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Sentiment remains strong around the Chipotle brand.  We expect continued strength in comps but are watching for any signs of margin contraction.

CMG delivered a strong 1Q and all indications suggest that another strong quarter is possible in 2Q.  1Q comps were 4.3%, almost entirely driven by traffic, and no price has been taken in the past 12 months.  From a topline perspective, the comparisons do not get much more difficult for the remainder of the year; 2Q, 3Q, and 4Q comparisons are 1.7%, 2.7%, and 2% respectively.  Given that marketing spend in 1Q was 1.1% of sales, and management guided to marketing spend of 1.8% for the full year, traffic should remain strong for CMG in 2Q.  However, the company will feel increased pressure on the other operating cost line as it invests in its new marketing campaign.  Any pickup in other drivers of traffic will be incremental but management has stated that they will not be taking price.  The only possibility for that would come in 2H10 when some additional food with integrity will be rolled out in certain markets with “either no or very modest price increases”.  Management did point out, however, that should inflation become more of headwind than expected (guided to a low single digit increase for the full year, primarily in 2H) that they do have the ability to raise prices, but will be patient before rushing into a menu price increase.

CMG: WATCH MARGINS - cmg detail

In terms of efficiency, 1Q results were partly attributable to progress made on throughput.  On the last earnings call, management stated that they had previously taken their “eye off the ball over the last couple of years” with respect to throughput.  Assuming that the initiatives addressing these issues remain in place, store productivity should remain high.

CMG: WATCH MARGINS - EBIT Margins.xlsx 1q10

The favorable commodity cost environment enabled CMG to attain higher margins from 1Q09 onward.  The company is not locked into many of its ingredients and could see margin pressure should inflation begin to impact their commodity basket.   The few items that management has locked in include rice, soy oil, corn, and tortillas.  Traditionally, Chipotle has also kept cheese locked in but decided that the spot market was more attractive and that this enabled them to move towards more pasture-raised dairy.  Holding current cheese prices constant, the Bureau of Labor Statistics’ PPI database is showing average inflation of 7.6% for the first 5 months of 2010. Moving to the spot market, while undoubtedly beneficial during the deflationary period of 2009, could cause more volatility and uncertainty for CMG management if inflation takes hold on their cost line in 2H10 (as they expect).  During the 1Q10 earnings call, management said that the inflation outlook seemed “manageable” but having such a proportion of their basket on the spot market means that their outlook is subject to the volatility of the commodity markets.

During the first quarter, CMG posted an EBIT margin of 15.3%, up over 300 bps YOY.  This YOY growth was impressive given the fact the company was lapping a nearly 300 bp improvement from 1Q09.  Going forward, margin comparisons get increasingly more difficult on a YOY basis, particularly in the second half of the year, as the company laps the extremely favorable food costs from last year.

Howard Penney

Managing Director