What Do the Shorts See in Chipotle?

The Fool is hosting a live chat with Chipotle co-CEO Montgomery Moran next Tuesday at 12 noon ET. It will last one hour. Come to Fool.com then to participate.

Burrito maker Chipotle (NYSE: CMG  ) has more than its share of detractors.

In the past week alone, 17 of the 33 Fools to rate the stock in CAPS say it will underperform. A handful of them are among our highest-rated investors, including jwfoster and jesvlim. They and others worry that the stock is overvalued at current prices.

"This remains one of my favorite companies, but I can't justify the current valuation," wrote Foolish colleague Rich Greifner (TMFTenacious) in sticking the red thumb to Chipotle in CAPS earlier this month. "Wouldn't be surprised to see this one drop 25%+ on less-than-great news."

Wall Street would appear to agree. According to Capital IQ, 10.6% of the burrito baron's shares outstanding are sold short. By contrast, only 1.5% of fast-growing Yum! Brands (NYSE: YUM  ) shares have been sold short. Yum! is the company behind Taco Bell.

What the shorts believe
Color me unsurprised. As a group, Big Money buyers have taken profits this year, and insiders haven't exactly been enthusiastic about the stock. As of October, executives had sold more than $5.5 million in the previous 12 months.

But lack of enthusiasm is no reason to short. Nor are valuation concerns. Plenty of stocks that appear richly valued have delivered wonderful returns over the past year, including salesforce.com and Netflix.

No, there has to be something wrong in order for shorts to get involved. My guess is that they fear Chipotle is overspending on expansion, positioning itself to become the next Starbucks (Nasdaq: SBUX  ) in the very worst sense of the phrase.

Why they're wrong
You may remember that Starbucks expanded too quickly, to the point that a record for rising same-store sales turned negative in 2008. Iconic CEO Howard Schultz was forced to return as the day-to-day leader of the coffee champ, but not in time to keep revenue from falling 5.9% in the year ended September 2009. Only now that newfound efficiencies have led to a better-than-20% return on capital over the past 12 months has growth begun to return.

Chipotle shows no ill effects from overexpansion or anything else. Margins and returns on capital are rising. Revenue continues to grow by double digits, and cash is flowing. Roughly $170 million has found its way into Chipotle's coffers over the past year. The company carries close to $300 million in net cash on its balance sheet.

Putting that in perspective, it cost Chipotle just $850,000 to open a new store during 2009. Management has enough cash on hand to open at least 350 stores right now. No additional financing needed.

The one legitimate risk facing Chipotle owners
Far as I can tell, the only real risk facing investors is valuation. It's as if the short sellers believe Chipotle is priced as if it must become the next Starbucks, forcing a pattern of overexpansion that can only end badly.

I think that's far too pessimistic a view. Yet there's little doubt that Chipotle commands a premium, trading for 44 times normalized net income. Trouble is, the stock traded for a similar multiple in 2006 and has rewarded shareholders handsomely in the years since.

What's more, comparable restaurateurs Red Robin Gourmet Burgers (Nasdaq: RRGB  ) and California Pizza Kitchen (Nasdaq: CPKI  ) trade for 55 and 30 times normalized earnings. Chipotle's valuation can't be that far out of whack, can it?

Maybe it can. But I'm more inclined to believe that Chipotle is simply a premium business selling for an appropriately premium price. I'm happy to hold on to my shares.

Think I'm wrong? Is Chipotle setting up for a fall? Please vote in the poll below and then leave a comment to explain your thinking.

Join us for a live hourlong chat with Chipotle co-CEO Montgomery Moran next Tuesday at 12 noon ET. It's going to be spicy.

Netflix and Starbucks are Motley Fool Stock Advisor selections. Chipotle and salesforce.com are Motley Fool Rule Breakers recommendations. Chipotle is also a Motley Fool Hidden Gems pick. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is a member of the Rule Breakers stock-picking team. He owned shares of Chipotle at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool owns shares of Chipotle and Yum! Brands and is also on Twitter as @TheMotleyFool. Its disclosure policy is enjoying carnitas at the moment. Back soon.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 12, 2010, at 1:48 PM, AndreWilliamson wrote:

    "Far as I can tell, the only real risk facing investors is valuation."

    Bingo. That's all that is needed to be bearish here. This is an absolutely fantastic company, but the stock is priced for perfection.

    Using a 2006 peak multiple to justify why the current multiple is ok isn't a great approach imo - first of all, folks buying at that prior peak were underwater for a long time. Second, the company is probably 3-4 times bigger than it was then, and that makes future growth that much harder to attain.

    I think it's more instructive to think about the PE in concrete terms: the company, in a positive environment, is generating ~175 million in net income, but has been priced recently at $7-$8 BILLION. That is a pretty big disparity.

    I think stockholders with a 10+ year price horizon have nothing to worry about, but anyone less committed (i.e., just about everyone) runs a big risk here. Besides, why not wait and see if there's a much cheaper entry point in the near future?

  • Report this Comment On December 13, 2010, at 10:44 AM, AceOfSpades13 wrote:

    44x income? Can you spell overextended? Do trees grow to the sky? I'm waiting for a good short-entry point - and it looks like we're might be there very soon...

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