Chipotle’s Food Costs Could Weigh On Earnings As Restaurant Expansion Continues

Chipotle Mexican Grill (NYSE:CMG) is scheduled to announce its Q4 and full year results on February 5. The stock has gradually recovered more than 20% after the market punished it for the weak Q3 results. A lack of menu price hikes in 2012 were partly the reason behind the restaurant chain’s faltering same-store sales, but now that the management has announced its decision to raise the prices in the second half of 2013, there is once again an optimism surrounding the company’s earnings.

Meanwhile, restaurant expansion will continue with the company aiming to add another 165-180 restaurants in 2013. The restaurant chain had already opened 123 in the first three quarters of 2012. ^[1] As Chipotle expands to more places, it is increasingly looking beyond large metropolitan cities to open its next set of restaurants. Keeping this in mind, the company decided to open A Model restaurants from 2010 onward. A Model restaurants are opened in secondary trade areas where the average cost of opening a new restaurant as well as the occupancy costs are lower. At the same time, you can expect average revenue for an A Model store to be lower than that for a traditional restaurant. Overall, the company feels the demographics of the area are good enough to open the restaurant such that profit and return on investment are maintained.

Outside the U.S., international locations such as Canada, the U.K and France are lucrative markets where the company already has a presence. As of September 30, the company had 10 restaurants outside the U.S. (5 in Toronto, 4 in London and 1 in Paris). However, Chipotle doesn’t enjoy the same brand recognition internationally as other major chains such as McDonald’s, Pizza Hut or Burger King and therefore the company will be hesitant to expand aggressively. The macro-economic environment in Europe are not very encouraging either so we don’t expect any sudden jump in the number of international restaurants.

See full analysis for Chipotle Mexican Grill

Margins Could Get Squeezed

Historically, the margins have risen over the years since the sales growth has outpaced the rate at which the fixed costs (such as labor and occupancy costs) have increased. On the other hand, now that the same-store sales aren’t expected to reach their historic highs, we could see the margins beginning to stabilize.

In the fourth quarter, we could even see some deterioration since the company recently warned that the margins in the upcoming earnings could be hurt due to higher costs of raw materials. Chipotle expects the cost of food to account for 33.5% of the sales this quarter up from 32.6% in the third quarter. On the bright side, the company plans to hike the menu prices in the second half of the year which could help reverse this trend and widen the margins. Chipotle will have to be careful about the magnitude of price hikes though since a sudden spike in prices could drive away customers.

Chipotle has recently also forayed into the catering business which we estimate has a potential to add more than $200 million to the top line once established nationwide. Its new vegetarian product called Sofritas (made out of tofu) is also creating a lot of buzz, so the company has been in the news lately for the right reasons.

We have a price estimate of $313 for Chipotle Mexican Grill, which is in line with the current market price.

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1. CMG 10-Q [↩]