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What P/E multiple would you pay for a restaurant company with the following characteristics?

(1)    5-yr EPS growth of 18-20% (13% unit growth, 4% SSS and some margin expansion?)

(2)    Consumer loyalty that cyclical (otherwise management would have raised menu prices)

(3)    Little pricing power (management implied that last night)

(4)    Significant margin volatility due to significant commodity exposure (read the rest of this note)

Pick from the following:

(A)   20x earnings

(B)   25x earnings

(C)   30x earnings

(D)   35x earnings

This brackets the valuation of CMG at some where between $120 and $210 per share, with stock having closed at $256 (and trading up at $275).  Yes, you can accuse me of having a BEARISH view of CMG, but I also feel like I’m being rational in a market that is irrational.  Right now I have CMG earning $6.00 in 2011 below the $6.66 consensus estimate.  I’m the bearish one so I’m going to use 25x as an appropriate multiple to value CMG - that puts $100+ downside to CMG. 

Read the balance of this note and you tell me that the current 42x multiple is justified.  

CMG once again beat street expectations, reporting 4Q10 earnings of $1.47 per share and 12.6% comp growth relative to the street’s $1.31 per share and 9.9% same-store sales growth estimates, respectively.  With restaurant-level margins up over 140 bps to nearly 26%, and operating margins up 240 bps YOY, it is hard to poke any holes in the company’s fourth quarter results.

CMG maintained its reported FY11 guidance to open 135 to 145 new restaurants and for low single-digit comp growth, but outside of that, all of management’s commentary around its outlook for this year was decidedly bearish.  In short, same-store sales comparisons, and more specifically, traffic comparisons, get increasingly more difficult as we progress through the year, inflationary headwinds will put real pressure on margins and labor costs will creep higher as a result of the recent immigration inspection in Minnesota, which could ultimately affect additional markets.

Same-store sales growth

 During the fourth quarter, CMG successfully lapped its first quarter of slightly positive traffic growth reported in 4Q09 after lapping five quarters of traffic declines.  The traffic comparison turns significantly more positive in 1Q11 to about 4% and jumps to double-digit growth in the second half of the year.  Given that the company is currently not planning any menu price increase for the first half of the year and menu mix has only been a minor driver of comp growth in recent quarters, the sharp uptick in traffic comparisons will likely cause comp growth to slow, particularly in the second half of the year, to closer to 3% from the double-digit growth reported in 2H10.   

On the earnings call, management announced a loyalty program based on rewarding “our best customers for their knowledge and understanding of Chipotle, rather than simply rewarding visits as most loyalty programs do”.  While CMG’s intentions may be admirable, to ‘educate people about “Food With Integrity”’, I am skeptical that this initiative will prove incremental to comparable sales and traffic growth when it is rolled out in April.

During the first quarter, a tougher comparison will not be the only hurdle; however, as management said that although comps held up well in 4Q10, “it's been pretty volatile so far in 2011 with extreme weather throughout much of the country.”  Given this volatility, I am currently modeling 6% same-store sales growth during 1Q11, which implies about a 200 bp deceleration in two-year average trends.  For the remainder of the year, I am modeling flat two-year trends with the fourth quarter because management did specify that, outside of the weather impact, there does not appear to be any change to underlying trends.  But again, flat two-year average trends imply a significant slowdown in comp trends on a one-year basis (pictured below).

CMG: C NOTE - cmg1


Inflationary headwinds

CMG sounded decidedly more negative today regarding its commodity cost outlook for 2011 relative to the company’s 3Q10 earnings call when it said it could face low-to mid-single digit cost inflation.  During the fourth quarter, food costs as a percentage of sales increased nearly 100 bps to 31% and that is with comps up 12.6%.  Now, management is saying that, using that 31% of sales level as a starting point, overall food cost inflation will climb to mid-single digits during the year.  This new guidance does not even include the expected 200 bps of pressure that the company could face in the coming months as a result of recent freezes in Mexico and Florida that have impacted the supply and cost of tomatoes, green peppers and tomatillos. 

After hearing this outlook, I assumed management’s next comment would be that it has already or will soon be implementing a price increase to offset this margin pressure.  That was not the case.  Instead, the company said it will not take any price for the next two quarters until it sees how the commodity environment pans out and how consumers react to its competitors’ price increases.  I understand management’s caution around taking price in this economic environment, particularly since traffic growth has been the primary driver of CMG’s comp growth. 

Increasing prices could likely be detrimental to traffic growth, but without pricing, CMG’s margins will take a hit, and likely a big hit, specifically during the first half of the year until we see how the situation in Mexico and Florida shakes out.  Rising corn prices are also a major concern.  Specifically, management stated, “reports of continuing or even worsening supply shortages of corn will only add to inflationary pressure on the meats that we serve.”  To that end, management continues to think it has pricing power and will decide whether a price increase is necessary during the second half of the year.  We could easily see food costs as a percentage of sales up 200-300 bps in the first half of the year.

CMG: C NOTE - cmg2

Labor cost pressure

As a result of the recent Minnesota immigration inspection, CMG has had to hire and train hundreds of new employees, which management called “disruptive.”  CMG has 50 restaurants in Minnesota and the company has had to train new employees in nearly all of them, which adds up to 20% to 30% more crew hours in those restaurants.  At the company level, these increased labor hours in Minnesota alone are expected to add 20 to 30 bps of extra costs to the labor expense line, which should then level off over the next few months.  But, this might not be the extent of the damage because the company has already received a similar notice of inspection for all of its restaurants in Virginia and Washington D.C. and I would not be surprised to see more markets added to the list.

During the 3Q10 conference call, management provided an insightful comment pertaining to the company’s ability to sustain margins going forward; “so long as we continue to see some comp growth – and we typically need something mid-single digit, generally with normal inflation [to hold margins]”.  Given that the inflation picture has worsened and they are now guiding to low-single digit comps, margin contraction, not expansion, seems more likely.

Timing the 2011 Headwinds:

1Q11: Experiencing “volatile” trends quarter-to-date, could face an additional 200 bps of commodity pressure on top of the already climbing commodity costs (would not be surprised to see food costs as a percentage of sales up 200-300 bps YOY), expecting at least 20-30 bps of incremental pressure on the labor line as a result of the immigration inspection in Minnesota, no price increases…I am expecting the biggest YOY restaurant-level margin decline in 1Q11 (down about 300 bps).

2Q11: Lapping a more difficult 8.7% comp relative to 4.3% in 1Q11, facing continued commodity pressure (would not be surprised to see food costs as a percentage of sales up 200-300 bps YOY) and likely additional costs associated with an expanded immigration situation, no price increases

2H11: Lapping double digit comp and traffic increases, commodity pressures will be an issue; though they may mitigate somewhat as the year progresses, company may implement a price increase if necessary

Howard Penney

Managing Director