In Chipotle, A Spicy Stock Cools Off

By John-Erik Koslosky - July 25, 2012 | Tickers: CMG, DNKN, MCD, YUM | 0 Comments

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No doubt, it was a highwire act for Chipotle (NYSE: CMG) investors so far in 2012. With a price-to-earnings ratio better than 50, there was little room for error for the burrito maker. And last week, Chipotle made that errant step.
The stock tumbled nearly 22 percent in a day after the company missed analysts’ expectations on revenue estimates and delivered a tepid-at-best outlook for the rest of 2012.

The company had various explanations for the slowing growth. Consumers are tightening their fists again. Competitors like Taco Bell (NYSE: YUM) are ramping up advertising. And wacky weather is starting to wreak havoc on food costs. All three are legitimate concerns for investors.

Which brings us to the big question: Is this plunge a sign to run for the border, or is it an opportunity to buy shares of a high-flying stock while it’s grounded?

Chipotle cannot keep growing this fast forever, and chain restaurants certainly are subject to consumer whimsy. Today’s Chipotle could be tomorrow’s Chili’s. But they also could be tomorrow’s McDonald’s (NYSE: MCD).

Let’s take a look at what’s putting pressure on Chipotle now and in the coming quarters.

Competition

Taco Bell is in the midst of an advertising blitz, as well as new product launches. First, it was the Doritos Locos Taco. Now, it’s the Cantina Bell menu, a play for more health-conscious eaters, complete with an endorsement from celebrity chef Lorena Garcia. Chipotle CEO Steve Ells  acknowledged that competitor advertising may be driving some customers to the other chains.

But Chipotle’s food is simply better.  (Do your own taste test if you don’t believe me.). And it comes at about the same price.  Lorena Garcia’s endorsement will be enough to drive some people to try the new items, but it won’t keep them. Rachael Ray’s endorsement of Dunkin Donuts isn’t fooling anyone into thinking its donuts are haute cuisine.

Things are slowing down

Chipotle’s outlook for the rest of 2012 is bleak. If that’s how things play out, Chipotle could to fall toward a much lower valuation. If Wall Street were to see Chipotle as a stock that deserves a valuation of 30, rather than the 50-plus PE it had been selling for, the stock could tumble another $40.

But even a modest turnaround next quarter could shore up the stock under a higher PE. Why? Because despite the pressures on the stock right now, Chipotle remains an intriguing fast-growth prospect. Even in a disappointing quarter, Chipotle's revenue was up some 21 percent over the second quarter of 2011.

And despite Chipotle’s popularity with investors, the chain remains relatively small and unknown in a lot of smaller U.S. markets. It now has around 1,200 U.S. stores. Compare that to Taco Bell’s 5,800 in the states.
What’s more, Chipotle has yet to eye the international market. With a premium on quality food, it may have limits in developing countries that other chains don’t necessarily face. But there’s still ample space for growth overseas.

The Squeeze

If the recent earnings report was indeed the beginning of the end of Chipotle’s growth story as some believe, the company may never again fetch 50 times earnings like it was just last week. But how far could it fall? Let's take a quick look at how Chipotle and some other food chains stack up in terms of valuation and growth:

*PEG Ratios through NASDAQ.

By those metrics, Chipotle does not seem to be selling at any great premium to other chain restaurants.

We learned from last quarter that Chipotle expects to see its profits hurt on one end by a more tight-fisted consumer spending less, and on the other by higher ingredient prices.

It's good to be skeptical whenever any company points the finger at broad economic trends to explain a bad quarter. But in this case, it looks legitimate.  We know this because McDonald’s, stalwart of all restaurant chains, days later reported getting hurt by some of the same problems. So, while Chipotle may be hurt by these problems, so should the entire industry. If I'm a short-term trader, I'm avoiding the industry altogether. But if I'm a long-term investor, which I am, this could create opportunity.

Can you handle the heat?

It’s a risky bet, but I’m willing to stick with Chipotle and average down. I’m in no hurry to add shares, however, as I think could continue to slide given how quickly investors soured on the stock after the recent quarterly report and outlook. But a bad quarter -- or two, if it happens -- is no reason to believe Chipotle’s story has come to an end. It’s far from done growing in the U.S. And expansion into international markets, as well as eventual growth of its Asian ShopHouse brand, could serve as engine of growth for Chipotle for years to come.

If you’re an investor with low-to-average risk tolerance, Chipotle’s likely too spicy a stock for you. But if you have an appetite for risk, Chipotle at sub-$300 prices may be one worth taking.

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