Chipotle Misses Expectations, but Market Overreacting

For the second consecutive quarter,  Chipotle Mexican Grill (CMG) was among restaurant industry leaders with respect to comparable-restaurant sales growth, average unit volume, and profitability, but failed to live up to the market's lofty expectations. 

For the third quarter, comparable-store sales grew 4.8% (16.1% on a two-year stacked basis), average unit volume for locations open for at least a year was $2.1 million, and restaurant-level margins improved 70 basis points to 27.4%, thanks to Chipotle's highly leverageable business model. However, these results were nominally below Wall Street's and our own internal expectations, which triggered a steep stock price decline Friday morning. We plan to make several adjustments to reflect what we believe to be a more competitive restaurant environment in the United States--particularly a meaningful increase in the number of new fast-casual restaurant operators--which may result in a moderate reduction to our $300 fair value estimate. Nevertheless, we view today's sell-off as an overreaction by the market and believe the current share price could offer an attractive entry point for longer-horizon investors.

We remain optimistic about the long-term unit growth potential of Chipotle and its secondary concept, ShopHouse Southeast Asian Kitchen (which plans to expand to a second market--Los Angeles--during the first half of 2013), as well as the leverage inherent in its business model. Still, there are a number of signs that the company is facing greater competitive pressures, including a year-over-year moderation in restaurant traffic (which grew approximately 4.2% during the quarter, but well below the high-single-digit gains experienced at the end of 2011), and decelerating new average unit volume (though this can be partly chalked up to a higher proportion of new restaurant openings in developing versus established markets). Management also attributed the softness to "moderate and uncertain economic growth," and there has been speculation that Chipotle may be facing increasing pressure from  Taco Bell's (YUM) more upscale Cantina Bell menu. 

While we believe there is some validity to these claims, we continue to believe the greater competitive threat is the number of new players entering the fast-casual restaurant market in 2012 (particularly among privately held chains with less than 50 units). With retail landlords looking for tenants for unoccupied real estate and restaurant operators finding themselves with easier access to capital, we believe the fast-casual restaurant market will only become more crowded in the months to come.

We believe increased competitive pressures may restrict comparable-restaurant sales growth to the low single digits over the next few quarters (or midsingle digits should management decide to take pricing to offset likely commodity food cost pressures stemming from higher corn prices, a consideration that we've factored into our base case model assumptions). Nevertheless, we think investors should balance these pressures with the reasons we've assigned Chipotle a positive moat trend: a disproportionate amount of bargaining power over its suppliers (who are often local ranchers and farmers rather than large food processing conglomerates), a brand that commands pricing power, and a lower-cost business model than most restaurant operators. The current share price represents roughly 24 times our preliminary 2013 earnings per share forecast and an enterprise value/EBITDA multiple of 12 times, compared with industry averages of 17 and 11 times, respectively. However, we believe Chipotle warrants a premium valuation because of its considerable market share opportunities. We'd prefer a wider margin of safety before taking a position until it is clear that Chipotle can fend off new sources of competition, but for the first time in several years, we believe Chipotle's valuation represents realistic long-term growth expectations.

There were few changes to the 2012 outlook, with management sticking with its mid-single-digit comparable-restaurant sales outlook (which also implies fourth-quarter comps decelerating from the third quarter due to more difficult comparisons and the roll-off of 30 basis points of pricing). The company confirmed that it expects new restaurant openings to come in at or above the previously announced range of 155-165 units (representing 13%-14% growth), with roughly 20% coming from lower-capital A Model formats. Management introduced 2013 guidance calling for flat to low-single-digit comparable-restaurant sales growth (which does not assume the impact of any price increases) and 165-180 new restaurant openings (representing 13% growth year over year, with approximately 30% of the openings in new or developing markets). 

We view the comparable-restaurant sales forecast as somewhat conservative and expect mid-single-digit growth in 2013 due to menu price increases to offset food cost inflation (which management pegs in the mid-single-digit range, with much of the pressure coming from the corn, protein, and dairy categories) as well as initiatives to drive greater throughput at peak hours. We remain comfortable with longer-term comparable-restaurant sales growth in the mid-single-digit range. Chipotle's restaurant openings plans for 2013 seem reasonable based on current commercial real estate availability, and our base-case assumptions continue to forecast that annual restaurant openings across all concepts accelerate to approximately 200 units per year starting in 2015.

Management doesn't explicitly forecast profitability, but we expect very little margin improvement in 2013 amid increased competition and food cost pressures (and probably some margin contraction in the first half of the year). Accordingly, we forecast restaurant-level operating margins and consolidated operating margins in the high 27% range and the low 17% range for the year, consistent with our 2012 outlook. However, over the next decade, we remain comfortable with our outlook calling for restaurant margins pushing 30% and operating margins eventually exceeding 20%, which could set the stage for margin upside surprises over the medium term.

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