This High-Flying Restaurant's Trajectory Is at Risk in 2011

The restaurant sector was one of the market's hottest in 2010, as the U.S. economy began to recover from the recession and consumers had more discretionary income to spend dining out. Many quick-service, casual-dining, and even higher-end restaurants posted significant gains as revenue began expanding and growth was taken off the back burner. However, two recently released reports show that this trend began to slow in late 2010.

The National Restaurant Association's Restaurant Performance Index slipped below its key 100 level for November, the first time in three months it fell below this level, indicating contraction in the industry. The report showed a net decline in same-store sales as well as customer traffic.

A report released this week by NDP Group showed a similar contraction in the third quarter of 2010 globally. The report showed that restaurant chains in seven of the 10 countries tracked, including the United States, showed restaurant traffic declines. One large exception was in China, where a 16.2% traffic increase was reported, which should benefit restaurant chains like McDonald's (NYSE: MCD  ) and Yum! Brands (NYSE: YUM  ) thanks to their large international operations and growth in China.

While less customer traffic is one concern for restaurants, another significant problem is increasing commodity costs. While I recently discussed how restaurant chains such as Panera Bread (Nasdaq: PNRA  ) and Einstein Noah Restaurant Group (Nasdaq: BAGL  ) have been able to battle inflation by hedging some of their input costs, for some chains this is more difficult. One restaurant stock that I believe could face significant downside in 2011 as a result is Chipotle (NYSE: CMG  ) .

Rising inflation, slower growth
Chipotle's continued focus on its "food with integrity" initiative, coupled with management's inflation expectations, will most likely force the company to raise prices in the coming year. The initiative includes using more expensive hormone-free livestock for its chicken and beef offerings, using organic vegetables and dairy products, and buying from local sources when practical. Chipotle has locked in its prices on beans, corn, and rice for most of the year; however, it has not done so for some of its other larger inputs, like meat, dairy, wheat, and avocados. In addition, the company's rapid growth has made it more difficult to source the quantity and quality of these products that customers have come to expect. Add in ever-growing food demand from all over the globe, especially in emerging markets, and increased costs are almost a certainty over the next few years.

In addition to cost worries, in 2011 the company faces the prospects of a slower and more difficult trajectory of store growth. While Chipotle's same-store sales growth has not been bad, much of the company's rapid sales growth can be attributed to new store openings. With more than 1,000 stores in the U.S. and another 135-145 planned this year, Chipotle is now in most major cities and areas where it can receive the maximum benefit from new openings. While the burrito maker still has room to grow domestically, as evidenced by the much larger presence of McDonald's, the point of diminishing returns on growth is now something investors must account for.

Chipotle has begun its initial expansion into other countries with a restaurant in Toronto, as well as in London. However, it is yet to be seen how Mexican-style food is accepted globally.

Valuation worries
While slower growth and inflation are industrywide worries, more worrisome is Chipotle's valuation, especially when compared to its peers; no quick-service restaurant is even close. Chipotle's share price increased by more than 140% in 2010, and it now is valued at enterprise value/EBITDA of 19.9.

Since Chipotle is somewhat between fast food and fast casual, an apt comparison would be Panera Bread, which I believe looks expensive at a much lower 11.7 EV/EBITDA. Cheaper alternatives include Einstein's, which trades at a 7.5 EV/EBITDA, or sit-down restaurant chains such as Darden Restaurants (NYSE: DRI  ) and Brinker International (NYSE: EAT  ) , which trade at 8.1 and 7.1, respectively. All three also pay investors a nice dividend.

Foolish takeaway
The research reports I discussed indicate a slowing of the trends that helped propel restaurant stocks higher in 2010. If the high inflation expectations of many of these companies' managements prove true and consumer traffic continues to slow, it could be a tough year for investors in restaurant stocks. I believe Chipotle, with its extremely rich valuation and premium input costs, is at the most risk in this environment.

Andrew Bond owns no shares in the companies listed. Panera is a Motley Fool Stock Advisor recommendation. Chipotle is a Motley Fool Rule Breakers pick. Chipotle is a Motley Fool Hidden Gems recommendation. The Fool owns shares of Chipotle and Yum! Brands. You can follow Andrew on Twitter @Bond0 or on his RSS feed. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.


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  • Report this Comment On January 13, 2011, at 12:18 AM, Disaster1 wrote:

    Could also mention that the stock has technically formed a head and shoulders top, a neckline at around 224, has broken down below the neckline, rallied back up to it, and now appears to be starting a free fall, below its 50 DMA, with no support until 175-180 range, at its 200 DMA. So, technically- minded shorts must be drooling at this opportunity with a high-priced stock in the process of crashing, from its high of 260 range. Just my humble opinion, but I should mention I own JAN 220 puts.

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