CMG Q3 Earnings Preview

by Enis October 17, 2012 8:02 am • Commentary

Event: CMG reports Q3 earnings Thursday afternoon after the market close. The options market is implying about a 8.5% move, which is in line with the 4 quarter average of 8.5%, but slightly above the 8 quarter average of 7.5%.  CMG has closed lower on 5 of the last 6 earnings reports.  The stock was down 21.5% on the July report.  

Sentiment: Wall Street analysts are relatively neutral, with 7 buys, 19 holds, and 3 sells.  Short interest has climbed since July, now standing at 10.5% of float.

Balance Sheet / Fundamentals: Chipotle is about as straightforward a business as you’ll find for a $9 billion market cap company these days.  It has a clean balance sheet, and the company’s performance basically hinges on selling more burritos.  Practically all of its sales are in the U.S.  The stock finally broke in Q2 (down 21.5%) after an uninterrupted, impressive 3 year uptrend.  The main reason for the break?  Comparable sales growth of 8% were lower than the expected 10% growth, and management said it expected mid-single digit growth in the second half of 2012.

That was the first quarter since the second quarter of 2010 (which is when the stock really started to take off) that sales growth was below 10%.  That’s the key metric to watch in this release, as well as potential guidance for 2013.  Gross margins have been very stable, meaning the same percentage of revenues has hit CMG’s bottom line for several years.  So sales is the key.

Finally, hedge fund manager David Einhorn mentioned CMG as a short position 2 weeks ago, with the basis of his thesis that the days of 10%+ sales growth were over, especially with Taco Bell increasing its competitive battle.  Chipotle management indirectly acknowledged competitive forces in the Q2 call.  They will surely get questions on this issue on the call on Thursday.  Their response and demeanor will be closely watched.

Valuation:  The P/E multiple for Chipotle shot higher in 2010 and 2011 as sales growth was over 10% on each earnings report, and margins were stable, leading to earnings growth averaging 30%.   Here is the chart of the P/E ratio over the last 3 years:

 

 

The valuation multiple continued growing with earnings until the spring of 2012, and the July earnings report deflated the valuation as future growth expectations were slammed lower.  CMG consensus earnings growth over the next 2 years is 20%.  In my view, at 35x, CMG is still vulnerable to another 10-20% of P/E multiple compression if sales trends do not rebound by the end of 2012.

Price Action:  This chart is a classic example of the “escalator up, elevator down”.  Here is the 3 year weekly chart:

 

 

The gains from May 2011 to May 2012 were given up in 2 months.  The obvious technical resistance level is $350, and support resides around $250 based on the price action from 2011.

Volatility:  The chart of 90 day implied volatility over the last 2 years shows how uncertainty has returned to the stock, after investors became quite complacent in March as the up-trending escalator had not disappointed in 3 years.  With implied volatility up here, long premium bets offer less attractive risk/reward.

 

from LiveVol Pro

 

Vol in November is around 38 and will likely come in around 6-8 points following earnings. The weekly vol is in the 110′s which means calendars utilizing a short Oct weekly and long outer months might make sense if we don’t think a repeat of Q2’s 21.5% move is likely.

My View: CMG is an interesting stock for several reasons:

  1. Einhorn’s involvement on the short side has introduced a new set of traders that likely increases volatility going forward
  2. CMG had a trend-breaking quarter in July, which raised questions about the long-term growth story as well.
  3. Options are quite liquid and implied volatility is elevated

I think CMG will have a very tough time regaining the $350 level unless they see an unexpected sales surge over the next year (which management does not seem to expect).  If management is correct in expecting mid-single digit sales growth, then the valuation still looks rich.  My main concern on the short side is that Einhorn’s commentary 2 weeks ago might have introduced some Johnny-come lately’s to short the stock.  But if I take any position, it will likely be selling volatility, and likely short biased (I don’t expect another 20% move this quarter).  Regardless, Chipotle’s days of spectacular growth are behind it.