Chipotle's High-Flying Stock May Fall Back To Earth

About: Chipotle Mexican Grill, Inc. (CMG)
by: SmartStops

Chipotle's stock surged following better than expected fourth quarter results.

The company saw its cost rise significantly during the latest quarter as margins sank.

The stock is overvalued when compared to many of its fast-casual peers.

The shares of Chipotle Mexican Grill Inc. (CMG) skyrocketed after posting better than expected fourth quarter results. The stock is up nearly 35% in the first few weeks of 2019 and has more than doubled over the past year. It is a stark contrast to the many years of struggle for the fast-casual restaurant.

The good times may not last though, especially if the latest round of quarterly results continue to demonstrate the same problematic trends that investors may be choosing to ignore. The most glaring is that costs are rising sharply, and if not for many adjustments on the income statements, results in the fourth quarter would have been much worse.

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Rising Costs

The company reported revenue of $1.225 billion in the fourth quarter, easily beating Wall Street's consensus estimates of $1.195 billion, 10% higher than the $1.11 billion the company reported in the fourth quarter a year ago. However, trouble is lurking on the horizon because costs appear to be on the rise. Gross profit margins peaked at 19.7% in the second and third quarters and fell by roughly 270 basis points in the fourth quarter. Meanwhile, operating margins in the fourth quarter fell to 4%, down from nearly 9% in the second quarter and representing a 500 basis point decline.

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More serious still, despite the 10% revenue growth in the quarter, the company saw its net income drop to $32.0 million from $43.8 million before adjustments and restructuring charges. That is a drop of almost 27% versus the same period a year ago.

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Strong Digital Sales

The rising cost didn't stop the stock from surging after the results, as investors applauded the digital sales growth of 65.6% in the quarter. That growth helped to account for almost 13% of total sales in the quarter. And CMG will be investing even more in this space, with $90M estimated to be spent on digital-related initiatives. The company noted on its conference call it is expanding its digital efforts and is aiming to have all of the stores online by the end of 2019. Their digital efforts include the establishment of separate process-line for mobile app orders. Should the company stay on track, digital sales could provide the company with additional revenue growth opportunities in the future.

Surging Profits

Despite the falling margins and rising cost, analysts are looking for significant earnings growth this year and next. Consensus estimates in 2019 are for $12.22 per share, an increase of 35% versus 2018. Additionally, earnings are forecast to grow by 26% in 2020 to $15.36 per share. All that earnings growth will come on revenue growth of only 9% in 2019 and 10.3% in 2020. It would suggest that analysts are currently expecting margins to expand in future quarters. However, the current quarterly trends would indicate that it may be a significant challenge.

However, those bullish assumptions for margin expansion may be too optimistic. The company guided food cost to 33% in 2019, nearly in line with fourth quarter results. Even labor costs in 2019 are expected to remain around the fourth quarter levels around 27%. Also, general and administrative expenses were guided to $277 million at the mid-point, nearly the same as 2018's $275 million. It means that margin expansion may not be all that easy to find.

The Stock Is Expensive

The stock isn't cheap either, trading at 38 times 2020 earnings estimates, nearly triple the S&P 500's 2020 earnings multiple. Even when adjusting Chipotle's earnings multiple for growth, the PEG ratio is at 1.5. The stock is even overvalued when compared to peers such as McDonald's Corp. (MCD), Yum Brands Inc. (YUM), Domino's Pizza Inc. (DPZ), and Red Robin Gourmet Burgers, Inc. (RRGB). All of these stocks trade with an earnings multiple in a range of 15 to 26, with McDonald's and Yum trading around 22. Of course, Chipotle is forecast to grow earnings at a faster pace than the others, but does that warrant a more than 50% premium, especially when those expected growth rates may be hard to achieve? Most likely it should not.

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How To Protect Your Profits

It may be wise to protect oneself from a sudden drop in Chipotle's stock. Our proprietary model suggests that if the stock falls below a price of $552.70, the shares could be at risk of a further decline. Over the past three years when the stock fell below our trigger price, it fell on average by 12.9%. However, during that time losses have been as high as 36.2%, such as from June through October 2017. Over the past 3-year period, the stock has entered this risk zone 11 times. Our aggressive model price point runs a tighter smart adjusting trailing stop and can be used for better profit protection, whether proactively or with immediate risk alerting. In fact, should the stock continue to rise, our suggested trigger point will continue to rise along with it, adjusting for those increases.

For those that own stock, it may be wise to protect your profits should investors grow more concerned over the rising cost for the company or the equity's high valuation. It would seem that investors homed in only on the company's fast digital sales growth, choosing nearly to ignore the potential red flags.

With that in mind, it would not be surprising to see Chipotle's stock come back to earth over the course of the next several weeks from its near astronomical prices. Protect yourself.

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.