Burrito Bust: Why Chipotle Profits Are Hurting

Source: Getty Images

Source: Getty Images

Upon the release of Chipotle Mexican Grill’s (NYSE:CMG) first-quarter earnings, shares spiked as high as $588/share after closing on Wednesday at $552/share. However, as reality set in during the day, the stock began to slump — shares closed near the day’s low of just under $520/share.

To readers of my March 31 article on Chipotle, this weakness should have come as no surprise. In that piece, I suggested that the shares were grossly overvalued at $567/share, and that the company was vulnerable to several risk factors, including one that hit margins in the Q1 report — rising food prices.

Investors initially bid up shares of Chipotle because of its strong revenue growth — 24 percent year-over-year. This is a growth rate that is virtually unparalleled, and it is one of the reasons that investors are willing to pay such a high P/E multiple — 42 — for Chipotle shares. However, profits grew at just 8.5 percent, which is completely unacceptable for a company trading at such a high multiple to earnings. Furthermore, profits fell short of analyst estimates, coming in at $2.64/share versus an estimate of $2.86/share.

The reason for the unimpressive profit growth was margin compression due to an increase in executive compensation and rising food prices. The two combined to hit margins by about 280 basis points, which is devastating for a company that had just 10 percent profit margins in Q1 of 2013.

Rising commodity prices is a risk to the company’s shares that I pointed out in my March 31 article. I maintained that investors failed to price in the risk that rising agricultural commodity prices would eat into the company’s profits. This is exactly what happened. Going forward, I suspect that this will remain a significant risk for the company, which will eventually be forced tor raise prices. Whether or not this will hit the company’s sales remains to be seen, although such unknowns make owning expensive growth stocks an unattractive proposition.

Despite this disappointing earnings report, I think management believes that margin compression is largely done with. Furthermore, Chipotle executive believe that the stock is undervalued as evidenced by the announced $100 million addition to the already outstanding share repurchase program, which has $77 million remaining.

With the stock trading at such a lofty multiple to earnings, this seems like a waste of shareholder capital. Nevertheless, it fits with a broader market belief — held by analysts and executives — that Chipotle shares offer good value. While Thursday’s report will likely push some analysts to lower their price targets, the consensus target is still $600/share with just 1 “sell” rating versus 25 “buys” and “holds.” This bullishness means that as the company continues to report disappointing margins and sup-par profit growth there is a lot of air that needs to come out of this bubble.

Ultimately, investors shouldn’t be surprised that the company’s earnings came in short of expectations. Investors should also not be surprised that the stock was incredibly weak on the day. Additional weakness is almost certainly in the company’s future as investors come to the realization that 42-times earnings is way too high a price to pay for a company that is probably going to be growing its profits at a rate in the low double digits.

With that being said, Chipotle shares are still worth selling if you own them, and more aggressive investors should consider taking a short position. As great a company as Chipotle is, there is hardly any reason to value it at more than 15 or 20 times forward earnings, and this means the stock has enormous downside risk.

Disclosure: Ben Kramer-Miller is no position in Chipotle shares.

More From Wall St. Cheat Sheet: