Chipotle Mexican Grill, Inc. (CMG) stock is in major trouble, folks.
Yesterday, the popular burrito chain hit investors with even more bad news: CMG stock will probably lose $1 per share in the current quarter … a far cry from the 11 cents per share analysts had been expecting.
On top of that, Chipotle saw February comparable store sales plunge an incredible 26.1%, also much worse than the 22% decline Wall Street predicted.
Oh, and remember the food safety precautions that CMG implemented in February in response to the streak of norovirus and E. coli outbreaks at its restaurants? Yeah, it’s probably gonna wind some of that down. Specifically, Chipotle might stop high-res DNA-based pathogen tests on its ingredients.
CMG stock responded just as you’d expect it to: It fell sharply. In early morning trading Wednesday, Chipotle shares were down as much as 6%, hitting $473 as investors showed they’d had quite enough.
Then, inexplicably, Chipotle stock rallied from its early morning lows, and shares closed above the $500 level.
What did I miss?
CMG’s Savior: Jim Cramer Opens His Mouth
Yesterday morning on CNBC‘s “Squawk on the Street,” Jim Cramer enlightened the masses, defending CMG with his own form of reasoning:
Just look at Jack in the Box Inc. (JACK) and Yum! Brands, Inc.‘s (YUM)! Taco Bell. Both those fast food chains had what Cramer termed “horrible instances” of serious, food-caused sicknesses and even deaths … and yet they’re both still “alive and well” today!
Chipotle will be just fine in time, concludes Wall Street’s overcaffeinated talking head.
It’s true that Taco Bell and Jack in the Box both weathered tragedies, and they’re both still extant today. Okay, sure, yes.
Picture of Cramer’s 2007 book begging for an owner at a thrift shop. Buy CMG at $500 and you WILL stay mad for life!
But there’s a vitally important distinction between the way JACK and YUM structure themselves and how Chipotle is structured. It’s a simple difference, and it’s where Cramer’s desperate analogy falls apart.
Jack in the Box and Yum! Brands both fundamentally rely on the franchise model. Franchisees pay the company a fee for the right to use the brand, put up a store and sell their food. They also have to buy their ingredients from the parent company. And the napkins. And condiments. And straws. You get the picture.
At the end of 2015, JACK had 1,836 franchised restaurants and 431 company-operated locations. In its 2014 annual report, YUM told investors:
“We plan to open 2,000+ new international restaurants in 2015, 90% of which will be opened by our franchisees.”
Wow! That’s not much of a mix, is it? Well, how does Chipotle stack up? Glad you asked: At the end of 2015, CMG had 2,010 locations … and not a single one of them was franchised. They are all owned by the company.
That means a horrific decline in same-store sales deals a devastating hit to Chipotle, which has no one to share its costs with. YUM and JACK, on the other hand, continue to collect vast sums of cash from franchisees, who bear many risks themselves.
Chipotle acknowledged as much in its 2014 annual report:
“Because we do not franchise, the costs of compliance and other risks associated with government regulation of our business… may be more pronounced for us than for restaurant companies at which some or all of these risks are borne by franchisees …”
Governmental food regulations can lead to litigation, and Chipotle also notes in the 2014 report that “much of this litigation occurs in California.”
Unfortunately for CMG stock owners, that would prove to be a prescient observation. On Jan. 28, the U.S. Attorney’s office for the Central District of California served Chipotle with a subpoena that expanded the scope of an ongoing criminal investigation into food safety.
That subpoena may have been served regardless of Chipotle’s decision to not franchise, but the risks associated with not franchising — risks that JACK and YUM were not willing to take — do not end there.
Again, from Chipotle’s 2014 annual report:
“Because we do not franchise, risks associated with hiring and maintaining a large workforce, including increases in wage rates or the cost of employee benefits, compliance with laws and regulations related to the hiring, payment and termination of employees, and employee-related litigation, may be more pronounced for us…”
Cramer’s comparison of YUM and JACK to CMG is falling apart. Yesterday’s SEC filing that announced the same-store sales nightmare and the expected Q1 earnings per share of -$1 or less also said operating margins would be hit by higher food prices and labor costs. Chipotle incurred the latter to “ensure we were fully staffed as customers redeemed their free burrito offer.”
All in all, Chipotle is a total mess, and CMG stock, which currently trades at 36 times forward earnings, has officially become a total ripoff.
Bottom Line for Chipotle Stock
The market is suspending its disbelief that a burrito chain that was so hot for so long is now in utter disarray. What happens when analysts get their heads on straight and start scrambling to revise EPS projections lower? Because they will.
What happens then is Chipotle stock’s valuation becomes even more impossible to justify.
While Cramer thinks you should consider buying in below $500/share, there seems to be quite a lot this man is missing, so I wouldn’t rush to follow that advice.
Even at 30 times a more realistic 2017 EPS forecast of $13 (it’s currently $13.79), we get a fair value of $390. Don’t touch Chipotle till it hits $330.
Touch its burritos at your own risk.
As of this writing, John Divine did not hold a position in any of the aforementioned securities. You can follow him on Twitter at @divinebizkid or email him at editor@investorplace.com.
