Burrito chain Chipotle Mexican Grill (click ticker for report: CMG) reported strong earnings Thursday afternoon, but it failed to meet revenue and same-store sales expectations. Chipotle earned $2.56 per share, which was $0.26 better than the Street expected and 61% higher than earnings for the second quarter of 2011. The firm improved operating margins 280 basis points year-over-year, to 28.3%. However, revenue grew 21% year-over-year to $691 million, about $16 million short of consensus estimates. Yet, we’re more concerned about same-store sales, which grew 8%, 210 basis points shy of the 10.1% consensus expected. As a result, shares have fallen over 20% and are on their way to converging to our fair value estimate of $308, which remains unchanged.
For a mature retailer, 8% same-store sales growth is fantastic; however, Chipotle is still in growth mode. With prices now higher than a year ago, we fear Chipotle is losing traffic to Taco Bell (click ticker for report: YUM), which posted second quarter same-store sales growth of 13%. Taco Bell has a far more extensive menu and has recently partnered with former parent Frito-Lay (click ticker for report: PEP) to release the Doritos Locos Tacos, which are driving customers back to the store, in our view. Taco Bell also recently introduced the Cantina Bell menu to attract customers who are more interested in gourmet Mexican offerings. Taco Bell now offers Chipotle-esque items to complement its relatively vast and inexpensive menu. Though we do not think the broader economy is falling off a cliff, we suspect Taco Bell is more attractive to consumers searching for value, which also explains the resiliency of McDonald’s (click ticker for report: MCD).
Though same-store sale growth appears to be slowing, we think Chipotle still has room to grow. The firm has opened 87 restaurants year-to-date and expects to open 155-165 during 2012. Yet, the company will likely face higher costs in the back half of 2012 due to the terrible growing conditions for farmers throughout the Midwest and the resulting increase in feed costs that makes chicken more expensive. Still, we believe some of the gross margin pressures will be offset by the improved operational efficiencies that have driven the firm’s strong operating margins. Sales growth could also reaccelerate as stores opened in 2012 become more productive. This, however, could be offset by weak systemwide same-store sales growth, which management predicts will be in the mid-single digits.
Even after lower than expected results, we still think Chipotle is a strong business with a valuable brand. The market had assigned the company such a rich premium that we knew it would eventually experience some trouble. Nevertheless, shares remain expensive at current levels, trading above our fair value estimate. Given the volatility inherent in its short history and the risk that the competition is becoming a real threat, we’d avoid Chipotle at this time. We’d have to see a tremendous pullback before getting excited about the firm’s shares on the long side.