Please ensure Javascript is enabled for purposes of website accessibility

Why Are Chipotle Shares Sinking After Strong Earnings?

By Ryan Downie – Nov 2, 2019 at 12:00PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Chipotle continued to grow, but the stock dropped almost 10% following its earnings announcement, likely due to its high valuation and hidden threats to growth.

Chipotle (CMG 0.47%) reported Q3 2019 results on Oct. 22, and shares dropped from $850 to $770 in subsequent trading days, despite company earnings topping analysts' estimates by more than 15%. 

Chipotle's quarterly revenues grew 14.6% to $1.4 billion, driven by 11% same-store sales growth, most of which was attributable to rising transaction volumes. This top-line result was in-line with both analyst estimates and company guidance. Additionally, the company enjoyed strength in online orders, which now make up nearly 19% of total sales.

Profit margins also improved

Gross margin approached 20% for the trailing 12 months, marking the highest point since 2015 when the company dealt with input sourcing and quality control concerns that tarnished the brand's reputation. Price increases account for wider margins, and this pricing power suggests that management's long-term response to the contamination crises is working.

A Chipotle burrito in a basket with a side of guacamole

Image Source: Chipotle

Operating margins expanded 350 basis points year-over-year due to better restaurant-level margins, and gains from scale at the corporate level driven by a larger number of locations. Wage inflation, transportation, and input cost increases have lagged behind menu price inflation, which is a bullish signal for investors.

Chipotle remained consistent in producing free cash flow above net earnings, which indicates good stewardship over working capital. A 1.5 current ratio and a debt-free balance sheet with operating lease obligations making up the majority of liabilities indicate suitable financial health.

Why Chipotle stumbled with all this good news

Chipotle's stock carries an aggressive valuation, which can only be justified by continued growth. Richly valued stocks receive extra scrutiny when fears of a market downturn arise, and any concerns of decelerating growth can be sufficient to make investors reduce exposure to the name.

Chipotle carries a hefty 45 price-to-forward-earnings ratio, compared to the restaurant industry average of 18. Price-to-book is over 13 for the stock, price-to-free-cash flow is over 61, and EV/EBITDA is 31.3. The respective restaurant industry averages are 2.5, 20.1 and 12.7 for those valuation ratios.

While Chipotle does have a share repurchase plan in place, the stock does not pay a cash dividend, so there is no income play for shareholders. In contrast, other food stocks including McDonald's (MCD -0.82%), Starbucks (SBUX 0.24%), Dunkin' (DNKN), and Wendy's (WEN -1.56%) all pay a dividend and share similar macroeconomic drivers.

Chipotle's stock is indisputably expensive, which is primarily caused by the company's high growth outlook relative to its peers. The company reiterated revenue growth expectations for the last quarter of 2019 during the Q3 conference call, but also issued slightly reduced guidance for new store openings. Chipotle's executives explained that the addition of drive-through lanes to new stores, which augment revenues and improve margins, actually require more time to construct. This complication is delaying new store openings, which could be a threat to sustained growth rates in the medium term. 

Tying it together

Stripping Chipotle of its growth rate, the stock looks like an overvalued chain that sells a narrow range of products, at higher price points than large fast-food restaurants, with less geographical diversification and no dividend. Perhaps this 10% drop offers a discounted entry point to a well-run company that will enjoy sustained growth. However, investors are likely able to find less volatile opportunities among other large restaurant stocks for now, and exposure to Chipotle's growth will probably be cheaper to acquire in the next market downturn.

Ryan Patrick has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill and Starbucks. The Motley Fool recommends Dunkin' Brands Group. The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.