One of the uncomfortable truths about restaurant and clothing retail stocks is they often will enjoy spectacular growth in their early years, during which their stocks get bid up to lofty heights, only to fall back down to earth as growth wanes.
Clothiers are more susceptible to this, because consumers are much more fickle about what they wear as opposed to what they eat. Once consumers decide that they like a particular restaurant chain and its food, there tends to be a base level of support for that chain. It becomes one of the go-to choices in certain circumstances. Style and fashion, however, change like the wind.
Thus, clothiers can literally lose most of their customers while restaurant chains — particularly ones that offer simple menus like Chipotle Mexican Grill, Inc. (CMG) — will always have a base of fans.
Still, every fast-growing chain must slow its growth eventually. When that happens, multiples will contract. And there’s one other thing that can occur which might hasten that process — if the public loses confidence in the restaurant’s brand for some reason.
Sickness and CMG Stock
In the case of CMG stock, I am wondering about the bad PR surrounding Chipotle regarding the E. coli outbreak that the Centers for Disease Control declared over on Feb. 1.
From a crisis-management perspective, CMG did a fairly good job at handling things. The problem is that crisis PR is not a silver bullet, and there are some things that simply cannot be chased out of consumers’ minds. The safety of the food we eat is foremost in people’s minds, and this wasn’t a case of negligence or sabotage, which would have potentially been an easier fire to put out.
The result was a 30% decline in same-store sales in December. Chipotle stock lost almost half its value, dropping from $750 to $400, but has rebounded to above $500. Thanks to a massive, systemwide set of changes to its food safety process, and factoring in loss of customers, CMG stock looks to earn $8.25 per share for fiscal year 2016, down from $15.10. It is expected to rebound to $14.65 in FY17.
So investors are left with a problem. First, what is an actual fair valuation at this point? On the one hand, one might say $15 per share in EPS is a reasonable starting point, so the stock is selling at 34x FY17 earnings. Analysts are assuming five-year annualized earnings at 22%. But instead of adding 10% premiums for lots of cash on hand, great cash flow and a world-class brand, I’m not so sure those are applicable.
Yes, Chipotle stock has $1.3 billion of cash and short- and long-term investments, or about $43 per share, which lowers the effective P/E ratio to 31x and might lift the fair value to about 24x. However, cash flow has been and will be impacted by all the new safety efforts, and the brand has been hurt.
Am I willing to pay 31x for a stock worth 24x? Am I certain CMG stock will recover from this situation? I can’t say for sure.
That uncertainty, coupled with the fact that we are in a bear market, is pretty strong disincentive.
I don’t think CMG is terribly safe as these levels, and I would caution against buying.
As of this writing, Lawrence Meyers did not hold a position in any stock mentioned.
