The rising stock prices of certain companies, such as Starbucks (NASDAQ:SBUX) and Panera Bread (NASDAQ:PNRA) have some investors worried while others think there's potential to profit from their suspected return to more realistic valuations. In fact, some highly respected money managers have taken action. Take, for example, Chipotle Mexican Grill (NYSE:CMG). Successful investors such as David Einhorn and Jeff Gundlach have publicly made the case for shorting the company or betting the share price will decline.
Unimpressed by the stock's 50% rise over the last year, they believe that Chipotle will not be able to sustain its premium valuation much longer. Are they correct? Is it a good idea to short this high-flying specialty fast-food retailer? Let's take a look.
Things to consider when betting against Chipotle
Chipotle certainly has an extremely optimistic valuation. Expected revenue of $3.7 billion would generate cash earnings, basically net income plus non-cash charges such as depreciation and amortization adjusted for expected capital expenditures, of roughly $435 million at an 11.7% profit margin based on 2014 analyst estimates. This has Chipotle's stock trading at a hefty 38 times cash earnings compared to industry mainstay McDonald's, with more than $24 billion in sales and a 20.1% margin, trading at around 16 times.
To justify this premium, Chipotle needs to prove that it can maintain above-average growth. Recent quarterly results seem to have fulfilled that task. Company sales were up a hearty 18% from the prior year and diluted earnings per share grew 17.2%.
While much of the company's improvement came from restaurant expansion, the number of Chipotle sites grew by almost 2.5% in the quarter and more than 9% year-to-date, a 6.2% year-over-year increase in comparable-restaurant sales also contributed to the gains.
It looks like the company would have to post much weaker results before its valuation might be significantly threatened and that may not be likely. Continued restaurant growth should help revenue climb. An 11% to 13% increase in locations is planned for 2014. Sales metrics may also assist. Though the company is only expecting low single-digit comparable-restaurant sales advancement, the forecast excludes any menu-price increases in the coming year.
It's probable that Chipotle will raise prices, however. The hike is necessary not only to boost comp-store results but to also shore up the company's bottom line. In the latest quarter, food costs increased significantly and that profit pressure must be addressed.
The fast food retailer's social purpose may give it an edge in raising menu rates. By insisting on the use of fresh ingredients grown in an environmentally friendly way, while dealing with employees and suppliers in an honorable manner, Chipotle has built a kind of "beyond typical business" reputation. This reputation can go a long way in allowing a company to charge premium prices and increase them moderately without much damage.
Where Do Starbucks and Panera Bread Stand?
Starbucks (NASDAQ:SBUX) is a prime example of the success a highly valued fast-food retailer can achieve. With a stock market value ballooning from around $15 billion to more than $61 billion over the last 10 years, the enterprise continues to defend its share price effectively.
Starbucks reported robust gains in its latest quarter. Revenue increased 13% and adjusted earnings per share jumped more than 30%. Results were boosted by strong global comparable-store sales growth of 7%, with 8% spikes in key markets like the U.S. and China. Starbucks also expanded its store footprint, opening 558 sites in the quarter and developing 1,701 new locations, a 9.4% increase, so far this year.
The company expects next year to be another winner with revenue growth of at least 10% and comp-store sales increases in the mid-single digits. Expansion plans into Asia including China might offer the greatest possibilities. The region, which currently generates only about 6% of total revenue but has a company-best 35% operating margin, will add another 750 locations.
Starbucks' current growth and future promise seems to support a premium valuation. Based on 2014 analyst expectations of around $18.6 billion in revenue generating $2.4 billion of cash profits at a 13% margin, the company currently trades at a justifiable 25 times earnings.
Panera Bread (NASDAQ:PNRA) may not be in a similarly solid position, however. This high-flying stock, rising from around $65 per share in 2010 to a range of between $155 and $195 in the last year, might need to better justify its worth.
The company's recent quarterly results didn't seem to suffice. Though earnings per share rose a respectable 9% versus the prior year, comp sales were disappointing, rising only 1.3%. Further, where company-owned sites increased a slightly better 1.7%, the gain looked to be due to average check growth of 2.7%, which offset a transaction decline of 1%. A less-than-comforting statistic.
Site expansion, though solid, didn't provide a significant boost. Panera's 32 new bakery-cafes in the latest quarter increased total locations less than 2%.
Such performance, if maintained, isn't likely to support an enthusiastic valuation. The shares, currently trading at a market multiple of around 20 times cash earnings based on 2014 analyst expectations of $2.6 billion in sales generating $255 million in earnings at a 9.8% margin, may be revalued if Panera cannot improve its execution.
Is shorting Chipotle a good idea? Probably not, at least not at the moment. While it's usually foolish to bet against such accomplished investors as Einhorn and Gundlach, there does seem to be compelling evidence that their short-thesis may not play out for awhile.
Chipotle's admittedly high valuation may be well defended by an expanding restaurant base and probable menu-price increases. Beyond a general market meltdown, the company might not be vulnerable unless location-expansion gains get harder. Until Chipotle grows to somewhere greater than 2,000 sites, up from around 1,539 currently, and restaurant development does not provide sufficient growth, its optimistic share price may be here to stay.
Bob Chandler has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill, Panera Bread, and Starbucks. The Motley Fool owns shares of Chipotle Mexican Grill, Panera Bread, and Starbucks. 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.