Chipotle Still Smokin'

By Stephen D. Simpson, CFA | April 25, 2011 AAA

Like the smoked jalapeno it's named after, Chipotle Mexican Grill (NYSE:CMG) offers more than just heat. Chipotle continues to post eye-popping traffic growth and strong margins, and there still looks to be plenty of expansion potential. It is also worth noting, though, that Chipotle sports a valuation that may be too spicy for even the boldest growth investors.

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Another Great Quarter
Chipotle once again delivered impressive growth, exceeding the high end of the analyst range with 24% overall growth and nearly $510 million in revenue. While new store openings continue to be an important part of the story, the existing outlets are doing exceptionally well too - same-store sales growth was 12.4% for the first quarter, with higher pricing chipping in less than 1%. (For more, see Should Investors Ignore Monthly Sales?)

Profitability was a little more mixed, but still good news for the most part. Store-level margins contracted almost a full point, but still stand at an impressive 25.2%. Similarly, operating margin contracted a bit (from 15% to 14.7%), but operating income growth was still 22%. Growth was restrained a bit by promotional expenses tied to a buy-one-get-one-free offer, as well as higher food costs.

Immigration Issues More Embarrassing than Threatening
Chipotle is still getting flack from evidence that the company has employed illegal (or at least undocumented) workers, resulting in an ongoing government investigation. Although this is a serious matter, investors may not realize how common it is in the restaurant industry. It's arguably not quite as common to see headlines about illegal workers at the major quick-serve restaurants (though even McDonalds (NYSE:MCD) has had its problems), but it's a significant issue across the industry.

All in all, this is not likely to have a major impact on the company. Larger companies like Tyson (NYSE:TSN), Dole Foods (Nasdaq:DOLE) and, again, McDonalds, have had problems with hiring and the fines were not crippling, nor were the presumed increases in labor costs that followed from the change in policies. Still, in this political environment it's anyone's guess if Chipotle will pay a bigger price in terms of its image with some potential customers.

Food Costs Come and Go ... and So Do Tastes
Right now Chipotle is certainly seeing some pressure from higher prices for inputs like avocados, tomatoes and meat. Maybe that's good news for produce suppliers like Calavo Growers (Nasdaq:CVGW), Dole, Fresh Del Monte (NYSE:FDP) and Chiquita Brands (NYSE:CQB), but it is unlikely to have a long-term effect on the company. Simply put, food prices go up and food prices go down. Even if there is some sort of "produce supercycle" that is going to lead to permanently higher prices, the demand for Chipotle's products suggests some opportunity to pass along price increases as needed. (For more, see Food Price Inflation Still A Big Deal.)

The bigger issue for Chipotle is simply whether or not they exhaust their customers' taste for Americanized "Mexican" food or lose traction to a hotter concept. At this point, over-saturation seems a long way off - the company is not even in 12 U.S. states and is smaller than Panera Bread (Nasdaq:PNRA) in terms of locations, and much smaller than Yum! Brands' (NYSE:YUM) Taco Bell.

As for the "hotter concept" risk, who knows? Buffalo Wild Wings (Nasdaq:BWLD) continues to grow despite chicken wings being on almost every casual menu, and likewise Red Robin (Nasdaq:RRGB) is still growing even though people can get a hamburger anywhere. More specific to Chipotle, would-be rivals like Qdoba or Pollo Loco seem well behind on a regional (let alone national) basis and it is unlikely that authentic taquerias are going to draw away many of Chipotle's core customer base.

The Bottom Line
Relative to names like Panera or Cheesecake Factory (Nasdaq:CAKE) when they were in their great growth phases, Chipotle's valuation is high but not dramatically so, at least not once the pace of growth and the margins are factored into the equation. Still, that does not mean that Chipotle shares are cheap.

There's no way I'd recommend completely selling out of a torrid grower like Chipotle, but I'd at least consider protecting some of the gains - perhaps using some stop orders to protect the value of the initial stake and letting the rest ride. For those not already among the owners, maybe the best thing to do is hope for a market hiccup and the opportunity to pick up shares at a better price. (For more, see Restaurant Stocks Look Tasty.)

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