Chipotle Reaffirmed at Neutral (CMG)

Zacks

We are maintaining our long-term Neutral recommendation on fast food restaurant chain operator, Chipotle Mexican Grill Inc (CMG).

Chipotle’s second quarter 2011 results missed the Zacks Consensus Estimate due to higher food costs and legal expenses. During the second quarter of 2011, restaurant operating margin declined 110 basis points (bps) for the second time on a year-over-year basis due to a 250-bp rise in commodity costs.

In the reported quarter, operating margin also plunged 140 bps due to food cost inflation and a substantial rise in general and administrative expenses owing to incremental payroll tax and elevated legal costs related to the ongoing federal immigration investigation.g

Chipotle expects food costs to increase further in the third quarter by up to 50 bps, prior to the benefit of the menu price increase implemented by the company, attributable to higher avocados, dairy and meat pricing. Thus, increased costs will continue to weigh on margins. Moreover, fierce discount wars among quick-service operators and lower consumer confidence concern us.

However, the company has remained unaffected by the recent economic slowdown and has been able to deliver positive comparable store sales consistently. During the quarter, same-store sales increased 10%, mostly driven by higher traffic, coupled with a benefit of 1.5% due to the menu-price increase.

Additionally, despite the price rise, traffic trends continue to remain strong, ensuring persistent comps growth. The menu price increase is expected to benefit food costs by 110 bps and restaurant margin by 200–250 bps. Management expects to realize about two-thirds of the anticipated benefit during the third quarter and full benefit by the fourth quarter of 2011.

Management is also concentrating on overall improvement, developing workforce, and enhancing marketing, which will enable the company to drive traffic going forward.

Chipotle expects comps to grow in a high single- to low double-digit range in 2011 as against the previous expectation of mid single-digit growth based on menu price increases and higher traffic.

Moreover, with a strong debt-free balance sheet and healthy cash flow, strategic international expansion, and marketing initiatives, we believe the stock provides relative safety and consistent growth.

Chipotle has been exhibiting a commendable unit expansion plan, both domestically and internationally. In fiscal 2011, the company expects to open 135-145 new restaurants, compared with 121 and 129 restaurants in 2009 and 2010, respectively.

Furthermore, we are encouraged by the potential for improving unit economics as Chipotle executes its new smaller prototype openings, named A-Model as part of its expansion plan. The A-model with its higher return on investment is turning out to be beneficial for the company .

In 2010, Chipotle opened 36 A-model restaurants and about 30% of planned stores to be opened in 2011 would be A-Model. The company has also recently opened its first Asian-theme restaurant called ShopHouse Southeast Asian Kitchen in Washington, D.C.

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