Chipotle: Don't Hold Your Breath For A Recovery

| About: Chipotle Mexican (CMG)
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Summary

Chipotle reports amazing Q4 results considering the devastation to comp sales due to the multiple health issues.

Despite the stock drop from the Q4 peak, the valuation still prices in an unrealistic rebound in customers and margins.

The recommendation stays in place to avoid the stock as the full impact of the health issue won't pass until later in the year.

With all of the health concerns during Q4, the quarterly expectations for Chipotle Mexican Grill (NYSE:CMG) were somewhat low, though analysts and the market were aggressive with expectations for a earnings rebound starting in Q1. In the process, the stock traded from a high of $750 in October all the way down to $400 last month.

The rebound to $475 made the stock difficult to own going into earnings for the lingering issues highlighted in my previous research. Regardless, investors need to keep in mind that the restaurant concept produced amazing results in the face of multiple health concerns.

For the quarter, Chipotle still produced solid earnings and large margins in the face of comp sales that plunged to the negative 30% level towards the end of the quarter. The most impressive numbers was actual earnings of $2.17 per share for the quarter and restaurant level operating margins of 19.6%. Sure both numbers were substantial declines from the prior-year period, but the ability to maintain margins consistent with a generally strong restaurant is impressive considering the situation.

The good news is that the Center for Disease Control and Prevention concluded the investigation into the E. coli outbreak, but the bad news is that a resolution of the source doesn't exist. The stock will have a difficult time rebounding with the ongoing headline risks and increased expenses for 2016 even with this out of the way.

The bad news is that the company announced a broadening of a subpoena from California that doesn't even relate to the Q4 issues. Investors should expect some legal issues relating to the recent events now that the CDC has concluded the investigation. Without the blame placed elsewhere, Chipotle is likely to bear the brunt of any legal actions in the states impacted.

On top of that, the company plans to spend aggressively on food safety, labor expenses, and marketing for the year. In essence, Chipotle is going to bare no expenses to ensure customers return to the stores without any staffing issues and with the highest level of food safety.

For 2016, Chipotle expects food costs to increase to 35% of revenues compared to a level below 34% in Q4 and closer to 33% prior to the health issues. A 200 basis point increase is expected to become a lasting cost that will ultimately limit a rebound to the previous restaurant level margins that topped 27%.

In addition, the marketing and promotional expenses will increase 120 basis points for the year with a front-end loaded amount of 6% of sales in Q1. The spending could remain in place for the full year if traffic doesn't immediately rebound. The spending level is 4x the level spent last Q1.

The end result is that breakeven for Q1 is now seen as a good outcome. This compares to analyst estimates sitting at roughly $2 now and above $3 back only a month ago when I again warned investors to avoid the stock until all the bad news was fully in the expectations.

CMG EPS Estimates for Current Quarter Chart

CMG EPS Estimates for Current Quarter data by YCharts

The key takeaway is that Chipotle must spend very liberally to ensure the restaurant chain doesn't encounter any health scares this year. Another hit would devastate the concept making the company unable to relax spending any time soon. Lower comp sales and higher spending is not the recipe for a stock rebound. Especially considering that the stock trades at roughly 40x the non-impacted earnings from 2014 that hit roughly $14. These numbers don't even factor in the higher spending going forward. One must assume a good earnings going forward is hitting that 2014 level again.

The recommendation is for investors to avoid the stock until the company comes close to lapping the issue in Q4 without further problems. At the same time, a lower stock price is needed before the stock could approach an appealing level considering the ongoing headline risks and higher costs even in the best case scenario.

Disclosure: I/we 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.

Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.