Should You Bet With or Against Einhorn on Chipotle?

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you don't know who Einhorn is, I'm referring to David Einhorn of Greenlight Capital. To say that Einhorn is a good investor would be a big understatement, he has achieved an annualized 21.5% return since 1996 when he founded his firm. Last year, and again this year, Einhorn made headlines by calling out companies that he believed would underperform or outperform the market going forward. Last year's headline making call on Green Mountain Coffee Roasters caused the stock to plummet. He was proven right in the short-term, when the company released disappointing earnings. This year however, he named a company as a potential short that I respectfully disagree with in Chipotle (NYSE: CMG). He made the comment that no one should blindly follow his advice, as he's not always right, and I think Chipotle will be one of those cases.

To be fair, one of my first posts on this blog questioned the valuation of Chipotle's stock when it was at $350 per share. At the time, I wrote that the company's projected top line growth of 17% - 20% simply didn't appear to justify the P/E ratio of over 40 that the stock was carrying. However, a few months later I reversed my position. I realized that the company's more efficient operating model could be a reason to believe the stock should sell for a premium. Chipotle operates restaurants that require less employees to generate sales than many of their competitors. This lower operating cost allows the company to generate significantly more relative free cash flow. Though the stock was hit hard when the company reported earnings last quarter, this is yet another reason further weakness in the stock seems unlikely. There are a few challenges that Einhorn believes Chipotle faces going forward, so let's take them one by one and see what we find.

Chipotle has been a great company, but it's on its way to becoming just a good company. The stock is vulnerable.”

Chipotle looks anything but vulnerable when you look at its performance relative to its competition. For instance, none of its competition can match Chipotle's expectations for earnings growth over the next five years. Analyst expect over 21% growth at Chipotle versus 19% at both Panera Bread (NASDAQ: PNRA) and Starbucks (NASDAQ: SBUX). The company Einhorn says Chipotle should be compared to is YUM! Brands (NYSE: YUM), which is only expected to grow earnings by about 13.7%. If you look at Chipotle's operating margin of 19.36%, this is more than 4% higher than their next closest competitor which is ironically YUM! Brands.

On a free cash flow basis, Chipotle comes in second only to Starbucks, and significantly outperforms the rest of its competition. Using free cash flow per $1 of sales, Chipotle generated $0.13 of free cash flow in its most recent quarter. While Starbucks generated $0.15, neither YUM! Brands or Panera could keep up at $0.08 and $0.07 of free cash flow per $1 of sales respectively. If you want further proof of Chipotle's outperformance, check out my post from March of this year. In summary, I found that the company generates significantly more sales per employee than other fast-growing restaurant chains like Buffalo Wild Wings and BJRI Restaurants. As you can see, by almost any measure investors look at, Chipotle is clearly a leader in the restaurant industry.

According To Einhorn - "Chipotle doesn't belong with Panera Bread and Starbucks, but instead with Yum Brands' Taco Bell chain."

I would agree if we were looking at Chipotle when I first wrote about the company and the stock sold for about 40 times earnings. However, today the stock sells for 31.82 times this year's earnings and just over 26 times next year's projections. The average analyst expects over 21% earnings growth in the next five years. Using analysts 2012 figures, implies a PEG ratio of 1.50. If Chipotle belongs in the category with YUM! Brands' Taco Bell chain, then the stock is actually undervalued on a relative basis. YUM Brands sells for nearly 22 times forward estimates, and is expected to grow at about 13.7%, which results in a PEG ratio of 1.6. This represents a premium to Chipotle on a relative basis. By comparison, both Panera Bread and Starbucks sell for PEG ratios close to Chipotle, at 1.49 and 1.42 respectively.

"Chipotle may have pushed the limits of its pricing power before it begins to lose customers"

This has been a constant concern for Chipotle investors for well over a year now. A quick search online turned up two different articles specifically related to price hikes at the chain. In June 2011, the company decided to increase prices for the first time in three years. By February 2012, after the price hikes had already taken effect, the company still was seeing double digit increases in same-store sales. Even in the company's last quarter, same-store sales were still up 8%. While it's true that the company may not be able to continually increase prices, management has been guiding "single-digit" comparable sales increases for multiple earnings reports now. Knowing at what point the company will begin to lose customers due to pricing is near impossible. In addition, shortages due to drought will certainly affect pricing across the restaurant industry and not just at Chipotle.

Conclusion:

One of the primary arguments Einhorn used to say that Chipotle was vulnerable was the increased presence of Taco Bell as a competitor. What is interesting is this is not a new development as Taco Bell has been expanding and improving its offerings for several years. The difference between the two companies is Chipotle has positioned itself as offering all natural selections with its Food with Integrity program. The company's focus on natural food offerings fits well with consumers increased awareness of preservatives and other chemicals used in the restaurant industry. Taco Bell has a long history in consumers minds as a fast food restaurant where price was the differentiating factor. It's highly unlikely after years of thinking about the chain in this way, that customers will all of a sudden see Taco Bell as equivalent to Chipotle. While Einhorn may have his concerns, they appear to be based on opinion rather than facts.


MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Chipotle Mexican Grill, Panera Bread, and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Chipotle Mexican Grill, Panera Bread, and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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