings growth.

What to Watch For in the Near Term

Chipotle reports earnings on February 5 after the bell. Here are some of the things to look for in earnings reports and conference calls over the next few quarters to assess whether the street's 17% growth rate for FY13 is reasonable:

New Stores: Chipotle's estimate for FY13 is between 165 and 180 new stores. With everything else constant, new stores alone could provide 15%-17% in earnings growth the next year. If the new store projections drop, that will have a significant impact on earnings growth.

Sales per Store: In FY12 Q3, the yearly growth in sales per store dropped significantly. Watch to see whether the number stabilizes or even starts to pick back up. Historically, it has accounted for 10% in earnings growth. But if the trend from the last quarter continues, it may fall to the low single digit range in the next year. Although this factor is not as significant as new store openings right now, its importance will be heightened in future years because new store growth cannot be sustained forever.

Restaurant Costs: This is the most volatile metric of those analyzed above, and the most difficult to project over a long period. On the last conference call, Chipotle noted that food costs should not increase much because higher meat and dairy costs will be offset by lower avocado costs. Price increases will be difficult in the current environment as well. Right now, it looks like margins will be flat from the previous year and be neutral for growth.

Other Operating Costs: These costs will not be a significant factor given that their change is pretty gradual. But they are something worth keeping your eye on. Over the past few quarters, these costs have been neutral for growth.

Share Repurchases: An announcement of a larger share repurchase program could provide a boost to earnings growth. At the current level, the share repurchase should not have much of an impact.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Tagged: , Restaurants, Earnings
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