Recommendation: Buy CMG on a break above $295 as the stock bounces off support.
Options Alternative: Buy to open CMG Dec. 300 Calls under $14.
“Value trap” describes a stock that has been trading at a low multiple compared to its historical norm. The stock seems like a great value but trades low because investors suspect that future growth is likely to be negative. The “trap” is sprung when investors buy low, expecting the stock to recover and then it doesn’t.
This is a classic dilemma when evaluating a stock that has reached historical support levels and attractive valuations.
From a technical perspective, CMG looks rough. The stock is off 35% from its April 2012 highs, and it suffered a disastrous second-quarter report in July. The gap that opened up then can act as resistance, as it did when prices rallied back to $340 per share in September 2012, only to fall quickly back to support again in October.
Click to EnlargeThe lower gap boundary was also equal to a longer-term resistance level (see chart), which likely added to the bearish confidence. However, what really killed the stock this month was a bearish recommendation from Greenlight Capital’s Einhorn on Oct. 2.
His recommendation for a short entry on CMG became a self-fulfilling prophecy this month.
Right now, the percentage of floating CMG shares that are held by short traders stands at 23%, which is very high. It would take three to four days to unwind all those trades if all daily volume was dedicated to short covering.
That sounds bad, and it definitely isn’t a good sign, but it also creates the opportunity for a short squeeze. A squeeze occurs when short traders start covering their positions and buy the stock back at the same time. That buying drives the stock’s price higher very quickly. It’s quite likely that the rally at the beginning of September 2012 was a short squeeze. This is common for profitable, but oversold companies.
Much of the fundamental pressure on CMG is related to margin concerns. CMG’s products sit a layer above YUM Brands’ (NYSE:YUM) Taco Bell, but passing on price increases to customers is very difficult at the low end of the restaurant business.
CMG is somewhat at the mercy of commodity prices, but those costs are declining again. The stock has reached a long-term level of support at $280 where a short squeeze has already occurred and could do so again as corn prices continue to decline from this summer’s highs.
From a technical perspective, this trade is risky. But is it a value trap? We don’t think so.
It’s important to point out that, like any money pro, Einhorn has a track record that isn’t perfect. Most profitable investors are good at something specific. Einhorn’s biggest plays have been on companies that have accounting irregularities like Lehman Brothers (PINK:LEHMQ) in 2007. He seems to be able to smell them from a mile away, but no credible claims for accounting problems have been made about CMG.
Einhorn doesn’t like the stock because he thinks CMG is under commodity-driven cost pressure (we agree, but feel that it’s fading) and that Taco Bell’s new “Cantina Bell” menu will increase competition. Has he even had a Cantina Burrito? Yeesh!
We agree that the stock was overvalued before the big drop in July 2012. Many traders were already worried about the margin problem at that time, and the stock was pushed appropriately to the downside. Support is now in play, and input costs are dropping.
The fact that the stock dropped so quickly on Einhorn’s recommendation, rather than on fundamentals or technicals, indicates that the shares are currently undervalued. If shorts decide to take profits or cover potential losses before earnings on Oct. 18, then a short squeeze will push prices back up 20%, to $340 per share.
The options on CMG are actively traded, but open interest is fairly evenly spread between calls and puts. Volume has been picking up on the call side in the December strike prices as investors evaluate the stock at support but not so much as to drive implied volatility levels outside acceptable ranges.
For traders who want to use leverage, we like the December 300 calls for $14 per share or less. We would suggest using the same entry trigger of a break above $295 per share on the stock for the options. Our outlook on the stock is short-term. so the Dec. 21 expiration date should give traders more than enough flexibility.