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Chipotle is scheduled to report 4Q09 earnings after the close tomorrow, and based on the company’s recent track record (as shown in the chart below), it will likely beat street estimates.  I am modeling EPS of $0.84 versus the street at $0.81.  If my number is right, this outperformance would not come even close to the 26% earnings upside in 3Q09, but as the chart below also shows, this earnings beat was still not enough to get investors excited as the stock traded down 8% the following day.

CMG – WHERE TO FROM HERE? - CMG eps vs estimates


Investors have become accustomed to better-than-expected earnings, so what has mattered more is the trend in top-line numbers.  In 3Q09, the 150 bp sequential slowdown in 2-year average trends helps to explain why the stock performed so poorly.  To that end, we could see the stock trade higher on Friday as my estimates assume +2.3% same-store sales growth, better than the street’s +1.4% estimate.  Going forward, however, I would expect comparable store sales trends to get worse as we move through 2010, even if traffic trends on a 2-year average basis get less bad, which should influence CMG’s stock performance.

Throughout the third quarter, CMG’s EBIT margins have improved on a YOY basis in 2009, with the company operating at peak margins during 2Q09 and 3Q09 of 15.1% and 14.5%, respectively.  The company’s return on incremental invested capital has also moved higher in 2009.  These peak margins and returns are also reflected in CMG’s peak multiple.  The company is currently trading at nearly 11x on a NTM EV/EBITDA basis relative to the QSR average of 8x.

I have previously said that a restaurant company’s stock price performance is often highly correlated to the direction of returns and as the second chart below shows, this has been true for CMG.  The current direction of returns often impacts if a stock will move higher or lower and CMG’s trajectory of returns as of 3Q09 puts CMG in a seemingly favorable position.  So the most important question is whether the next leg is up or down and as I see it, CMG’s peak margins and returns are likely to roll over. 

CMG – WHERE TO FROM HERE? - CMG ebit margin 3Q09




In 4Q08, CMG rolled out a 6% incremental price increase, which helped to leverage the company’s P&L at a time when traffic was negative and deteriorating further on a 2-year average basis.  The 6% pricing impact from 3Q09 will come down in 4Q09 to +2.5% as we lap the 4Q08 price increase.  The company will have flat pricing as of January 1 and as of the last earnings call, did not expect to take any pricing in 2010 until management saw an uptick in consumer spending. 

My +2.3% same-store sales estimate for 4Q09 assumes some improvement in traffic trends on a 2-year basis (most likely the primary difference between my higher same-store sales estimate and that of the street’s) as we have seen sequentially better numbers in the fourth quarter from those restaurant concepts that attract higher income consumers.  Even so, EBIT margins should begin to roll over in 4Q09 from the peak levels earlier in the year.  I am expecting continued YOY margin growth but of a lesser magnitude than in the prior three quarters.  Some of this sequential decline in margins is explained by the fact that the fourth quarter typically results in lower margin and also the company is opening considerably more restaurants during the quarter, which implies higher preopening expenses and increased inefficiencies on the labor line.  The roll off in pricing also removes some of the leverage in the model and will have a bigger impact in 1Q10 when I would expect margins to begin to decline on a YOY basis.

Also impacting margins in 2010 is the fact that the company is forecasting low single digit food and labor cost inflation after getting significant leverage on both these expense lines in 2009.  In describing the gives and takes in its operating model, management stated on its last earnings call, “The way to think about it is in a perfect world if there was zero inflation and you had zero comps, our margins would hold up exactly as they are today. If you have a little bit of inflation - let's say it's 1% inflation across the board, across labor, across food, across everything - that would hit your margin for about 70 basis points; 2% inflation across everything would hit you for about 140 basis points.”  As I just said, management is not expecting zero inflation, but is expecting flat comps and the resulting impact on margins is obvious.  To be fair, management’s comp guidance assumes no improvement in consumer spending, so it might be somewhat conservative, and a lot will depend on whether management changes its stance on pricing in 2010. But, as I see it, operating margins are coming down in 2010.

Declining margins never bode well for returns and in my opinion, nor will the company’s new real estate strategy.  In 2010, CMG currently plans to open 120-130 new restaurants, even with the expected level of openings in 2009.  However, due to the “recent pressure on developers and the corresponding reduction in number of new developments currently available for [CMG] to buy or lease” (as cited by the company), CMG is now pursuing a new real estate strategy.  In the past, the company only opened restaurants in what it deemed “tier 1” trade areas.  Going forward, management plans to still open about two-thirds of its new units in these “tier 1” areas, but due to the limited number of opportunities, it will also pursue what it is calling “A model sites,” which it says are “tier two trade areas which still have attractive demographics typically characterized by lower occupancy costs and develop for a substantially lower investment cost.”

This new strategy will put pressure on new unit AUVs as the A model sites are expected to generate about $1.1 million in sales volumes, which is below the company’s average opening range of $1.350 million to $1.4 million.  In the past, CMG has built two-thirds of its new sites in proven markets, which yields opening volumes above its average new unit volumes and one-third in new and developing markets, which come in below average at $1.1M.

For 2010, CMG is planning to build 25% of its new openings as A model locations.  Initially, CMG said it will build these A models in proven markets, which means these relatively lower AUV new builds will take away from the higher volumes typically generated in proven markets.

Tier 2 sites are still expected to achieve cash on cash returns in the mid 30% range because the lower development, occupancy and operating costs will offset the lower expected sales volumes.  These new “A model sites” will not pose a problem should they generate the expected returns, but it always concerns me when a restaurant operator appears to be compromising its real estate decisions in order to maintain growth.  The fact that the company said it will pursue as many tier 1 locations as it can implies that they are still the preferred sites.  To that end, the tier 2 locations signal less discipline on the part of the company for the sake of maintaining growth.  These types of compromised real estate decisions often lead to declining returns.  And, increasing penetration of proven markets could put the company at risk of cannibalizing sales going forward.  That would not be a new story for a restaurant company.

Howard Penney

Managing Director