Chipotle Mexican Grill (NYSE:CMG) is set to open down 13% Friday after poor earnings after the bell Thursday. And I have to admit, I’m watching Chipotle stock with some sadistic glee.
I named the stock a surefire short for 2012 last December. Almost exactly six months ago, on April 18, I drew parallels between China and Chipotle as growth stories destined to end badly. CMG shares were $438 at the time. They’re down 35% from there to just $285.93 as of yesterday’s close.
The reason is that after Chipotle’s ugly Q2 revenue slowdown, it followed up with a report Thursday that once again showed growth concerns — namely, disappointing same-store sales and rising food costs that helped the stock miss both sales and earnings expectations.
Like all investors, I like to be proven right, but I’m not just writing to beat my chest here. I honestly wanted to revisit my Chipotle stock call now that things have changed so drastically to see what the score is.
Namely, should you expect further declines, or is Chipotle now a decent buy amid the negativity?
Let’s look at the pros:
Historic Valuation Multiple: Historically, Chipotle stock traded at a very high valuation on earnings. About a year ago it was trading for a P/E of around 40 … and now it has a forward P/E ratio of under 26. If you believe the earnings multiple for Chipotle will stay high while it’s in growth mode, then this is a decent argument. Reverting simply to a P/E of 30 based on 2013 forecasts of $9.97 in EPS (not a crazy feat) would give you roughly $300 a share — 20% upside from here.
Big Growth: Growth mode clearly still is where Chipotle lives right now, even if expectations were a bit high. In its recent report, revenue was up 18% and profits were up almost 20%. It’s not easy to find stocks — other than Apple (NASDAQ:AAPL), of course — growing at 20%-plus clip like clockwork. There’s something to be said for that, even if expectations were a bit higher.
Still Domestic: Most recently, Yum! Brands (NYSE:YUM) proved the power of Western restaurants pushing into overseas markets with its strong Q3 earnings report. But aside from a handful of sites in England and Canada, Chipotle is wholly a domestic brand. Yes, the U.S. restaurant industry does $220 billion a year or so … but China and other emerging markets is where the growth is. If and when Chipotle takes its act overseas successfully, there could be big profits for investors who got in before the move abroad.
Strong Brand: I love Chipotle. All my friends love Chipotle. Every store in the metro D.C. area is packed at lunchtime — not just a wait, but a line of 20 people or more. And when I say I “hate Chipotle,” meaning the stock, people typically look at me like I’m nuts because they worship the burritos. The bottom line is that consumer loyalty is a powerful force, and Chipotle seems to have that in spades.
Now, the cons:
No Leeway: After two straight earnings misses, it’s going to take some significant beats and a near-perfect record to restore investor confidence. Chipotle has to step up big-time going forward — and even if it beats expectations, that might not be enough to entice some traders burned by the stock. Future sales or guidance reports will be closely watched, and there’s no room for error.
Inflation Risk: Input costs already are a problem, with money spent on food, beverage and packaging rising 17% in the latest Chipotle earnings report. If you believe inflation is on the march, you don’t want to go anywhere near this pick. The Federal Reserve, some pundits and many investors remain unconcerned since inflation is running at about a 2% annualized clip based on September numbers — but if that heats up, expect Chipotle to see margins deflate, or raise prices and deter customers as a result.
No Short Squeeze Is Coming: As negativity mounted — particularly from bigwigs like Greenlight Capital’s David Einhorn — it got popular to bet the downside. Even a month or two ago, after the big leg down from CMG’s initial earnings debacle, short interest was easily north of 20% in Chipotle stock. The bulls sometimes touted this as a potential investment catalyst — including options traders John Jagerson and Wade Hansen over at InvestorPlace. But as the short sellers cover now and take their profits, the short interest has drifted down to about 12% of the float. High, but nothing that could spark a 50% gap up in a few days unless something crazy like a buyout by McDonald’s (NYSE:MCD) happens.
This Is How Momentum Ends: There’s a fantastic post by Tim Knight of Slope of Hope, outlining how momentum stocks crash. In a phrase, it’s a “series of gaps” and all of them down. It happened to Netflix (NASDAQ:NFLX). It happened to Research In Motion (NASDAQ:RIMM). And it’s happening to Chipotle. Anyone who has watched the implosion at Netflix or RIMM knows the damage doesn’t come in one or two big punches. There are the body blows that mark big legs down, but there are smaller jabs being slipped all the time that ultimately result in a rather ugly run over many months. Chipotle is only three months removed from the beginning of the end … and based on how momentum ends, that’s too soon to expect a recovery in share prices.
So what’s the score?
Well, my verdict would be to expect further but more modest declines in CMG stock across the next three months or so through its Q4 earnings. There simply cannot be an impressive showing after these two ugly quarters mid-year.
Maybe then, if Chipotle stock starts to see a valuation of around $200 that places it on par with other high-growth restaurant stocks, I will consider buying in.
But in the meantime, I’ll simply order a steak burrito with black beans every week or two and pass on CMG shares.
Though, come to think of it, I haven’t bought one of those overpriced burritos in a month or two, and I can’t say I’m missing it. A meal there costs roughly $10 a pop, and it’s hardly good for you with all the rice and delicious sour cream … plus there are plenty of other decent Mexican shops around worth eating at.
Maybe that’s the biggest problem of all for Chipotle, wrapped up in a simple package for you.
- My timely bearish call on Chipotle from April for bragging rights. Also, my first shot of negativity about 10 months ago in an article about surefire shorts for 2012, including CMG … but also Amazon (NASDAQ:AMZN), which is up 40%. Hey, you can’t win them all. (InvestorPlace)
- Tim Knight’s awesome post on how momentum ends. (Slope of Hope)
- Einhorn was right again, even if his Taco Bell call-out was kind of silly. (New York Times)
- Oh, and by the way … that Taco Bell dig wasn’t all that off base, if you think about it. (InvestorPlace)
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at email@example.com or follow him on Twitter via @JeffReevesIP. As of this writing, he owned a position in AAPL.