This Controversial Stock Keeps Crushing its Critics

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

When it comes to fast food, there is no more controversial stock than Chipotle Mexican Grill (NYSE: CMG). Although it’s been attacked by hedge fund titans -- David Einhorn and Jeff Gundlach -- the company continues to reward shareholders.

Shares surged during Thursday’s after-hours session following an impressive earnings report. Should investors consider buying shares, or is it too late to get in?

Chipotle remains misunderstood

When it comes to short selling, David Einhorn is up there with the best of them. The founder of Greenlight Capital has successfully identified major short selling opportunities in the past, including Green Mountain Coffee and Lehman Brothers.

Yet, the case he built against Chipotle last October seems to be constructed on a faulty premise. Specifically, Einhorn told investors he believed that Taco Bell (owned by Yum Brands (NYSE: YUM)) would soon “eat Chipotle’s lunch.”

Taco Bell has been working to expand its offerings and increase its quality. Its Cantina Bell menu certainly does attempt to go after the type of customers Chipotle attracts; however, as I've written previously, the company can't shake its low-grade image, especially when it continues to advertise items like Doritos Locos tacos.

More recently, Jeff Gundlach jumped on the anti-Chipotle bandwagon when he told a group of conference attendees that the concept of a gourmet burrito was an “oxymoron.” Tell that to the millions of customers Chipotle serves, Jeff.

Are you buying a business model or a menu?

But, despite the fact that Chipotle’s core business is sound, the stock certainly does trade at a steep valuation. Prior to Thursday’s earnings, shares were trading with a price-to-earnings ratio of over 37. That’s almost double rival McDonald’s (NYSE: MCD).

That valuation makes sense only if investors buy into the notion that Chipotle represents a new business model -- not just burritos.

That business model is a combination of high-quality ingredients (what the company calls food with integrity), a hip image, and unparalleled food customizability. Chipotle’s new concept restaurant, ShopHouse, attempts to apply that business model to Asian cuisine.

If it turns out customers are buying Chipotle simply because they really like the company’s burritos, then ShopHouse ought to fail, and Chipotle’s shares are likely significantly overvalued. But, if it turns out Chipotle is standing on the precipice of a new restaurant paradigm, then shares remain a bargain.

The silent fast food revolution

What is abundantly clear is that the old fast food business model is dead -- or at least, companies are acting like it is.

That old business model, developed over the last 50 or so years, was built around cheap, greasy food sold at bargain prices, with little customization (“Give me a number 1!”). In its heyday, it was undeniably successful, and nearly every fast food giant one can think of used it.

But those same fast food giants that rode that model to the top are now moving away from it, embracing (at least somewhat) Chipotle’s innovations.

While Taco Bell has been rolling out its separate Cantina Bell menu, McDonald’s has been adding new items to bolster its core offerings. These changes are embodied in the McWrap -- a rolled sandwich made with premium ingredients and offered in six different varieties.

As Forbes contributor BrandIndex notes, McDonald’s is facing a crisis among its younger customers, who prefer Chipotle’s new style of fast food over McDonald’s traditional, greasy burgers.

Buy or sell Chipotle?

Fundamentally, Chipotle’s valuation is difficult to justify. It only makes sense to the buy the stock if one believes the company has discovered a better way of doing fast food. If that’s the case, Chipotle should continue to grow, utilizing new concepts like ShopHouse to conquer the fast food world.

The old giants, however, are cognizant of the shift taking place. Both McDonald’s and Taco Bell have taken steps to capture some of what Chipotle is doing, however, their need to satisfy their core customers leaves them unable to fully reinvent themselves.

Perhaps, at some distant future date, Chipotle will surpass McDonald’s as the quintessential fast food giant. That possibility though, still seems remote. For the time being, cautious investors should avoid high-flying Chipotle -- but at the same time, don’t fall victim to the short selling mentality that fails to fully grasp the concept of what the company represents.

Joe Kurtz has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill and McDonald's. The Motley Fool owns shares of Chipotle Mexican Grill and McDonald's. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus