Is It Finally Time To Exit Chipotle Mexican Grill, Inc. Stock?

  • Chipotle Mexican Grill has posted its worst earnings report since the company went public.
  • Although a big part of the sales decline was orchestrated by the E.Coli disaster, industry trends are also to blame.
  • CMG stock might remain dead money for a couple of years.

It's about a week since Chipotle Mexican Grill (NYSE:CMG) reported abysmal Q2 2016 earnings. Luckily for investors, CMG stock has held up quite well despite the earnings wipeout, and is trading 3.1% higher since the report. Nevertheless, CMG stock is still down 10.2% YTD.

CMG stock chart

Source: Chipotle Mexican Grill stock price chart by amigobulls.com

Even though investors expected Chipotle to report weak second quarter numbers due to the E. Coli scare, the company posted worse-than-expected results. The burrito maker reported  revenue of $998.4M, -16.8% Y/Y growth and $51.6M lower than the consensus on Wall Street. Comparable restaurant sales tanked 23.6% while comparable restaurant transactions fell 19.3%.

Earnings took an even bigger hit: net income plunged 81.7% to $25.6M while diluted EPS slipped 80.4% to $0.87. Operating margin dropped sharply from 28.0% a year ago to 15.5%.

Chipotle Mexican Grill stock has managed to rack up some gains after Chipotle's management reported that its Chiptopia loyalty program was off to a ''nice start.'' Chiptopia is a free program where customers receive a free entree after every four purchases made in the space of one month.

But the qualifier ''nice'' by CMG's management is relative. Chipotle said that the new program had, in July, helped to cut into steep comparable store losses to the tune of 200-300 bps sequentially. This in effect means that year-on-year comparable store sales are still down ~20% (in July). The upside of the promotion is that Chipotle said that it can market directly to 3.2M customers through the program. Analysts are optimistic that the company can leverage the massive amount of data that it will collect through the promotion to drive more mobile sales.

It's highly doubtful that Chipotle will fully recover any time soon. Recent NPD data showed that the perky fast-casual segment is running out of steam after posting its first decline in foot traffic since 2004. The report, which appeared in WSJ about a month ago, went on to say that the fast-food segment has completely stalled over the past three months, which raises a red flag since fast-food represents 80% of the restaurant industry. The recent earnings miss by McDonalds (NYSE:MCD), the sector's flag-bearer, validates the NPD data and suggests that this could be a secular trend in the making.

Chipotle's chief executive Steve Ellis said during the company's earnings call that there is a high likelihood that Chiptopia will be extended beyond the initial 3-month summertime timeframe. But discounts and giveaways are hardly an ideal long-term strategy because they not only cut into profit margins but also because customers come to expect them. Starbucks (NSDQ:SBUX) customers hit back by fleeing its stores after the company tweaked its popular loyalty program.

Chipotle's margins were almost cut in half during the last quarter mainly due to intense promotional activity. It's also ironic that the company's food costs as a percentage of sales increased 110 bps to 34.2% at a time when most rival chains are benefitting from lower commodity costs. This tells you that store closure due to the E. Coli disaster led to a significant loss of scale for Chipotle.

Investor Takeaway

It's looking increasingly likely that Chipotle will have to engage in full-time promotions to bring back customers to its restaurants. This is likely to keep margins squeezed and make it harder for the company to grow into its already steep valuation. JPMorgan has said that Chipotle's same-store sales are likely to remain in negative territory till 2018. The market might recalibrate CMG stock if the growth narrative comes to a screeching halt. There is a strong likelihood that CMG stock will remain dead money over the next two years.

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  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
  • I am not an investment advisor, and my opinion should not be treated as investment advice.
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  • I do not have any business relationship with the companies mentioned in this post.
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