Fade Chipotle Stock As It Rallies Towards $500

Chipotle stock looked good below $430, but as it closes in on $500, the time to sell is rapidly approaching

3 more reasons to sell CMG stock

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Fast casual Mexican eatery Chipotle (NYSE:CMG) has been both Wall Street Hero and Wall Street Zero before. From 2012 to 2015, Chipotle stock played the role of Wall Street Hero, as the company was rattling off strong comparable sales quarter after strong comparable sales quarter, margins were rushing to all time highs and the stock was roaring.

Then, the E. coli scandal hit and numerous other health-related issues plagued the company thereafter. CMG stock went from hero to zero, and lost well over half of its value during a three year stretch wherein sales, margins and profits fell off a cliff.

Chipotle stock has since staged a strong comeback in 2018. That rally is warranted. The numbers are starting to improve. Margins are starting to trend consistently higher. Big profits are back in the picture.

But this rally won’t last forever. There are still some structural problems with the long term bull thesis on Chipotle, and there are some red flags in the current numbers. Meanwhile, the valuation isn’t all that compelling.

Thus, with CMG stock rapidly closing in on $500, now looks like a good time to fade the rally.

Chipotle Still Has Problems

The Chipotle of today is much better than the Chipotle of 2017, and the stock price appropriately reflects that. The company has a new CEO in the innovative Brian Niccol, the same man who orchestrated an impressive turnaround at competitor Taco Bell earlier this decade. He has implemented several new strategies which are reinvigorating sales growth, including menu innovations and digital expansion. At the same time, margins are steadily trending higher with stable sales growth, and profits are now back in the picture.

Yet, despite all the positive developments at Chipotle over the past year, this company remains structurally challenged.

Namely, traffic is still down. So, while the comparable sales turnaround is in full effect, that turnaround is being powered by price hikes, not more customers. This isn’t a sustainable combination. Eventually, the price hike tailwind will run its course. Unless traffic trends improve by then, this is a flattish-comparable-sales company. That is awful news for margins, because, with flat comps, it’s tough to benefit from opex leverage and drive margins higher.

Thus, the question is: can Chipotle turn negative traffic trends around? The answer is yes. But it’s nothing to get too excited about, and traffic growth will never again be huge.

The reality is that the fast casual dining space passed by Chipotle. While Chipotle was dealing with health scandal after health scandal from late 2015 to early 2018, the consumer moved on. They stopped eating Chipotle burritos. Instead, they discovered poke bowls, superfood cafes, cold-pressed juices and fast casual sushi. All those new options replaced Chiptole burritos as the go-to healthy lunch. Now that Chipotle is trying to win its old customers back, it is struggling, and will continue to struggle, because everyone is eating poke and acai bowls — and enjoying them.

Thus, while traffic will normalize and eventually bounce back, traffic growth will never again be huge. That puts a lid on comparable sales growth over the next several years. It also puts a lid on margins. Ultimately, it puts a lid on Chipotle stock.

Valuation Is Full

At the end of day, it always comes down to the numbers with stocks. Unfortunately, the numbers simply don’t support CMG stock as it rallies towards $500.

Comparable sales growth trends are improving and running in the positive mid-single-digit range. But all of that growth is from price hikes, not traffic growth. Eventually, those price hikes will run their course, and comparable sales growth will normalize lower to the low-single-digit range. That level of comparable sales growth, plus unit expansion, should drive around 5-10% revenue growth over the next several years.

Meanwhile, restaurant level operating margins are also trending higher. But, year to date, RLMs are up just 170 basis points to 19.3%. At their peak, they were above 27%. Thus, even though this is supposed to be part of Chipotle’s big bounceback, you are getting less than 200 basis points of margin expansion from a severely depressed base.

Why? Costs are going up. Wages are going up. Fulfillment expenses are going up as the company takes a deeper dive into digital. Input costs are going up with inflation. Overall, costs are rising, and unless traffic growth comes back in a huge way, it’s tough to see RLMs getting back to their peak levels on a higher cost base.

Thus, over the next several years, Chipotle is a company defined by tepid revenue growth and mild margin expansion. All together, I think that combo still drives earnings per share of $32.50 in five years. A McDonald’s (NYSE:MCD)-level multiple of 20 forward earnings on that implies a four-year forward price target of $650. Discounted back by 10% per year, that equates to a year-end price target of under $450.

Hence, this rally to $500 seems premature and overstated.

Bottom Line on CMG Stock

CMG stock has healthy, but not robust, long-term growth fundamentals. At current levels, the market is overvaluing this company’s long-term growth potential, while ignoring some glaring red flags in the numbers. As a result, this is a rally worth fading.

As of this writing, Luke Lango was long MCD. 

Article printed from InvestorPlace Media, https://investorplace.com/2018/12/fade-chipotle-stock-as-it-rallies-towards-500/.

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