The valuation debate rages on for Chipotle Mexican Grill's (NYSE:CMG) stock.
After shares dropped as much as 17% since its all-time high of $727 in February, a Barron's report now says the stock could fall another 15% to 20%, citing rising food costs, slowing growth, and growing competition.
Chipotle is no stranger to bear calls. In 2012, hedge fund titan David Einhorn famously shorted the stock, making a similar argument to Barron's, saying that Chipotle sales would slow due Taco Bell's new Cantina Bowl lineup and that the stock was dramatically overvalued.
Though Chipotle shares plummeted nearly 50% over a six-month period in 2012, they have since battled back, gaining over 150% from that low point. Barron's argument may be familiar to Chipotle investors, but it's important to understand the potential downsides of a stock and any reasons to sell. Let's take a closer at the bearish thesis put forth by Barron's.
1. Increasing threat from competition
Author Jack Willoughby notes that competitors like Fogo de Chao offer "fresh food alternatives" and points out that Taco Bell has improved its ingredients in an attempt to emulate Chipotle's success. He also says that a slew of restaurant IPOs have come on the market over the last year, including much-hyped Shake Shack. These are creating a new crop of well-funded alternatives to Chipotle.
This argument of Chipotle succumbing to competitors has been made many times before and has always proven false, however. There have been plenty of pretenders that were supposed to steal Chipotle's thunder, like Qdoba, Baja Fresh, and Lime Fresh Mexican Grill, to name a few. All of which have failed to stop Chipotle's monstrous growth, and as it gains in size and momentum, it seems unlikely that any competitor will throw it off track. The restaurant industry is huge and highly fragmented. Even if a viable contender for the burrito crown were to emerge, there is plenty of room in the market for other successful chains. Just look at fast-food burger joints, of which there are more than 30,000 nationwide.
2. Slowing growth
Chipotle missed revenue expectations slightly in its last two reports, prompting the sell-off that's soaked the stock this year. Investors have also been scared away by projections of only modest same-store sales growth of low-to-middle single digits this year.
Charles Lieberman, chief investment officer at Advisors Capital Management, said he expected the company to have trouble expanding at a pace of 200 new stores a year, believing the stores would begin cannibalizing themselves and that good real estate would be hard to find. However, the opposite has been true as Chipotle has succeeded by focusing on "A-Model" stores, which have smaller footprints than its traditional restaurants. As customer preference has shifted to takeout, such a model has become more practical, and it has led to increasing operating margins by lowering occupancy costs.
Regarding concerns that Chipotle's overall growth is slowing after a blockbuster performance in 2014, CFO Jack Hartung noted on a recent conference call that comps tend to move in three-year cycles so a lull is natural after such strong growth last year. It's not unusual for most businesses to see such a shift.
Chipotle shares aren't cheap, especially compared with legacy fast-food chains like McDonald's and Yum! Brands, but at a P/E of 41, today they are acutally modestly priced by historical comparisons. And with less than 2,000 stores under its umbrella, the company should have a long growth path ahead. Considering several major chains have more than 5,000 locations domestically, it's easy to imagine Chipotle reaching that figure, if not eventually 10,000 or more. This is plausible when factoring in the potential of nascent sister chains ShopHouse and Pizzeria Locale. With average unit volumes near $2.5 million, among the top in the restaurant industry, and comparable sales still growing, the demand for more Chipotle locations is clear. All the company has to do is execute.
While the burrito chain remains in a strong position overall, the stock could still see a near-term pullback. The market has been disappointed with the two previous reports this year, and a third subpar report could send the stock tumbling. Still, investors should be mindful to view any sell-off as a potential buying opportunity, rather than a reason to run from the stock.
Jeremy Bowman owns shares of Chipotle Mexican Grill. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of 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.