Remaining Neutral on Chipotle

We are maintaining our long-term Neutral recommendation on Chipotle Mexican Grill Inc.(CMG - Analyst Report), a chain of restaurants located in the United States, United Kingdom and Canada, specializing in burritos and tacos.

Chipotle’s first-quarter 2011 results topped the Zacks Consensus Estimate on double-digit top-line growth and margin expansion. Revenue in the quarter rose 25.8% year over year to $640.6 million, based on new restaurant openings and comparable-store sales (comps) growth of 12.7%. The restaurant operating margin enhanced 220 bps to 27.4%.

The company has remained unaffected by the economic slowdown and has been able to deliver positive comparable-store sales consistently. Chipotle expects comps to grow in the mid single-digit range in 2012 based on strong traffic, menu price hike and increased promotional efforts.

The fast food chain operator still possesses pricing power as compared to its peers, but management has no plans to execute pricing initiatives in 2012, even if food cost pressure continues. Management is also concentrating on improving throughout, developing the workforce, and enhancing marketing, which will enable the company to drive more customers going forward. Additionally, management believes that throughput enhancements will further drive comps, particularly during the peak time. However, the comps are expected to slow down in 2012 due to tough year-over-year comparisons.

Chipotle’s ‘Food With Integrity’ program provides a significant competitive advantage in the fast-casual segment. The program’s focus on the increasing mix of naturally raised pork, chicken and beef, as well as organic produce, led to the growth in its natural and organic food sales in the U.S. The program also helps Chipotle to support farming communities around the country. The customers are fond of its naturally raised ingredients and this results in higher traffic.

In 2012, Chipotle will continue to focus on its marketing strategy to educate the customers regarding the program and also standout among its peers with its “Food with Integrity” initiative. The company’s marketing program will have traditional advertising including outdoor, radio and print; increased in-store communications about “Food With Integrity”; and social media programs to increase customers’ awareness about the “Food With Integrity” concept.

Chipotle boasts a debt-free balance sheet and positive free cash flow to support new unit growth as well as modest share buybacks. The company has been pursuing a commendable unit expansion plan both domestically and internationally. The company plans to open 155-165 new restaurants (13% expansion) in 2012. Thirty percent of the planned stores will be A-Model restaurants, which provide higher returns on investment. In the international market, Chipotle currently has five restaurants, three in Canada and two in London. It also plans to open an outlet in Paris in the spring, three additional restaurants in London and a few more in Canada by the second half of 2012. The company is also eyeing new markets such as Germany.

The company’s first Asian-themed restaurant called ShopHouse Southeast Asian Kitchen in Washington, D.C, continues to perform well, which we believe will be an important long-term growth driver for the company. In the second half of 2012, Chipotle plans to open its second ShopHouse restaurant in Washington, DC market.

However, like other peer companies Red Robin Gourmet Burgers, Inc. (RRGB - Analyst Report) and Panera Bread Co. (PNRA - Analyst Report), Chipotle continues to experience food cost inflation. During the first quarter of 2012, commodity costs rose 20 bps to 32.2% due to higher beef and chicken pricing, partially offset by lower avocado and dairy costs. Management expects food cost inflation to remain in the mid-to-single range in the next few quarters, driven by higher costs of avocados, beef and dairy. Thus, increased cost structure will continue to weigh on margins. Additionally, management expects the tax rate to increase from 38.5% in 2011 to 39.0% in 2012 due to discontinuation of HIRE Act and expiration as well as non-renewal of Work Opportunity Tax Credit and the R&D Tax Credit.

Additionally, the uncertain economic environment has resulted in lower consumer spending, fierce discounting wars among quick-service operators and ongoing audit investigations of Chipotle’s hiring records related to the citizenship of its workers, further make us skeptical.

Agreement of Estimate Revisions

In the last 7 days, the estimates have not budged, implying that the analysts reaffirm their view on the stock.

Magnitude of Estimate Revisions

Over the last 7 days, earnings estimates also remains unchanged at $2.30 and $8.87 for the second quarter and fiscal 2012, respectively.