Chipotle Mexican Grill (CMG) is experiencing every restaurant chain’s worst nightmare — an outbreak of the E. coli bacteria, which hit several Chipotle branches in six states. The outbreak has created a health scare which could hit sales and distance its diners.
Investors, typically, have shown no mercy and were quick to sell CMG stock as the uncertainty grew. But if the past is any indication, this crisis is temporary and it leaves Chipotle stock cheap.
CMG Stock: E. Coli Effect Will Fade
One reason for investors’ concern was that the outbreak may have been of Chipotle’s own making. By that, I mean it may be as a result of Chipotle’s resolution that everything be made fresh. Unlike other chains, which use more “industrialized” products, Chipotle’s farm-to-table approach means a greater risk for food contamination. The emphasis on freshness is a key pillar to Chipotle’s popularity, and the abandonment of that principle could turn off some fans of the chain.
But that fear is largely overrated. The latest news indicates that several cases of E. coli contamination were found in Costco’s (COST) roast chicken. That alone clearly demonstrates that the E. coli problem is not unique to Chipotle.
Of course, those 43 branches in Seattle and Portland have since reopened for business after substantial cleaning. That included replacing all food stocks as well as ensuring that all branch staff were certified as E coli free.
There have been a further few reports of E coli in the U.S. recently — in California, Ohio, New York and Minnesota. However, none were directly linked to Chipotle.
Finally, one must point out that according to the Centers for Disease Control, there are 265,000 cases of E. coli a year in the U.S. Given that, it’s no surprise that several cases of E. coli were reported in other chains, like Costco.
The CDC has declared Chipotle safe to dine at and allowed the restaurant chain to reopen its restaurants. That just reaffirms that the E. coli effect on Chipotle, and hence on CMG stock, is temporary.
Chipotle Still Has Momentum
True, there has been a slowdown in growth momentum for Chipotle, especially in comparable sales. Yet revenues still grew 12.2% year-over-year for the third quarter. Operating margin remains at a healthy 28% and net income grew by 10.8%
But most importantly, Chipotle keeps expanding.
According to the company’s median estimates, it is expected to reach 2,001 restaurants by the end of 2015 and hit 2,229 by 2016. That reflects growth of 12.4% and 11.4%, respectively, in the number of Chipotle restaurants.
It has been suggested that restaurant expansion is approaching a climax. While Chipotle is expected to have roughly 2,001 restaurants by year’s end, that shouldn’t be a concern. Chipotle’s peers — for example, Yum! Brands Inc.‘s (YUM) KFC — have more than 14,000 branches in the U.S. alone. So, really, there is a lot of room for growth for Chipotle before its number of branches becomes a problem.
If we also consider that Chipotle is concentrated primarily in the U.S., then that is more reason to be upbeat.
And, of course, the fact that CMG stock has a very low debt ratio means the company has yet to use its ability to borrow in order to expand. That is quite unlike some of its peers, like McDonald’s Corporation (MCD), which are far more indebted.
CMG Stock; Down to Targets
Now the most important question; if CMG stock looks solid and the E. coli risk is transitory, what should its value be? Quite simply, CMG stock will return to its average valuation premium.
Since we’ve focused on sales momentum, naturally we’ll use the sales growth matrix to put a price tag on Chipotle. CMG stock’s historical price-to-sales is 4.4. Meanwhile, CMG stock is currently trading at a price-to-sales ratio of 3.9. Once the E. coli effect fades, there’s no reason why Chipotle shouldn’t return to its long-term average valuation, i.e. price-to-sales of 4.4. That will give us at least 10% upside from where it’s currently trading.
Of course, the E. coli crisis might take a bit longer to wind down. Consequently, it might take a bit longer for CMG stock to return to its highs.
Still, sometimes the best opportunity to buy a solid stock cheap is during periods of temporary distress, and CMG stock certainly fits that case.
As of this writing, Lior Alkalay did not hold a position in any of the aforementioned securities.
