Is David Einhorn's Short Thesis About to Be Vindicated?

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

David Einhorn's short thesis on Chipotle Mexican Grill (NYSE: CMG), delivered at last October's Value Investing Congress, sent the stock diving once word spread that the famous short-seller thought the stock was too expensive. The stock has since climbed 25%, presumably making it a more attractive short.

However, even at 44 times earnings, the decision to go long or short Chipotle is not an easy one. Several factors will play a key roll in determining whether investors will make more money betting with the company or against the company.

Why it could be a buy

To many investors, Chipotle is just another restaurant in the fast-casual space that will grow at a moderately quick pace over the next decade. However, to consumers, Chipotle is an entirely different restaurant than, say Panera Bread (NASDAQ: PNRA).

Panera also operates in the fast-casual space. It has slightly more locations than Chipotle, and its long-term franchise agreements secure for it a predictable stream of cash flows. Moreover, Panera has an extensive supply chain and delivery network, which enables its restaurants to carry less inventory.

However, Panera's restaurants do not generate nearly as much revenue as Chiptole locations, and its growth prospects are not quite as good. On the surface, this can be explained by brand equity; Chipotle is known for sourcing natural-raised food, whereas Panera is not known for anything in particular.

This enables Chipotle to ride the organic food trend currently overtaking the country. In addition to building streamlined stores that require relatively little capital, the health food trend will give a significant boost to Chipotle over the coming decade. As a result, the company's profits will inevitably rise at a faster pace than the rest of the fast-casual space.

Why Einhorn is short

But David Einhorn is skeptical that Chipotle's expected profit growth will materialize. The short-seller's main argument is that, at such a high multiple of earnings, expectations are too high for a company that has low barriers to entry and an enormous liability in the form of Obamacare (Chipotle does not currently provide health care for its employees).

Moreover, Einhorn argues that Yum! Brands' (NYSE: YUM) Taco Bell poses a significant threat to Chipotle in the near-term. Taco Bell's Cantina Bell menu is similar to that of Chipotle, except it is cheaper.

Einhorn conducted a survey of Chipotle customers and found that they visit Taco Bell at least as much as they visit Chipotle. Two-thirds of those customers said that Taco Bell's Cantina Bell menu was "good," while half thought it was better than Chipotle's menu. As a result, Einhorn concludes, Chipotle is unlikely to stave off competition for much longer.

Is Taco Bell really a substitute for Chipotle?

Although Einhorn conducted a survey of actual customers, common sense suggests their responses are not representative of Chipotle's broader customer base. Cantina Bell burritos range from $4.79 to $6.99, while Chipotle burritos normally go for $6 to $9. Logic would say that people who think Taco Bell is at least as good as Chipotle would opt for the lower price, but that does not seem to be happening.

Instead, customers are willing to pay more for Chipotle's high-quality ingredients, while Cantina Bell's association with a fast food restaurant will forever relegate it to the "low quality" category in consumers' minds. Therefore, it is unlikely that most American consumers will equate Taco Bell's menu with that of Chipotle.

Bottom line

Einhorn's thesis rests on rising expenses and increased competition. Although the company will undoubtedly suffer higher expenses due to Obamacare and rising input costs, it seems unlikely that significant competition will overtake Chipotle in the next five years. As a result, the short side does not look particularly appealing.

However, at 44 times earnings, investors are betting on a lot to go right just to justify the current valuation. Although higher profits will inevitably materialize, a high future return is not assured. Therefore, the long side is not appealing either.

Sometimes investors just have to take a pass. This is one of those times.

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Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill and Panera Bread. 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!

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