Chipotle Confirms Short's Suspicions

This week's earnings report for Chipotle held a lot of water for the company. Since the company's giant mid-July sell-off, investors have been waiting to see if improvements are on the horizon for what once was a true Wall Street darling. Unfortunately for the company and its investors, it was a lousy report. The company missed on both top and bottom lines, sending the stock down more than 10% in after-hours trading on Thursday. Was David Einhorn right about the burrito fabricator? Is it time to move on, or even short the company?

If only
Only a few months ago, around April, Chipotle Mexican Grill (NYSE: CMG  ) was trading well over $400 per share, and drastically overvalued. It was an enticing short for many, but the company has had a history of trading at lofty valuations. To me, though, the story brings to mind a classic Keynes quote: "The market can stay irrational longer than you can stay solvent."

Well, the shorts won this time. Since that July sell-off, it's been a downhill ride for the company. At the recent Value Investing Congress, David Einhorn presented his case for shorting Chipotle, and why Yum Brands (NYSE: YUM  ) would steal away market share with its revitalized Taco Bell menu.

Most of the value guys I spoke to were in line with Einhorn's call, but other investors were holding out for this earnings report to see some sign of change in the company's direction. Sorry, optimists, not this time.

If one were to read the company's press release, the earnings didn't look all that bad:

  • Revenues up 18.4% yoy
  • Comps up 4.8%
  • 36 new restaurants
  • 7% increase in restaurant level operating margins
  • Net income up 19.5%

Sure, those numbers look fine in isolation, but the Street was looking for more. The slowdown in Chipotle's growth does not signal that the company is headed for the dumpster, but it does tell the market that the era of extreme valuations for the company may be coming to an end.

Even more discouraging is the company's guidance for flat to low single-digit comparable sales growth in 2013. That information, coupled with a 26 times forward earnings premium, makes for a bad stock forecast.

So what are the factors affecting Chipotle's growth?

The factors
It's not that Chipotle's quality is suffering, or that its management is doing the wrong thing -- it's still a well-run company with a great product. It's a variety of external factors that seem to be keeping the company from achieving what Wall Street wanted.

For one, commodities prices are rising, and negatively impacting the business. The Chipotle CFO told Fox Business back in August that all ingredients would be more expensive going forward -- and it looks like we're seeing those effects now.

Another thing going against the company is the Einhorn affect. Whether you like the hedge fund manager or not, David Einhorn has become a real market mover. When he presented his case against Chipotle, it was a well-organized and easy-to-follow thesis as to why the company is sailing into strong headwinds. And it's not just Einhorn saying the company is overvalued, it's him putting his money where his mouth is. His firm's short in the company shows investors that one of the top hedge fund managers in the world is deeply convinced that this story is a declining one.

Yum Brands' Taco Bell has had a very successful remodel, thus far. The company has introduced new burritos and burrito bowls that compete directly with Chipotle's offerings. While it will take some time for people to consider Taco Bell on par with Chipotle in terms of quality and sustainability, it looks to be an idea gaining traction fast, especially with Yum Brands posting impressive same-store sales gains for its Taco Bell stores.

The play
Chipotle has always attracted investors who strongly believe in its business model and what it has to offer society -- healthier fast food. In that light, those who originally believed in the story will likely remain there. Value investors haven't been too interested in the stock due to its high valuations, which, despite its major sell-offs, is still well above its competitors.

In my opinion, Chipotle remains overvalued and has a decaying environment for at least the next year. If you trust wholly in the concept, and are in it for the long run, now is certainly not the time to sell. But for those attracted to the recent shares on sale, stay away -- this is quickly becoming a stock you don't want to become involved in any time soon.

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Fool contributor Michael B. Lewis has no positions in the stocks mentioned above. The Motley Fool owns shares of Chipotle Mexican Grill. Motley Fool newsletter services recommend Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On October 19, 2012, at 9:11 PM, TrojanFan wrote:

    I love David Einhorn.

    He helps make capital markets more efficient by beating down hyper-inflated securities prices one company at a time.

    In fact, I'm celebrating right now by eating an enchilada. Not from Chipotle, of course. That's the thing about Mexican food....it's ubiquitous. You can find it anywhere and everywhere and for a whole lot less than at Chipotle.

    I'm sure he's going to indure much criticism and derision for launching his short attack on this company....but come on!! Can you blame him????

    That is some seriously low hanging fruit!!!!

    And I went on record in CAPS to that effect months ago so it's not like I'm Monday morning quarterbacking here.

    There is NO WAY that Chipotle restaurants are worth $10 million per location which is what a $400 per share plus valuation implied!!! There are a lot of things I would consider paying $10 million to own, but a Chipotle location is not one of them.

    Sanity check everybody. Spare me the rule-breaker, "this business model is different" balony. This company is in the business of serving Mexican food in a made to order, quick service format. THAT is their value proposition to consumers, NOT to revolutionize the cultivation and consumption of food as we know it. Beware of spin stories like that when making investment decisions. That's the talk of charlatans and snake oil salesmen.

    This is a good and useful business that serves a purpose, but it was overvalued at $400 a share and it continues to be overvalued at $243 a share, though obviously much less so now then before.

    And by the way, David Einhorn is doing the capital market system a service by shorting this company. When securities prices are allowed to be wildly distorted in the upward direction we all suffer. Anyone who invests in a mutual fund that mechanically purchases baskets of securities in the restaraunt sector for instance and that was mechanically lifting offers of CMG at $400 per share plus under the false presumption that the market clearing price was efficient is suffering now if even in an inperceptible way. When you add it up though, that's a lot of lost capital that could have been avoided had more short sellers like Einhorn intervened earlier.

    We need more sensibly bearish participants like Einhorn to prevent bubbles from happening like tech stocks and real estate.

    The best way to prevent bubbles is to levy serious financial harm upon those who enable them. That is the intrinsic didactic benefit of the free market system when it is allowed to function properly. It heaps rewards upon the shrewd and astute at the expense of the impetuous, the careless and the foolish (small f) and the system imposes discipline by causing the fallen to learn from their mistakes and hopefully make better decisions in the future.

    I sincerely hope that all the investors who have taken a beating over the last couple of months of 40% or more take a deep breath and sensible appraisal of the situation, cut their losses before the get even worse, and take a serious moment to reflect on where they went wrong in their analysis by buying this stock (if purcahsed in the last couple of months) or continuing to hold it at $400+ if they bought it long ago.

    We will end up with a slightly more intelligent resource allocation system at the margin as a result.

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