- Things can’t get much worse for Chipotle investors.
- In fact, Chipotle stock is positioned for a sustained recovery rally given strengthening fundamentals.
- I have revised my financial model lower, and still come away with the impression that the stock is fundamentally attractive.
Chipotle Mexican Grill Inc. (NYSE:CMG) continues to exhibit substantial volatility weeks after the announcement of its quarterly earnings. While I can agree with a lot of the pessimistic points cited by sell-side analysts, I also believe there’s now enough visibility going into the next quarterly earnings announcement to regain conviction in a deep value recovery thesis.
Furthermore, there’s sufficient upside from these levels to make a re-entry into the stock more appealing. This is assuming the cost trajectory remains relatively stable. Going forward, earnings beats will have a greater impact on the share price, as many analyst models varied considerably from previous results. The analyst estimate range has narrowed, which implies that an earnings beat will be an actual “surprise.”
While I was wildly over-optimistic, the sell side proved to be slightly more realistic, but still off by 4 percentage points in the prior quarter. Leading up to the announcement, the consensus revised estimates higher.
The sheer divergence in opinion among buy/sell side analysts contributed significantly to volatility. But, with the estimate range narrowing and investors getting back into the stock, I feel more compelled to write a detailed follow-up to my prior article.
Structural factors driving expectations lower, but share price higher
Coming out of the prior quarter's earnings/sales beat investors saw even more capitulation in Chipotle share price given heightened investor expectations. In other words, while it was broadly anticipated that Chipotle Mexican Grill’s EPS figure would turn positive, the degree of cost deleveraging was not anticipated.
In the past couple of days, Chipotle stock has exhibited enough momentum to warrant further investigation. The looming pessimism pertaining to CMG has died down considerably following the revisions of estimates by the analyst consensus and regained conviction in comparable sales growth.
Despite the management’s guidance of $2 million/restaurant unit, I’ve projected a slightly more conservative figure, and have also established a sustained baseline of operating costs in response to prevailing trends in the labor market, and increased cost in response to food safety practices following the E. Coli incident.
The lowest wage cohort, i.e. entry-level jobs in the food services industry exhibited the most improvement in wage growth in the past year alone. Labor inflation added a couple points to CMG’s labor cost in conjunction with overstaffing in response to the shift towards safer food practices. While some of the cost dis-synergies can be addressed over time, long-term structural headwinds reduce the likelihood of gross margin expansion.
Normally, CMG would pass on higher costs with higher pricing, but given the recent drop in same-store sales, there’s very little incentive to increase pricing. As such, I have modeled a scenario that assumes slower margin recovery despite revenue recovery to an average unit revenue of $2.26 million by FY’17.
Furthermore, the structural patterns of the labor market are here to stay given the drop off in the availability of less-educated workers.
In the prior earnings call Chipotle’s management addressed labor pricing:
We also have labor inflation that has crept in since then, and I'm just guessing that's probably at least another 200 to 300 basis points. The labor inflation especially in the last year has been significant. We had intended to pass on the wage rates that we were seeing because of local pressures, because of raises in minimum wages, some of them very significant at $10, $12, $13, and we haven't really raised prices.
The comments by the management were more or less in-line with the average price increase in the sector. As it stands currently, CMG’s average hourly wage should be hovering at around $13.11/hour when based on survey data by Bank of America Merrill Lynch. The recent pricing gains will likely continue, but with labor efficiency likely to tick higher, I’ve also maintained a stable cost trajectory on labor.
I have revised my estimates of sales/earnings lower for FY’16 and FY’17. My EPS estimate is more or less in-line with the consensus currently, but my expectations differ, as I anticipate costs to remain at elevated levels, but revenue to surprise analyst estimates going forward.
That being the case, I’ve revised my estimates of diluted EPS for FY’16 lower from $7.15 to $3.72, which compares to consensus estimates of $3.87. My revenue estimate for FY’16 was reduced from $4.392 billion to $4.152 billion, compared to a consensus estimate of $4.05 billion.
I’ve revised my FY’17 diluted EPS estimate from $24.68 to $10.64, which compares to consensus of $10.42. My revenue estimate was revised lower from $6.357 billion to $5.379 billion, which compares to consensus revenue estimates of $4.75 billion.
I’m anticipating margin expansion driven primarily by revenue growth, as opposed to efficiency gains. Furthermore, I’m anticipating revenue to accelerate given promotional activity due to q/q acceleration in transaction counts. The impact on sales wasn’t felt due to promotional activities adding to deferred contra-revenue accounts. However, the deferment of discounts/promotional items will eventually roll off the income statement by Q4’16, which translates into a more normalized pattern of average unit revenue from Q1’17 onward.
Furthermore, Chipotle mentioned that it might scale back restaurant openings, but the impact is limited to FY’18, as capital deployment is driven by long-term lease obligations for future commercial real estate construction. Given that the window for new units construction occurs over a two-year time frame, I’m anticipating a stable trajectory in unit growth between FY’16 and FY’17.
Management didn’t provide guidance beyond FY’17, but mentioned a strategic re-prioritization towards markets where revenue ramp on a per-unit basis would happen quicker. I didn’t factor those considerations into my long-term revenue model. As such, I’m anticipating the blended average of new/old restaurant units to average out at 4% q/q sales growth over the foreseeable six-quarters.
Given the improvement in visibility, I’ve revised my price target lower, but maintain my high conviction buy recommendation. My current price target is $508.94 versus $543.11 (prior). The reduction in my price target reflects reductions to my EPS/revenue model but is more reliable given greater visibility on cost/revenue ramp when compared to the prior quarter.
While CMG is a relatively volatile stock, the risk-to-reward has improved quite considerably. Furthermore, the stock’s recent resurgence sounds more sustainable, as it’s difficult to imagine things getting worse.
As such, investors should take a deeper look at Chipotle stock. While on the surface it seems like a dropping knife, there’s enough evidence to support a value recovery thesis.