Chipotle's Still Sizzling Ahead of Earnings

NEW YORK (TheStreet) -- If you want to define "chipotle," as in Chipotle Mexican Grill (CMG), just take look a the company's stock price, which is up close 20% over the past three months and is up 50% year-to-date. At a price-to-earnings ratio of 46, more than twice the valuation of Yum! Brands (YUM), these shares carry some eponymous heat.

I don't deny that Chipotle has built itself into a leading fast-casual restaurant that's posting strong growth and above-average margins. To the extent that the company now deserves a P/E that is almost 3-times that of McDonald's ( MCD), I don't believe it does. Not to mention this leaves absolutely no margin for error in an environment where discretionary remains unstable.

I will credit Chipotle management for growing same-store sales and managing costs. On Thursday, when Chipotle reports third-quarter results, the company will get a chance to convince the Street that the valuation is deserved. Analysts will be looking for earnings of $2.78 per share on revenue of $820.28 million, which would represent earnings and revenue growth of 22% and 17%, respectively.

Given that Chipotle has consistently posted double-digit profit and revenue growth, the Street is not expecting the company to divert much from its historical performance. What I am interested in (among other things) is how the company continues deal with the rising costs of chicken and beef from suppliers like Tyson ( TSN).

If anything has kept the stock sizzling, it's been Chipotle's strong restaurant-level margins, which registered an astounding 27.6% in the July quarter. While that number is significantly higher than both McDonald's and Yum! Brands, I did notice a 160-basis point decrease. Chipotle has called that a "trivial" decrease. But let's not forget that it was preceded by 110-basis point decrease in the April quarter.

Now, I don't want to make too much this, but should restaurant-level margins decrease again on Thursday, it then becomes a trend. My issue here is that, while Chipotle's overall profit margins still remain high relative to its quick-service peers like Panera ( PNRA) and Qdoba, which is owned by Jack in the Box ( JACK), this is because Chipotle operates a premium-priced restaurant.

I've raised this point before and it's worth repeating here: Food costs were 33% of Chipotle's revenue, increasing by 100 basis points in the July quarter, and remain a concern. Management was able to offset some of these higher prices with lower costs for avocados. But how long can this last without adding pressure on management to raise menu prices? I don't see a way around it if margins are to remain strong.

Management has done an excellent job of executing what seems as a "simple" business plan. But Yum! Brands, which operates the Taco Bell chain, has adopted some of the same concepts and has -- to some extent -- duplicated Chipotle's model of offering a small number of fresh ingredients to produce a variety of menu choices. Now, I wouldn't dare say that Taco Bell is as tasty as Chipotle. But Taco Bell's menu prices are without a doubt easier on the budget.

The good news is, given the strong rate of growth Chipotle has experienced (an average of 21% per year over the past decade), consumers have had no problem paying for its premium-priced burritos. Accordingly, the Street has had no problem assigning a premium-priced multiple to the stock.

Investors should nevertheless be mindful of anything that threatens the Street's confidence. To that end, I believe on Thursday, one of the ways to avoid a disaster is to monitor Chipotle's restaurant-level margins, which has -- to this point -- been a key value-differentiator for this company in terms of an investment. That said, as a value investor, these shares are now just too spicy for my taste.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Richard Saintvilus is a co-founder of StockSaints.com where he serves as CEO and editor-in-chief. After 20 years in the IT industry, including 5 years as a high school computer teacher, Saintvilus decided his second act would be as a stock analyst - bringing logic from an investor's point of view. His goal is to remove the complicated aspect of investing and present it to readers in a way that makes sense.

His background in engineering has provided him with strong analytical skills. That, along with 15 years of trading and investing, has given him the tools needed to assess equities and appraise value. Richard is a Warren Buffett disciple who bases investment decisions on the quality of a company's management, growth aspects, return on equity, and price-to-earnings ratio.

His work has been featured on CNBC, Yahoo! Finance, MSN Money, Forbes, Motley Fool and numerous other outlets.

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