Chipotle Mexican Grill (CMG)

These hot, momentum stocks always do. Even ones with tremendous fundamentals and a great long term story like Chipotle.

And Chipotle has certainly cracked. After reporting 2nd quarter earnings after the close yesterday, including a falloff in same store sales growth to 7%, Chipotle shares are selling off down to $68 this morning - off 56% from its high reached Dec 31, 2007 (CMG 1 Year Chart).

Three analysts (Jefferies, JP Morgan, RBC Capital) this morning downgraded Chipotle from Buy to Hold.

Oh how the pendulum swings in our seamlessly rational, perfectly efficient capital markets.

Chipotle shares are starting to look interesting to me here for a potential bounce. They’re at 52 week lows, 40% below their 200 day moving average, and 56% off their highs from Dec. 31, 2007.

Valuation is even reasonable here with shares trading for about 22 times next 4 quarter earnings once you back out the $200 million in cash on their balance sheet. That appears to be about Chipotle’s current growth rate so valuation has really gotten back into line after being completely ridiculous.

the biofuel initiatives among other things have led to soaring commodity costs which directly affect Chipotle's bottom line in the form of higher food costs. Not only are flour and corn products more expensive, but also cattle and chicken farmers are facing rising feed costs for their livestock, which translates to higher meat and poultry costs. Management has addressed this concern and believes that their price increases in markets where they are introducing naturally raised beef will offset the higher food costs keeping margins at a steady level.

However, there are some concerns with cheese costs, as well as the fact that the company no longer has fixed contracts in place and is at least temporarily paying high spot market prices for its dairy. It seems unreasonable to assume that 3% higher menu prices in a few markets will be effective in stabilizing margins across the whole company in this inflationary environment.^[1]

1. ↑ http://zachstocks.com/2008/04/chipotle-mexican-grill-cmg-setting-up-for-disappointment/

Looking specifically at Chipotle, it appears that the valuation is high due in a large degree to confidence in the company’s management. Since the restaurant chain was able to grow so quickly and effectively under current management’s guidance, the perception is that this trend will continue indefinitely. At the same time, management is sending signals to the street that growth trends will be under pressure for at least the next several quarters. Despite the veiled warnings, investors still appear optimistic that growth trends of the past will continue.

The macro environment that Chipotle faces (along with the rest of the industry) is not exactly a rosy picture. There are two major factors which should cause investors concern. The first issue faced by retail chains in general is the pressure on consumer spending. This is not a new issue as many are aware that slumping home prices, a leveraged American public, and declining employment statistics will likely put pressure on spending.

The perception, however, is that Chipotle will emerge from this environment unscathed due to their quality of food and the need for a busy but health conscious public to find fast food at reasonable prices that is good for their health. But, when the credit cards become maxed out and consumers are forced to tighten budgets, eating out anywhere will likely cease to be an option for many.^[1]

1. ↑ http://zachstocks.com/2008/04/chipotle-mexican-grill-cmg-setting-up-for-disappointment/

The quick-service restaurant industry is highly competitive and Chipotle must compete against large chains such as Qdoba, Rubio's, Taco Bell, and Baja Fresh as well as local Mexican restaurants. Rivals are pushing a low cost, “value meal” approach that CMG does not pursue and unlikely will given the management team’s commitment to quality.

Greater than expected Same Store Sales (SSS) deceleration will hammer the stock given the metric’s importance among restaurants. Should Chipotle’s SSS fall below what we think are management’s conservative numbers, it may prove that the Chipotle concept is weakening. Given the rich valuation still in the stock, we would expect as much as a 20% decline in the stock (the next support level being ~$80). Although Chipotle has thus far averted the revenue shortfalls that its rivals have succumbed to, a look at other high growth concepts over the last few years (PNRA, BWLD) suggests that ultimately, Chipotle, too, will sees its fundamentals catch up with its lofty stock price. While we are recommending purchase of Chipotle stock to investors looking 2-3 years out, more risk adverse investors with a shorter time frame would likely be better off avoiding the name until a better entry point presents itself.

Founder Steve Ells is responsible for Chipotle’s brand build-up and rapid growth: if he leaves, investors will likely follow suit.

The company's focus on higher quality, costlier ingredients results in lower margins compared to other competitors. Moreover, soaring Commodity Costs are Chipotle’s biggest nightmare in the event they cannot defray them through price increases: the ethanol boom has popped corn prices, which have impacted chicken prices since corn is the primary feedstock for chickens. A possible “over-increase” in Chipotle’s prices may scare consumers, many of whom are already being pinched by high gas prices and an unstable economy.

Competitor and # 2 Player Qdoba (owned by Jack in the Box) has posted 34 straight quarters of same store sales increases. Qdoba, which plans to open an additional 75 units in 2008, remains Chipotle’s biggest threat. However, we do not think its franchising strategy will create the same level of dining experience that Chipotle can create through its employee-driven, customer-embracing ethos.

A protracted consumer shakeout would thwart our “P/E re-expansion thesis” and keep the stock range bound. Right now, we are modeling an economic recovery in the 2H08, but we may be premature in our thinking given the excesses still dogging the housing space