Chuy's Holdings (NASDAQ:CHUY) stock launched out of the IPO gate due to the excitement over the potential for the Southwest regional chain to expand nationally. The Austin, Texas-based Tex-Mex chain only operates 48 full-service restaurants and recently expanded into the Carolinas and Ohio.
In the past month, the stock has faced selling pressure after the third-quarter earnings report showed declining margins. However, other successful restaurant chains have had periods of weakness followed by huge returns. Fellow Mexican chain Chipotle Mexican Grill (NYSE:CMG) and industry leader Darden Restaurants (NYSE:DRI) share another theme: strong restaurant-level margins while maintaining restaurant growth. Is the recent margin decline a blip for Chuy's due to absorption of all the new restaurant growth or has the company bitten off more than it can chew?
Massive restaurant growth
During November, Chuy's opened its ninth restaurant of the year, in Raleigh, N.C., which brought the total growth in units for the year to 23%. The company plans to open 10 or 11 new restaurants in 2014 for at least 21% unit growth.
Neither Chipotle nor Darden has the high growth of Chuy's these days. Chipotle is still building roughly 180 units a year, which adds roughly 13% growth per year. Darden only added about 7.5% unit growth for company-owned restaurants over the previous 12 months ended in August.
Naturally, investors expect a smaller concept like Chuy's to grow faster then Chipotle, which has more than 1,500 units. The problem is that Chipotle generated higher comparable-sales growth of 6.2% in the last quarter. This number easily exceeded Chuy's sales figure, which allowed the overall growth at Chipotle to nearly match the 19% revenue growth of Chuy's. Darden provides a completely different story, with dated chains Olive Garden and Red Lobster struggling to keep customers; total sales only grew 6.1% for the quarter.
The biggest reason for Chuy's stock declining more than $8, or roughly 20%, in the last couple of months was declining margins as operating costs jumped to 81.7% in the third quarter compared to 80.9% last year. These higher expenses have led to a persistent drop in restaurant-level EBITDA margin, which averaged more than 20% in 2012 and is now hardly holding 18%. Any investor paying attention to the net income might be blinded by the sharp increase led by the elimination of nearly $2.3 million in quarterly interest expense. Investors are always more concerned about how efficiently the restaurants are operated rather than financing costs, which can always be rearranged for strong operators.
Though Chipotle is a fast-casual restaurant, it still provides an ample comparison of the margin generated by the top operator around. For the third quarter, it generated restaurant level margin of a whopping 26% due to labor costs of only 22.8% of revenue. Chuy's had labor costs at 32% of revenue.
On the other hand, Darden Restaurants also operates full-service restaurants and generated a restaurant-level margin of 21.2%, down from 23.8% in the comparable period last year. Labor costs are around 32% of revenue for Darden so it didn't do any better than Chuy's on those costs. The biggest difference in costs for Chuy's is the substantial 20% of revenue it spent on occupancy and other operating costs, where both Chipotle and Darden spend slightly less than 17% of their revenue.
Investors are rightfully concerned that fast growth in new restaurants is leading to subpar margins. A combination of limited comparable-sales growth and higher labor costs due to training new staff will wreak havoc on any income statement. An overextended expansion plan could be even more negative than low growth.
Another potential issue is that the eastern locations might not be as receptive to the Tex-Mex concept. Regardless, the concept is a lot more tasty with the stock 20% lower now. Margins should rebound as the new restaurants increase their productivity, but investors need to keep an eye on whether they do indeed rebound. Any signs that exceptionally fast growth is crushing operations would be a huge red flag for investors to consider jumping ship.
Fool contributor Mark Holder has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill and Darden Restaurants. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.