Chipotle Stock Downgraded: What You Need to Know

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

In just a little over two weeks, Chipotle Mexican Grill (NYSE: CMG) will report financial results for fiscal Q2 2018. Investors, however, aren't waiting to see the numbers before buying this stock; Chipotle shares are up 14% over the past year -- and up 82% since hitting their low point in February.

These are impressive results to be sure, but today, one analyst is warning Chipotle shareholders not to press their luck.

Here's what you need to know.

Halt! Or I'll say "halt" again!

Chipotle's surging stock price has taken some skeptics by surprise. Over at Mizuho Securities, for example, analysts downgraded it to neutral back in February and assigned the shares a target price of only $300. Despite the company having just reported 182% growth in EPS in its Q4 2017 report, Mizuho was "discouraged" by Chipotle's rising operating costs, "ineffective marketing campaign, and aggressive capex plans."

And yet, instead of the mild stock performance Mizuho predicted back then, Chipotle stock has delivered spicy returns. Buoyed by a 7% rise in sales and 33% increase in profits last quarter, Chipotle shares continued to rally, delivering gains of 80% and more.

What's an analyst to do when investors fail to heed its advice -- and worse, get proven right for ignoring that advice? In Mizuho's case, the correct answer is to double down: The analyst is downgrading Chipotle shares to underperform.

Downgrading Chipotle

Most analysts who follow Chipotle today are optimistic, predicting the burrito maker will continue growing earnings this year (to as much as $8.41 per share, a 36% improvement over 2017) -- and more than double those earnings over the next three years (to $18.38 per share by 2021, according to data from S&P Global Market Intelligence).

These are some pretty exciting growth rates. Mizuho, however, is once again warning Chipotle shareholders against entertaining irrational exuberance about their stock. At its current valuation of nearly 70 times earnings, Chipotle is priced to assume "an aggressive recovery in both comps and margins," which if it happens, could well deliver these projected earnings -- but these things are not a given.

As fellow contributor Rick Munarriz pointed out earlier this week, Chipotle's "comps" (also known as same-store sales) only ticked up 2.2% last quarter -- and all of that increase and more can be explained by the fact that Chipotle raised prices on its menu and added a new topping that helped to grow the average price of a meal at Chipotle by 5%. As far as getting new customers in through the door, however, Rick observed that this remains "an issue" at Chipotle.

As regards the hoped-for "aggressive recovery" in margins, the news here is a bit better -- but only a bit. Gross profit margin finally stopped sliding last year, and actually inched up 230 basis points to 31.5%. On the bottom line, net profit margin at Chipotle bounced off 2016's sub-1% levels and rose to 3.9% -- but still sit far below their 10%-plus levels of five years ago.

The upshot for investors

Granted, the fact that Chipotle did earn a 10%-plus profit margin five years ago, and indeed held it at about the 10% level for four years in a row, shows there's both room for improvement at Chipotle and provides evidence that the company is capable of achieving and maintaining such profit margins when things go well. A return to 10% levels of profitability would go a long way toward the doubling, and indeed trebling, of Chipotle's net profits over the next three to four years, as Wall Street is predicting. So would continued growth in comps and growth in sales overall.

It remains to be seen, however, whether Chipotle will be able to earn the same kinds of profit margins it did in years past, in the current era of historically low unemployment rates and agitation to raise the federal minimum wage to $15 an hour. As for whether Chipotle can bear up under the new challenges, and keep its numbers rising under the leadership of new CEO Brian Niccol, we'll get our next clue in Chipotle's next report.

Q2 earnings are due out July 26.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. The Motley Fool has a disclosure policy.