Two important restaurant companies announced earnings late last week…
- Both beat analyst expectations.
- Both reported strong same store sales increases
- Both noted rising expectations for food inflation
- And both stocks advanced sharply on the news.
But while these two companies are related by blood (metaphorically speaking), there are significant differences between the growth trajectories, risk metrics, and investor profile.
Chipotle Mexican Grill (CMG) is the daughter company – a 2006 spinoff – from the restaurant behemoth parent company, McDonald’s Corp. (MCD). For the last several years, CMG has been a growth darling – opening new restaurants, growing revenues and profits, and attracting investor capital by the truckload.
In contrast, McDonalds has played the proverbial tortoise – plodding along with steady, predictable growth – and attracting little attention for its boring expansion profile.
There are times when it makes a lot of sense to invest in exciting growth stories. CMG’s 600% advance in less than 3 years is evidence of this type of environment…
But there are other times when predictability commands a premium – and during those times, a cash cow like McDonald’s can be a long-term investors best friend, and a nimble trader’s exceptional opportunity.
Let’s take a look at the current environment for both of these successful restaurant leaders…
The Earnings Reports
After the close on Thursday CMG announced third quarter earnings of $1.90 per share, representing a 25% increase over the same quarter last year. The bottom line number came in ahead of analyst expectations.
For the quarter, revenue growth was 24.1%, and more importantly, same store sales increased by 11.3%. Management attributed the growth to both higher store traffic and menu price increases.
Profit margins decreased by 100 basis points, due to higher commodity costs. Keep in mind, Chipotle focuses on “food with integrity” – meaning they buy premium chicken, beef and pork – and make an effort to offer customers a healthy choice for fast food – or casual dining. (Of course “healthy” is a relative term – especially if you like all of the “fixins” on your burrito like I do…)
During the quarter, the company opened 32 new restaurants – including new Southeast Asian Kitchen concept stores. Management expects to open 165 stores in 2012 – continuing the rapid expansion CMG has become so well known for.
On Friday, shares traded 8.6% higher, finishing at the highs of the day. Investors were encouraged by the growth – were willing to look past the profit margin issues – and of course the action was helped along by a strong day for US equities.
McDonald’s earnings came in at $1.45 for the quarter – up 12% over last year and beating analyst expectations by 2 cents. Revenue was up 14% and same store sales increased by 5.6%. Considering the fact that McDonald’s is a much more mature organisation (with a store base that has been in place much longer), this same store sales figure is particularly impressive…
Management said that the strong growth was specifically due to strong performance for the company’s fruit smoothies, chicken mcnuggets, and their breakfast menu. Over the last several years, McDonald’s has been focusing on improving their coffee quality and selection – and successful execution for their coffee products has led to increased demand for other breakfast items.
Looking forward, MCD is also dealing with higher food inflation – and the company is guiding investors to expect 5% cost inflation for ingredients.
Similar to the reaction to Chipotle, investors plowed capital into the stock – causing the price to gap higher and finish the day 3.9% higher. It’s interesting to note that while CMG shares still remain below their recent highs, MCD gapped to a new all-time high on robust volume.
Handicapping The Trading Environment
Considering the positive reaction to both earnings announcements, it’s going to be easy for bullish investors and traders to make a case for both of these restaurant powerhouses.
But the actual reasons for owning Chipotle versus McDonalds should be in sharp contrast with each other.
- Chipotle is a rapid growth story – McDonald’s is a “stability play”
- Chipotle offers premium quality at a “fair” price – McDonalds caters to a more “budget conscious” customer
- Investors in Chipotle receive all of their profits in the form of capital gains – McDonald’s pays a 2.6% dividend yield
- With a forward PE of 38, CMG is already pricing in tremendous growth – the forward PE for MCD is 16.2, indicating more stability and a lower expectation hurdle
None of these business or investment differences is a “right or wrong” issue. As flexible traders, we prefer to think about the metrics in terms of “what is right – right NOW?“
Looking first at the business environment, there are some significant concerns with the US consumer. Since unemployment remains stubbornly high, and the middle-class consumer is facing significant challenges, CMG could run into problems selling quality food at a premium price.
Now of course we all understand the concept of value that CMG brings to the table. I’m sure there will be emails and comments reminding me that “considering what you GET and what you PAY, Chipotle is a tremendous value. Point conceded… But considering the US consumer’s shift towards saving and away from debt, consumers may be more sensitive to price increases – and more likely to trade down to McDonald’s dollar menu items.
Higher food costs will be a challenge for both CMG and MCD, but considering CMG’s focus on premium ingredients, higher costs combined with scarcity (it’s becoming tougher to find ingredients that meet the firm’s quality standards), CMG could be at a disadvantage.
As traders, we also have to look at the investment environment to understand where capital is more likely to flow. Even if CMG and MCD’s growth rates remain stable, changing appetites from investors could cause the two stocks to vary significantly.
Friday’s market action showed us that the bulls are not ready to give up yet. There is still a risk appetite in the market and institutional investors are putting capital back to work.
But considering the economic risks that are still in place, investors will likely be more careful in HOW they put this capital to work. High growth names with pricey multiples carry much more risk. Low multiple growth stocks with decent dividend yields are easier to justify.
A manager with a mandate to hold a 3-5% allocation in the restaurant industry may very well choose to pick a blue chip company making new highs with a dividend yield, over a growth company with a PE of 38 that carries more risk.
The beauty of having full discretion over our trading book is that we aren’t ever required to have an allocation to any sector, group, or industry. But if the market is signaling that another bull move is underway, we want to be opportunistic while still managing our risk.
This week, we’ll be watching both MCD and CMG closely to see how they follow through on the recent earnings-related strength. McDonald’s could easily be a buy candidate – provided we get the right setup that allows us to manage risk carefully and set up a strong reward-to-risk scenario.
Chipotle, on the other hand, may be a better short candidate – but only under the right circumstances… If the stock gives up its recent gains – the broad market loses its momentum – and investors shun risk, that would be a great environment to begin nibbling on the short side.
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