Chipotle Earnings: Should You Sell CMG Before Its Report?

by Susan J. Aluise | October 16, 2013 6:03 am

By any measure, Chipotle Mexican Grill (CMG[1]) has been a success story in 2013: Chipotle stock is trading near 52-week highs, same-store sales are gaining ground, and Chipotle earnings for the third quarter — to be announced Thursday after the bell — should impress.

New menu items and a strong business model seem only to sweeten the deal.

But beware the Law of Unintended Consequences: All that good news could conspire to create the classic trap game for Chipotle stock investors, making the hours before the Q3 Chipotle earnings report a good time to consider the old adage of selling greed and buying fear.

Why Chipotle Stock Is Flying

It’s hard to ignore the fact that the greedy have got game; the proof is readily apparent when you look at this stellar player in the fast-casual restaurant segment. CMG shares have gained roughly 45% year-to-date, driven by consumers’ increased taste for fresher, higher-quality choices.

A recent survey by industry research firm NPD Group[2] found that foodies and restaurant regulars — which comprise 58% of the market — increasingly care more about quality and freshness than they do about meal price. Those trends clearly are in the wheelhouse of chains like CMG and Panera Bread (PNRA[3]).

That’s why analysts on average are expecting Chipotle earnings for Q3 to pop. Optimism also is rooted in past performance, however: In the second quarter, CMG profits grew by double digits, thanks to a 5.5% gain in same-store sales. Wall Street expects Chipotle earnings growth of more than 20% for the third quarter, and analysts believe CMG same-store sales will continue to exhibit strength.

The company is flexing its menu muscle, too, by moving into the catering space, tempting vegetarians in Chicago with tofu[4] and teasing a breakfast menu launch[5].

Still, Be Wary Ahead of the Chipotle Earnings Report

But while CMG is doing a lot of things right in its business model and menu — and restaurant trends clearly favor its menu strengths — I’m not buying Chipotle stock right now.

In fact, I think investors who’ve already made a tasty profit on CMG this year should consider selling or even shorting the stock before the Chipotle earnings report.

Here’s why: Despite the strong second-quarter numbers, Chipotle’s margins slipped by 160 basis points in the period. That’s not surprising since the chain is feeling the increased pinch of higher commodity costs — in Q2, these increased 100 basis points year-over-year[6], and those trends show no signs of reversing themselves anytime soon. Should the trend continue into Q3, that’ll be a huge weight on earnings.

Chipotle stock has experienced phenomenal growth over the past decade, as has the company itself, boasting more than 1,400 restaurant locations in the U.S. But I don’t think it’s realistic to expect any company — let alone a consumer cyclical business — to sustain an average growth rate of 20% a year for the long haul. And even though CMG’s 5.5% growth rate in same-store sales is impressive in the restaurant sector, it’s a slip from the 8% growth rate CMG posted in Q2 2012.

My biggest worry about Chipotle stock right now is that its valuation is too hot to handle. This is a stock that is trading at more than 34 times forward earnings; compare that to restaurant rivals like McDonalds (MCD[7]) at 15.5 and Taco Bell and KFC parent Yum Brands (YUM[8]) at 18.5. Even fast-casual peer Panera has a comparably cheap forward P/E of 20.4.

Bottom Line

CMG is a sound investment for the long-term, but the stock is long overdue for a significant correction. Chipotle earnings that are anything but a screaming beat could be the perfect catalyst.

Whether you buy put options or short the stock directly is a matter of personal preference, but InvestorPlace’s Lawrence Meyers lays out a valuable walkthrough of how to use options to short stocks that are insanely overvalued[9] — like I believe CMG is right now.

Either way, now doesn’t seem like the best time to get bearish on Chipotle.

As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities. 

Endnotes:
  1. CMG: http://studio-5.financialcontent.com/investplace/quote?Symbol=CMG
  2. recent survey by industry research firm NPD Group: https://www.npd.com/wps/portal/npd/us/news/press-releases/fresh-ingredients-and-choice-are-key-factors-in-restaurant-consumers-value-equation-reports-npd/
  3. PNRA: http://studio-5.financialcontent.com/investplace/quote?Symbol=PNRA
  4. with tofu: http://www.upi.com/Business_News/2013/10/12/Chipotle-to-test-tofu-in-Chicago/UPI-20281381602460/?spt=rln&or=3
  5. breakfast menu launch: http://investorplace.com/2013/10/chipotle-test-hints-national-breakfast-rollout/
  6. these increased 100 basis points year-over-year: http://ir.chipotle.com/phoenix.zhtml?c=194775&p=irol-newsArticle&id=1839087
  7. MCD: http://studio-5.financialcontent.com/investplace/quote?Symbol=MCD
  8. YUM: http://studio-5.financialcontent.com/investplace/quote?Symbol=YUM
  9. how to use options to short stocks that are insanely overvalued: http://investorplace.com/2013/06/how-to-short-stocks-using-options/

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