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Will Rising Avocado Prices Hamper Chipotle's Turnaround?

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Per a research note from Credit Suisse, Chipotle Mexican Grill, Inc.’s (CMG - Free Report) profitability might be severely affected in the near-term, given a recent surge in avocado prices.

Though the investment firm maintained its neutral rating on this quick-casual and fresh Mexican food restaurant chain operator, it lowered its price target by 4.5% to $320 from $335.

Moreover, Credit Suisse slashed its estimates for Chipotle’s 2017 and 2018 earnings per share (EPS) to $6.38 and $9.57, respectively, down from $6.95 and $9.71. Also, for the third quarter, the firm expects adjusted earnings per share to come in at $1.15. In fact, the Zacks Consensus Estimate of $1.84 per share is pegged well above the guidance.

What’s the Fuss About?

Notably, avocado is the central ingredient in guacamole. Credit Suisse analysts Jason West and Jordy Winslow note that avocado prices have amplified about 75% since mid-July and are up about 50% year over year, given shortages in Mexico and a weaker harvest in California, which are two of the largest suppliers of the green fruit.

Per the analysts’ estimates, avocados make up nearly 10% of Chipotle’s cost of goods sold. Therefore, they are of the view that every 10% increase in avocado prices impacts Chipotle’s restaurant margins by 30 basis points and EPS by about 30 cents, or 4%. The spike thus puts pressure on Chipotle’s food costs, which in turn, is likely to dent profits.

Earlier, at its second-quarter conference call, management anticipated avocado prices to moderate in the rest of the year, besides expecting a 20% drop in prices moving into the second half of 2017.

However, as per the firm, the avocado prices are now likely be up 10% and 25% in the third and fourth quarter, respectively, which could potentially cut off 25 cents, or 13%, of the third-quarter consensus earnings per share estimates, and 35 cents, or 20%, in the fourth quarter.

Though Chipotle is possibly the biggest fast-food chain to feel the heat of the rising avocado prices, other restaurants serving guacamole, including Yum! Brands Inc. (YUM - Free Report) owned Taco Bell and Moe's Southwest Grill have also come under the scanner.

Bottom Line

Chipotle started 2017 on a positive note, marking a turnaround as its sales finally started bouncing back from the massive food safety scandal related to the E.coli and norovirus outbreak, which surfaced toward 2015 end, and resulted in sales plunging and hurting its reputation.

Additionally, the company’s continued focus on food safety, simplification of restaurant operations, menu innovation (possible roll out of queso), improved digital offerings and increased brand marketing bode well for growth.

However, the recent closure of a Washington-area outlet due to an apparent norovirus alert has started a fresh round of food-safety scare. Evidence of rodents was found at a Dallas outlet, further adding to the woes. These might possibly dent same-store sales, going forward. Alongside, rising avocado prices also pose a threat to the restaurant chain's profitability.

Evidently, Chipotle shares have declined 35.7% in the last three months compared with the industry’s fall of 5.1%.

Thus, given potentially soft comps along with material implications on margins and earnings from higher avocado prices, we would like to remain on the sidelines in the near term. This is because it seems that the company will certainly take some time to completely restore its economic model as well as customers’ trust and return to its former glory.

Zacks Rank & Stocks to Consider

Chipotle currently carries a Zacks Rank #3 (Hold). Better-ranked stocks in this sector include Papa John's International, Inc. (PZZA - Free Report) and Domino's Pizza, Inc. (DPZ - Free Report) holding a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

The Zacks Consensus Estimate for Papa John’s 2017 earnings climbed 1.4%, over the past 60 days. Moreover, the company’s trailing four-quarter average earnings surprise is a positive 5.10%.

Domino’s earnings surpassed the Zacks Consensus Estimate in the trailing four quarters, with an average beat of 6.75%. Meanwhile, for 2017, EPS is projected to witness a rise of 33.8%.

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