Chipotle: Perfect for High Risk, High Return Hunters?

The fast casual chain's risk/reward proposition looks attractive

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Mar 21, 2016
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Shares of Chipotle Mexican Grill (CMG, Financial) are down nearly 40% from its all-time high of $757 reached in October last year. Chipotle is currently trading at $455 per share, and this is after a recent resurgence in price, which saw the stock rise from a multi-year low of $399. The company has experienced a torrid time over the last few months including multiple food quality problems in many of its restaurants nationwide.

While the general view among investors appears to be bearish, the current situation could actually yield a massive return for aggressive risk takers. This is because despite the current food quality crisis and the inevitable decline in top and bottom lines, Chipotle is still one of the best casual foods stocks in the market. Patient investors who would be willing to take the risk in Chipotle stock are likely to be rewarded in the long run in a big way.

The company’s shares have not traded at the current price levels since October 2013, and before the recent woes, it was impossible to imagine Chipotle's stock falling to trade below $500 per share. Therefore, given the current circumstances and the possibility of recovering from the food quality quagmire, now may be the right time to buy Chipotle stock.

What do the fundamentals say?

Chipotle currently boasts a gross margin of 38%, which is significantly better than the industry average of 31%. Following the current decline in revenues, however, the company’s margins are expected to squeeze a little in the next few quarters.

Chipotle reported 7% decline in revenue for the most recent quarter and 44% decline in earnings. Nonetheless, with Chipotle currently implementing measures to put an end to the recent food quality problems, revenues and earnings are expected to improve albeit at a slower rate as customers slowly return to the company’s restaurants.

The company also enjoys a decent operating margin of 17%, while its current profit margin for the trailing 12-month period stands at 10%. Chipotle has no debt on its books, which means that the massive cash outlay of more than $663 million can help it to endure the current difficult period.

The company’s current return on asset of 18% indicates the efficient application of assets, while the return on equity of nearly 23% indicates that shareholders are receiving a good return on their capital.

With a current ratio of 2.91, it is pretty clear that Chipotle is still a very good stock from a financial position, which has been hurt by recent events. As such, if the company manages to overcome the current situation without a major damage on the fundamentals, it will present an interesting opportunity to investors.

Food is Chipotle’s primary business, so can the company fix the problem?

In a bid to get rid of the food quality issues, Chipotle had opted for pathogen testing as a safety measure, which it implemented across all its restaurant chains. However, the Wall Street Journal recently reported that the company might actually be considering doing away with the testing.

Reports indicate that Chipotle has been precooking all beef before vacuum sealing, after which it ships it to all its restaurants. This exercise has ruled out the need for pathogen testing since precooking kills E. coli bacteria.

With precooking, however, Chipotle also risks ruining the taste of the final product, and this has caused concerns among customers who know their meals well. Therefore, as Chipotle dumps the expensive pathogen testing process of trying to detect E.coli bacteria, the cheaper precooking process may as well turn out to be costly from a sales perspective.

In summary

Chipotle is trying to find the best solution to its food quality problems and customers are already returning to the company’s restaurants. This is a good step forward regardless of the short term misfortunes which include among others offering promotional products such as burritos to woo customers back.

The company’s food issues have been overblown by the press, leading to the current price levels. As such, once the first quarter results are announced in April, it could shed some positive light on the current situation. Chipotle has already announced that it expects a potential loss per share of $1.00, which compares to analyst expectations of EPS of 11 cents.

It is unlikely to beat analyst estimates given its own guidance, but if it can deliver better results than guided, then that could signal good progress in the turnaround campaign. This is why I believe that those who are willing to take the risk could be the biggest beneficiaries if Chipotle manages to turn things around in the near future. At the moment the progress looks good, judging by the Chipotle stock price.