Last week, Chipotle Mexican Grill (NYSE:CMG) beat analyst estimates with adjusted EPS of $2.35 in the first quarter. The good news sent Chipotle shares up as much as 10% as investors regained some confidence in the company's prospects. Chipotle has become a short target for some high-profile investors in the past year, most notably David Einhorn. At the Value Investing Congress last fall, Einhorn argued that Yum! Brands (NYSE:YUM) subsidiary Taco Bell would steal market share from Chipotle with its new Cantina Bell menu. Cantina Bell items were designed to be higher-quality than typical Taco Bell fare, but still cheap compared to Chipotle.
Wall Street seems to be downplaying the threat from Taco Bell, but Chipotle's first-quarter results were not nearly as impressive as they may seem to be. In the earnings release highlights, the company pointed out that diluted EPS rose 24.4% year over year, but later on it disclosed that much of the gain was due to one-time items. Moreover, comparable restaurant sales growth has nearly come to a halt, which is potentially ominous for Chipotle.
Anatomy of an earnings beat
Chipotle reported that revenue grew 13.4% year over year to $726.8 million last quarter. However, restaurant-level operating margin narrowed from 27.4% to 26.3%, primarily due to higher food costs. Normally, this decrease in restaurant operating margin would put pressure on profitability, but Chipotle's general and administrative expenses dropped from 7.7% of revenue to just 6.1% of revenue. This drop was partially caused by leverage (spreading fixed costs over higher revenue), but the biggest change was a drop in stock compensation expense.
In other words, whereas Chipotle reported high stock compensation expense in 2012 because the stock was rising quickly, employee stock compensation was "cheaper" this year, because the stock price had fallen. This change improved year-over-year EPS growth by around $0.11. Chipotle also received $3.3 million of 2012 tax credits during the quarter, which boosted EPS by approximately $0.10. Reversing these two adjustments, Chipotle experienced EPS growth of 13%, almost exactly in line with revenue growth.
The growth problem
With a forward P/E of 29, Chipotle is still priced like a growth stock. In the past, that's been warranted by the company's performance. Comparable restaurant sales grew by a whopping 12.7% as recently as first quarter 2012. However, comparable restaurant sales grew by just 1% last quarter. To make up for this slowdown, Chipotle has ramped up new store growth, adding nearly 200 locations in the past year. These new restaurants were the primary driver of the company's 13.4% revenue growth.
In part, comparable restaurant sales growth has slowed because Chipotle has not raised prices in the past year. Some people expect a price hike as soon as this fall, which could restart comparable restaurant sales growth. However, I think management may be worried about getting too far ahead of Cantina Bell in terms of pricing. While many Chipotle customers are fiercely loyal to the chain, last quarter's slower growth suggests that some of the more price-sensitive customers may be cutting back on their Chipotle intake.
For the time being, Chipotle can use new restaurant openings to maintain double-digit revenue growth. However, with 1,458 locations as of March 31 (most of which are in the U.S.), Chipotle could start saturating many of its markets in the next few years. While it's not clear what the ultimate potential for Chipotle is, it seems unlikely that the chain will ever have tens of thousands of locations like fast-food giant McDonald's. If Chipotle begins to exhaust its highest-value expansion opportunities and has to reduce its growth rate, shares could take another hit.
Risks and opportunities
I am a big fan of the Chipotle concept: just not the current stock price. If management is able to implement a significant price increase soon without losing customers to Taco Bell and other competitors, then margins could start expanding again. Furthermore, if the company's new ShopHouse Southeast Asian Kitchen concept takes off, that could provide another big boost to growth. However, I will wait on the sidelines to see if either of those things happens before considering an investment in Chipotle.