Why We Have an 'F' Grade on Chipotle Stock

Chipotle Mexican Grill, Inc. (CMG - Analyst Report) has its back to the wall!

The burrito maker was once the darling of Wall Street with revenues exhibiting a extraordinary CAGR of more than 23% (till 2014), since going public. This stunning growth was supported by solid comps growth. However, toward the end of last year a series of E. coli and norovirus contamination issues ruined its fairy-tale growth story. In fact, the company lost more than 30% value over the past year.

The stock currently has a VGM score of “F”. Here “V” stands for Value, “G” for Growth and “M” for Momentum and the score is a weighted combination of these three scores. However, it is important to keep in mind that each Style Score will carry a different weight while arriving at the VGM score.

Chipotle fares poorly in the Style Score department, with a Value, Growth and Momentum score of F, D and D, respectively.

Negative Publicity Since 2015-end

Chipotle’s fall from grace started with the E. coli outbreak which began in Oregon and Washington at the end of Oct 2015 and later spread to Illinois, Maryland, Pennsylvania, California, Minnesota, New York and Ohio. In December, a norovirus outbreak at a Chipotle outlet in Boston's Cleveland Circle affected around 136 diners. Though the fast casual chain closed several outlets which were linked to these incidents as a safety measure, the damage was done.

Toward the end of December, the U.S. Centers for Disease Control and Prevention (CDC) announced that it was probing the Colorado-based restaurant chain’s links with a new E. coli outbreak (with a rare DNA fingerprint) in three states, namely, Kansas, North Dakota and Oklahoma.

Though the negative publicity cannot be discounted, what’s more alarming is the fact that as soon as Chipotle reopens a store, it is forced to close another because of new contamination incidents. Ever since the health scares, traffic has been severely hit and the company is still reeling under the impact.

Shift from the Main Selling Point

Chipotle has used only healthy ingredients which has long been its marketing strength and attracted customers despite the comparatively high prices. With the negative publicity associated with the E. coli outbreak, the company is likely to fall out of favor with health-conscious diners.

Also, management is unsure whether its local suppliers will be able to comply with the stricter guidelines that Chipotle enforced in the wake of these outbreaks. So changing suppliers would raise the costs and mark a major shift away from the company’s policy of using locally produced ingredients.

First-Quarter Loss Predicted

This month, Chipotle announced that it expects to incur a loss of $1.00 per share in the first quarter due to declining comps, higher expenses and lower margins. This would be the first time that Chipotle slips into the red since its IPO. Previously, during the fourth-quarter 2015 conference call, the company had predicted break-even results.

The company expects expenses to rise due to higher marketing and promotional costs – to bring back diners and boost sales – and other operating costs, which are anticipated to increase significantly on a year-over-year basis in the first half of 2016.

The company also expects elevated food costs mainly because of the added food safety procedures and wastage related to the food contamination incidents. As a result, food costs are expected to increase about 200 basis points in the near term.

The company’s labor costs also rose due to extra staffing at its restaurants to help customers redeem promotional offers, like free burritos. The company also said that it expects higher legal costs because of a Department of Justice investigation into the E. coli outbreak.

In the to-be-reported quarter, Chipotle expects restaurant-level operating margin in the mid single-digit range. Management expects margins and earnings to turn around gradually as sales pick up.

The company’s February comps declined 26.1%, as against a 36.4% drop in January. Comps declined 21.5% for the week ended Mar 7. Moreover, comps in the second week of March declined 27.3%, as a restaurant in Boston was shuttered after employees fell sick.

Apparently, the weak first-quarter outlook is the least of Chipotle’s worries as is indicated by its fundamental statistics. EPS is projected to plunge more than 100% in the current quarter for this Zacks Rank #5 (Strong Sell) stock.

This is not all.

Chipotle trades at a price-to-earnings ratio (P/E) of 73.63x, much higher than the industry average of 23.24x. Estimates aren’t on Chipotle’s side either, with almost all analysts revising their estimates downward for this quarter over the last 30 days. Also, they believe that the beleaguered fast casual restaurant would find it difficult to record revenue growth before 2018, despite the gradual uptick in traffic