Are The Burritos Getting Cold at Chipotle?

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Last week, Chipotle Mexican Grill (NYSE: CMG) released earnings for the third quarter and missed analysts' earnings expectations by a little over 1%.  The result was a sell-off in the company's shares of over 15%, which rivaled the sharp decline following David Einhorn's bet against Chipotle.  The result is a new 52-week low and a closing share price for the week of $243.   This represents a sizable decline of over 45% from the highs reached just six months ago as shown in the chart below: 

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CMG data by YCharts

This article aims to take a step back from the panic of the market and figure out what Chipotle's results really mean for the investment thesis in the company.

Results: A Mixed Bag

Chipotle reported revenues of $700.5 million and earnings of $2.27 per share; these results represent year-over-year increases of 18.4% and 19.5%, respectively.  Earnings growth was aided by an increase in operating margins by 70 basis points to 27.4%.  Regardless of expectations, these are solid numbers.  On the growth front, Chipotle expects to be at the high range of its 155-165 store opening target for 2012 and expects 2013 store openings to ramp up to 165-180.  This information also supports the thesis that Chipotle has plenty of growth ahead of it.

So what is driving panic?  The single number generating the most attention is same store sales ("SSS"). Chipotle had been consistently generating low double digit SSS growth, but the third quarter showed a drop to just 4.8%.  Furthermore, guidance for Q4 calls for "mid-single digit" SSS growth followed by "flat to low-single digit" SSS growth in 2013.  This SSS pressure has been felt across the industry, which began with McDonald's reporting SSS growth of just 1.9% for the quarter.  In addition to the top line pressures, rising food costs have become a cloud over the restaurant industry in recent months; given that Chiptole's margins increased pretty significantly over last year, this does not appear to be a valid driver of the recent decline.

Watch Out... The Bears Are Coming!

From my perspective, there are three reasons for Chipotle's sharp decline in recent months.  First, the earnings miss noted above (analysts expected $2.30 per share as compared to $2.27 reported by Chipotle).  Second, SSS growth essentially being cut in half is a definite red flag for measuring the growth trajectory of the company going forward.  How much of a warning sign depends on what the real underlying reason for the decline is.  If it is the economy (which is the explanation given by Chipotle's management), then the performance is not that worrisome.  Chipotle's CFO cited fewer drink sales and fewer large to-go orders being the primary culprits, which seem to reflect the idea of economy-driven results.  

However, if competition is the reason for SSS pressure, there is an entirely different discussion to be had.  Competition is at the core of David Einhorn's short recommendation on Chipotle.  Einhorn recently stated that “Taco Bell has started to eat Chipotle’s lunch"; this statement must really be taken seriously, both because of the past achievements of Einhorn as well as the implications for Chipotle.  However, I tend to agree much more with the idea that Einhorn's thesis significantly exaggerates this risk for several reasons.  First, Yum Brand's (NYSE: YUM) Taco Bell attracts very different customers than Chipotle.  Second, the experience at a Chipotle and a Taco Bell is completely different.  Third, Taco Bell's "Cantina Bell" menu really isn't that good.  I've tried it several times; it is a significant step up in quality from Taco Bell's legacy menu, and I certainly appreciated real guacamole as opposed to the "guacamole" that is squeezed out of a caulk gun that comes with Taco Bell's normal menu.  But to compare the quality of a Chipotle burrito to a Cantina Bell burrito in terms of freshness, quality of ingredients and taste is an insult to people's intelligence.  To be honest, the best tasting  menu item I've found on Taco Bell's menu recently is the Doritos Locos taco; that type of flavor and bargain price combination remains Taco Bell's strength.  While Taco Bell is in fact offering improved food at a price that is lower (although starting to approach) Chipotle, there is a sufficent gap in the overall experience to question whether anyone would make the switch unless budget was the driving reason.  Finally, I'd like to point out that competition is nothing new for Chipotle.  Jack in the Box's Qdoba concept has been a strong national competitor for years, and there are plenty of smaller regional and local purveyors of burritos; of the half dozen most popular options in my hometown of Charlotte, NC, I'd put Taco Bell's Cantina Bell menu in a tie for last place based on taste and popularity amongst friends, family and co-workers.

So Where Does That Leave Us?

At $243 per share, Chipotle is trading at a TTM P/E of 28 and a forward P/E of just 22.  These are remarkably low ratios compared to historical valuations since Chipotle became a public company: 

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CMG PE Ratio TTM data by YCharts

Essentially, the Great Recession is the only time in the company's history that the shares have traded at a lower valuation.

So Is Chipotle A Buy?

Back in July, I laid out a simplified model for valuing Chipotle's growth.  Since then, shares have dropped from $380 to $243.  This certainly makes the company more attractive if you believe in the long term investment thesis.  Personally, this thesis is founded on several assumptions:

  1. Chipotle can reach 3,000 locations in the U.S. (Chipotle current has just 1,340)
  2. Chipotle can grow materially internationally (Chipotle has just 10 international locations today in London, Toronto and Paris)
  3. Chipotle can expand into new restaurant concepts (Chipotle has 1 ShopHouse location)
  4. Chipotle can grow SSS by 5% or more over the long term
  5. Chipotle can finance all of the growth above by cash from operations without using significant leverage (unless it is strategically beneficial to take advantage of current low rates)

I look at this list, which hasn't changed all year, and I still don't see any reasons to doubt it.  The store opening guidance for next year is actually higher than the expectation of 160 stores per year built into my valuation model.  Plans are underway to open a second ShopHouse in D.C. this year and a third location in Los Angeles in early 2013.   The early success of Chipotle's international locations will lead to expansion both in the near future and remains a wide-open opportunity.  Chipotle continues to generate strong free cash flow, so the $421 million of cash and equivalents appears to be ample to support further growth (as well as ongoing share buybacks).  The only question mark relates to SSS.  At this point, the evidence appears to support management’s assessment that the decline to 4.8% is the result of the economy.  Companies aren't ordering as many catered lunches, and people are foregoing drinks to keep costs down.  If in fact competition the reason for the dip, the investment thesis will need to be re-assessed and valuation models will need to reflect a lower growth expectation.  To monitor this threat, it is important to monitor both Yum Brand's SSS results as well as those of other pure-play "fast casual" dining companies such as Panera Bread since Panera operates a more similar business in terms of food quality, price and atmosphere.  

The Bottom Line

Shares of Chipotle have been hammered this year, but my relatively informed opinion (both as an investor and a fan of burritos) is that Chipotle's shares have been unduly punished and a solid buying opportunity has presented itself.  A TTM P/E of 28 and a FCF yield of 6.4% are an excellent value point for a company with no debt and plenty of growth ahead of it.  If you buy into the idea that the investment thesis hasn't changed, you may want to buy shares of Chipotle as well.

BrewCrewFool owns shares of Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Panera Bread. Motley Fool newsletter services recommend Chipotle Mexican Grill, Chipotle Mexican Grill, Jack in the Box, McDonald's, Panera Bread, and Yum! Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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