Investors enthusiastically bid up shares of Chipotle Mexican Grill (NYSE:CMG) after the company reported earnings that beat Wall Street’s expectations. At first glance, the headline numbers along with Wall Street’s reaction would indicate that the stock is a “buy.” But I think that the headline numbers mask a couple of issues.
The company grew its revenue by 28.6 percent to $1.05 billion. Profits grew by 25.5 percent to $110.3 million. These numbers suggest that the company is growing, but it is also suffering from margin compression. Furthermore, this is continuing margin compression, and that’s not a good sign.
I’ve been arguing that the company is having a problem with rising input costs as prices of beef, pork, avocados, limes, and dairy products continue to rise despite the recent bear market in grains. This led to relatively weak earnings in the first quarter and a subsequent decision to increase prices. We will see the full impact of the price increases in the next quarter, but in the second quarter we saw the price increases initiated.
This has a couple of implications. First, the company’s 28.6 percent increase in sales doesn’t mean that the company is selling 28.6 percent more products. Some of this sales increase is due to inflation, and so the number is not as impressive. Furthermore, despite the fact that the company is increasing prices, it still reported declining profit margins. This means that input costs continue to be a serious issue for the company.
With this in mind, we see that Chipotle’s numbers weren’t quite as strong as the headlines or the price action would indicate. So why did the price spike initially?
In all likelihood, this isn’t due to investors initiating new positions. Few investors chase stocks to new all-time highs in the after-hours trading session. But short sellers may cover, and I suspect that this is what is going on. Since short selling is such a risky endeavor, it makes sense that they would close their positions on the first whiff of trouble, even if they completely agree with my above concerns.
Going forward, it is difficult to say how Chipotle’s stock will react. But one thing is for sure: The shares are overvalued, trading at over 50 times earnings. So far this year the company’s earnings growth has only been around 16 percent, which doesn’t justify anything near its earnings multiple. Even a 25 percent growth rate, which reflects this quarter’s earnings growth, doesn’t justify a 50+ earnings multiple. And if we couple this with the concerns I bring up above, the multiple seems way out of line.
Chipotle is a fast-growing business and is highly profitable. Therefore it deserves to trade with a premium earnings multiple. But at the same time it operates in a highly competitive industry, and Chipotle’s success could be fleeting. For instance, some customers could decide they don’t want Chipotle’s food after the recent price hikes. This or a myriad of other things could lure customers away.
With this in mind, I think Chipotle deserves to trade with a price-to-earnings multiple that is more in line with its growth rate, or maybe slightly higher. With a growth rate of 25 percent, the stock is a whopping 50 percent overvalued!
So if you own Chipotle, I think you should evaluate your position. Virtually no stocks deserve to trade at such a lofty earnings multiple, and given the risks to Chipotle, it is certainly not one of them. The stock could levitate for some time, but I think it is going to end badly, and now is a good time to sell.
Disclosure: Ben Kramer-Miller has no position in Chipotle Mexican Grill.