Description

As a follow-up to sidhardt1105’s outstanding short write-up of CMG in March of this year, I am presenting CMG again as a compelling short idea.  I believe that CMG is a much more timely short now than it was at that time because CMG is now at the point where it will begin to show (dramatically) decelerating year over year growth, which I believe will likely spell the end of the stock’s skyhigh earnings multiples.

Since this is valueinvestorsclub, I’ll start with touching on CMG’s nosebleed valuation, though I don’t think that even the company’s most ardent supporters would argue the point that CMG is extremely expensive.

The average 2015 earnings estimate for the company currently stands at 17.44.  CMG therefore trades at approximately 38.5 times this forward estimate. Obviously, that is an extraordinary multiple (especially for a relatively mature restaurant company like CMG). By comparison, CMG’s similarly fast growing competitors EAT, YUM and DIN trade at approximately 17, 20.4, and 17.9 times forward earnings, respectively. PNRA’s forward multiple is somewhat higher, at 26.2, but still approximately 12 percentage points below CMG’s multiple.

Over the last three years, CMG has traded at an average of 37.5 times forward estimates. So, while the stock’s current multiple is in line with its recent norms, it is important to understand that CMG has traded at such tremendously rich multiples over the last few years because of its extremely impressive growth.   As shown in the chart below, CMG’s same store sales growth has been both outstanding and accelerating quickly in the last year. However, CMG’s same store sales growth is about to begin to DECELERATE and I believe that this deceleration, and the correlating slower EPS growth that comes along with it, will cause CMG’s multiple to contract significantly, even if CMG meets the Street’s ambitious year-over-year EPS projections (which I believe is very doubtful, as addressed below).

• Q3 2013: 6.2%

• Q4 2013: 9.3%

• Q1 2014: 13.4%

• Q2 2014: 17.3%

• Q3 2014 19.8%

  In its last earnings report, CMG called for 2015 same store sales growth in the low to mid-single digits, down sharply from projected same stores sales growth in the mid teens for 2014. Analysts nonetheless project year-over-year earnings growth of approximately 21% in 2015.  I believe that there is a very high likelihood of CMG falling short of this estimate given its tepid SSS growth forecast.  Clearly, the Street is basing its EPS estimates partly on the assumption that CMG’s margins will remain at least static.  I believe that this is very likely an incorrect assumption for the following reasons:

1. As addressed in more detail by siddhart105, competition for CMG appears to be increasing significantly, with Qdoba, Freebirds World Burrito, and Moe’s Burritos all posing significant, and increasing, threats to CMG’s business

    

2. While CMG expects to open slightly more new stores in 2015 than it opened in 2014, in its 21 year existence the company has already opened roughly 1700 of the 3000 stores management has forecast as its total market opportunity.    I agree with siddhart105’s conclusion that the low hanging fruit has likely already been picked in terms of optimal store locations for CMG, and that it will therefore be difficult for future new locations to match the productivity of the existing stores. The tipping point in this regard may start to occur this year, or it may occur in 2-3 years, but either way the street is wrong to price CMG as if it were a young company with a dramatic growth runway of underserved locations, rather than the mature company that it is.

    

3. While I don’t view this as CMG’s primary obstacle to maintaining high margins, the company identified the rising real estate market as an issue in its last call, saying: “…the market overall has become more competitive for the kinds of sites are looking for….We expect to see some pressure on rents in major markets, but think that we can offset some of that with a strong supply of new, smaller retail strip centers.” 

    

4. Another relatively small, but not insignificant, negative for CMG’s prospective margins  will be an increased tax rate in 2015, as the company projects its effective tax rate to rise from 38.5% in 2014 to 39.1% in 2014.

    

5. CMG is not planning additional price increases in the near term (which makes sense, as CMG is already a relatively high priced fast food option following last year’s price hike). When asked in the last call whether the company might consider another price hike in 2015, CMG’s CFO replied that it was “probably too early for us to consider a price increase.”  Therefore, increases in food prices which have occurred since CMG’s last price hike in March 2014, and are forecast to continue, will not be offset by additional CMG price increases, and should therefore adversely affect the company’s margins.  The company essentially admitted as much in its last call: “We expect these elevated food costs as a percentage of revenue to continue and even increase slightly in Q4 as continued inflation in beef and dairy is expected and will be offset by lower expected avocado costs. As we look to 2015, we hope our costs will stabilize, but we expect food cost inflation will be in the low single digits from where food costs were in Q3. …We don't know exactly what the pressure is going to be. We think it looks like it will be relatively modest barring unusual things like weather or supply shortages or things that we can't predict today. And so we think there's likely to be some modest pressure on the 34.3% that we're seeing in the third quarter today.”

I also agree with Siddhart105’s conclusion that Shophouse and Pizzaria Locale are not significant factors in the trajectory of CMG’s growth, or likely stock price performance, at this time. Leaving aside the daunting competition and other obstacles facing these ventures which Siddhart105 addressed in detail, it is important to note that: 1) Chophouse has only 8 locations in the US after launching the concept 3 years ago; and 2)  Pizzaria Locale has only two locations, both in Denver, and the company has no plans for expanding beyond Denver at this point. Therefore, neither of these ventures is going to move CMG’s growth needle anytime soon.

Catalyst

The company swings from a trend of same store sales increasing every quarter to comps decreasing dramatically year over year, resulting in multiple compression.