Should You Buy Chipotle Stock? 3 Pros, 3 Cons (CMG)

Chipotle stock has dipped significantly since its Q1 report, but could the discount go even deeper?

Chipotle Mexican Grill, Inc. (NYSE:CMG) has had a rough go of things ever since its first-quarter earnings report in late April. Chipotle stock is off some 7%, putting it squarely in the red for the year-to-date.

chipotle-cmg-stockWhy the drop? Well, while CMG exceeded Wall Street’s earnings expectations ($3.88 per share vs. $3.66), revenues of $1.09 billion came in just shy of the hoped-for $1.11 billion. Another contributing factor? Same-store growth of 10.4%, while robust, disappointed analysts who were looking for 11.8%.

However, despite this lackluster growth, analysts at Citi, at the very least, still think Chipotle stock is worth buying. Looking beyond the shortcomings highlighted above, Citi analysts like CMG’s free cash flow, return on invested capital and future earnings outlook — all of which they believe aren’t yet priced into the stock.

If nothing else, the downward trend in CMG is providing a good entry point. So should you buy Chipotle stock? We’ll weigh the pros and cons of CMG to see.

Chipotle Stock Pros

Going GMO-Free Is Good PR: Chipotle recently announced that it has “become the first national restaurant company to use only non-GMO ingredients” in its food products. While the FDA has yet to deem the use of GMO crops dangerous to human health, the fact that the debate against the use of GMO crops is gaining ground paints the use of GMOs in bad light. Chipotle definitely has seized the stage to tell the world that it’s delivering value. Moreover, if for whatever reason the usually risk-averse FDA rules against the use of GMOs in future, Chipotle has already positioned itself to be the trusted fast-casual, since its competitors won’t be able to switch overnight. In general, though, even if the FDA doesn’t rule against the use of GMOs, Chipotle has given consumers some sort of assurance that it serves healthy food.

Long-Term Earnings Outlook: The company’s plan to open more than 4,000 takeout-only locations is a good pointer to what’s ahead. The queue at CMG’s current 1,800-plus locations is usually long; an inherent implication of this is that CMG hasn’t been realizing its full sales potential. Perhaps it has been losing part of its should-be sales to its competitors … but by opening so many new locations, the lines are likely to shorten, encouraging more consumers to patronize the company. In turn, this could mean that CMG will capture more portion of the fast-casual market, which should translate to sizable earnings growth. Also, these smaller locations — which likely will require fewer employees, too — should help bolster margins.

Innovations That Should Spur Growth: One other thing to admire about Chipotle is that its management embraces innovation. Consider this: CMG also has entered into a partnership with Postmates, an Internet-based delivery service, to deliver Chipotle’s burritos, tacos and bowls. CMG says that the pilot program has seen a 30% increase in delivery orders between March and April. This growth confirms my thought from above that long queues at CMG locations have limited the company’s sales potential.

Chipotle Stock Cons

Non-GMO Could Kill Margins: Yes, going GMO-free might be good for Chipotle’s public image, but it could be bad for margins. In October 2013, Chief Financial Officer Jack Hartung admitted the company was seeing an increase in the cost of oil as it moved from GMO soybean oil to non-GMO sunflower oil. Now that the company has all but completed the switch to non-GMOs, the cumulative impact of the increased cost of ingredients will be bigger. Considering Chipotle didn’t hike prices amid this change, we could see shrinking margins. The only consolation here is that Chipotle said in the official statement that the move “did not result in significantly higher ingredient costs for the company” — but we’ll have to see what “significantly” ends up meaning.

Valuation: Another negative side of Chipotle stock is its lofty valuation. Currently, CMG trades at more than 30 times next year’s estimated earnings, and its trailing P/E of 40 is significantly higher than the pretty frothy 33 average across the restaurant industry. Still, investors shouldn’t be too concerned, as Chipotle can justify these valuations with performances like its 47% year-over-year earnings growth in Q1. In addition, the expansion plans discussed above should also help improve its valuation.

Uninspiring Guidance: In its first-quarter report, CMG said it expects low- to mid-single-digit comparable-store sales increases for the whole of 2015. That’s uninspiring given the fact Chipotle registered 16.8% comps growth in 2014. With a forecast well below that, Chipotle stock could be looking at a rough year ahead.

Verdict

As stated above, with the less-than-impressive forward guidance coupled with the lackluster growth the company’s experiencing, 2015 will be a tough year for Chipotle. In fact, with the market’s nature of overreacting to short-term issues, I won’t be surprised to see the stock trade around the $600 mark soon.

So for investors looking for short-term gains, Chipotle stock shouldn’t be considered.

On the flip side, long-term investors should see the downward trend in Chipotle stock as a chance to buy (more) shares of CMG on the cheap. You have to consider the growth opportunities discussed above. These opportunities suggest that the current issues won’t last.

As of this writing, Craig Adeyanju did not hold a position in any of the aforementioned securities.

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