Investors weren't too pleased with Chipotle Mexican Grill's (NYSE: CMG ) recent earnings report. While earnings per share grew 7.8% to $2.64, that fell short of the average analyst estimate of $2.86. As a result, shares fell about 6%. However, while Chipotle stock is up 50% year over year, this drop seems like a great buying opportunity.
First of all, Chipotle generated unbelievable comparable-restaurant sales growth of 13.4% last quarter, in spite of bad weather. Second, the company is still growing its restaurant count by more than 10% annually, pushing revenue growth even higher. Third, Chipotle has the pricing power to win back the margins it lost due to cost inflation last quarter -- and it plans to implement a price increase very soon.
Efficiency hits a peak
A good portion of Chipotle's comparable-restaurant sales gain can be attributed to improvements in throughput -- the number of customers who can be served per hour. (An easy comparison to Q1 2013 also helped.) This allowed Chipotle restaurants to serve about seven extra customers during the peak lunch and dinner hours.
Chipotle's strong throughput performance bodes well for the next two quarters, which tend to be busier due to the favorable weather. Most Chipotle restaurants have long lines for several hours a day during the peak season, so faster throughput means that each restaurant can ultimately serve more customers.
Comparable-restaurant sales gains are obviously good for revenue, but they also help Chipotle's profit margin by making better use of labor, occupancy, and capital expenses. Last quarter, labor costs fell from 23.6% to 23% of Chipotle's revenue; occupancy costs fell from 6.6% to 6.1% of revenue, and depreciation and amortization expense fell from 3.2% to 2.8% of revenue.
Despite the good sales leverage on labor, occupancy, and depreciation/amortization costs, Chipotle's operating margin fell by 150 basis points last quarter. Food costs were the main culprit. Rapid cost increases for beef and dairy caused food, beverage, and packaging costs to move from 33% of sales to 34.5% of sales.
Furthermore, corporate general and administrative expenses soared more than 50% year over year, increasing from 6.1% of sales to 7.4% of sales. This was primarily caused by higher stock compensation expense.
Last week, many investors appeared to be spooked by Chipotle's margin issues. This was due in part to the rise in food costs last quarter, but management's forecast that food costs would rise even further in Q2 compounded these concerns. Investors seem to be worried that Chipotle can't raise prices fast enough to keep up with food cost inflation.
No reason to fear
These worries seem overblown to me. On the earnings call, Chipotle announced that it will implement mid-single-digit menu price increases starting later this quarter.
This alone will not move food costs back under 33%, a level seen as recently as 2012. However, the rapid price increases seen for items like beef (up 25% in just a few months) are likely to reverse eventually.
Moreover, the increase in menu prices should improve Chipotle's ability to leverage non-food costs, which represent about 50% of revenue. Obviously, it takes the same amount of labor and store overhead to serve the same burrito after its price goes up by 5%.
Lastly, the rise in G&A costs will slow dramatically later this year, largely because stock compensation expense is disproportionately weighted toward the first half of 2014. For the full year, G&A costs will increase by just 50 to 60 basis points over 2013. Part of this increase is due to the biennial All-Manager conference, which is held in even-numbered years and will therefore become a tailwind in 2015.
In sum, while Chipotle will probably have a tough Q2 margin-wise, it could see solid margin expansion in the second half of 2014 and 2015. It will benefit from higher prices, lower stock compensation expense, and potentially also from easing commodity costs. This will boost Chipotle's already-strong margin growth.
For much of the past year, I have been wary of Chipotle stock, which seemed overpriced as it rose past $400, $500, and eventually $600. However, the company's ability to keep posting strong comparable-restaurant sales growth while adding nearly 200 restaurants a year -- and the recent stock price correction -- have changed my mind.
Chipotle stock is still pricey at more than 30 times forward earnings. This seems like a price worth paying, though. Chipotle has tremendous long-term growth prospects and enough pricing power to maintain or even improve its already-stellar profit margin over time. This is a recipe for great long-term investing returns.
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