by Susan J. Aluise | October 16, 2013 6:03 am
By any measure, Chipotle Mexican Grill (CMG) has been a success story in 2013: Chipotle stock is trading near 52-week highs, same-store sales are gaining ground, and Chipotle earnings for the third quarter — to be announced Thursday after the bell — should impress.
New menu items and a strong business model seem only to sweeten the deal.
But beware the Law of Unintended Consequences: All that good news could conspire to create the classic trap game for Chipotle stock investors, making the hours before the Q3 Chipotle earnings report a good time to consider the old adage of selling greed and buying fear.
It’s hard to ignore the fact that the greedy have got game; the proof is readily apparent when you look at this stellar player in the fast-casual restaurant segment. CMG shares have gained roughly 45% year-to-date, driven by consumers’ increased taste for fresher, higher-quality choices.
A recent survey by industry research firm NPD Group found that foodies and restaurant regulars — which comprise 58% of the market — increasingly care more about quality and freshness than they do about meal price. Those trends clearly are in the wheelhouse of chains like CMG and Panera Bread (PNRA).
That’s why analysts on average are expecting Chipotle earnings for Q3 to pop. Optimism also is rooted in past performance, however: In the second quarter, CMG profits grew by double digits, thanks to a 5.5% gain in same-store sales. Wall Street expects Chipotle earnings growth of more than 20% for the third quarter, and analysts believe CMG same-store sales will continue to exhibit strength.
The company is flexing its menu muscle, too, by moving into the catering space, tempting vegetarians in Chicago with tofu and teasing a breakfast menu launch.
But while CMG is doing a lot of things right in its business model and menu — and restaurant trends clearly favor its menu strengths — I’m not buying Chipotle stock right now.
In fact, I think investors who’ve already made a tasty profit on CMG this year should consider selling or even shorting the stock before the Chipotle earnings report.
Here’s why: Despite the strong second-quarter numbers, Chipotle’s margins slipped by 160 basis points in the period. That’s not surprising since the chain is feeling the increased pinch of higher commodity costs — in Q2, these increased 100 basis points year-over-year, and those trends show no signs of reversing themselves anytime soon. Should the trend continue into Q3, that’ll be a huge weight on earnings.
Chipotle stock has experienced phenomenal growth over the past decade, as has the company itself, boasting more than 1,400 restaurant locations in the U.S. But I don’t think it’s realistic to expect any company — let alone a consumer cyclical business — to sustain an average growth rate of 20% a year for the long haul. And even though CMG’s 5.5% growth rate in same-store sales is impressive in the restaurant sector, it’s a slip from the 8% growth rate CMG posted in Q2 2012.
My biggest worry about Chipotle stock right now is that its valuation is too hot to handle. This is a stock that is trading at more than 34 times forward earnings; compare that to restaurant rivals like McDonalds (MCD) at 15.5 and Taco Bell and KFC parent Yum Brands (YUM) at 18.5. Even fast-casual peer Panera has a comparably cheap forward P/E of 20.4.
CMG is a sound investment for the long-term, but the stock is long overdue for a significant correction. Chipotle earnings that are anything but a screaming beat could be the perfect catalyst.
Whether you buy put options or short the stock directly is a matter of personal preference, but InvestorPlace’s Lawrence Meyers lays out a valuable walkthrough of how to use options to short stocks that are insanely overvalued — like I believe CMG is right now.
Either way, now doesn’t seem like the best time to get bearish on Chipotle.
As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities.
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