Contrarian's Corner: Chipotle Mexican Grill's Shares Will Recover From the E. Coli Outbreak

It's the week of Christmas and stock market activity has slowed. U.S. stocks are slightly higher in late morning trading on Tuesday, with the Dow Jones Industrial Average (^DJI 0.69%) and the S&P 500 (^GSPC 1.20%) up 0.66% and 0.54%, respectively, at 12:35 p.m. ET.

Things are not as calm for Chipotle Mexican Grill: Three-quarters of the three-month average daily volume had already changed hands 10 minutes into today's session. The shares are currently down 4.24%.

Colorized scanning electron micrograph of E. coli bacteria, grown in culture. Author: NIAID. Republished under CC BY 2.0.

Chipotle's shares continue to suffer from food poisoning as the E. coli outbreak that was first reported at the end of October continues to take its toll with a downgrade from J.P. Morgan, which lowered its price target to $555 from $630.

Here are the numbers: So far, 47 confirmed cases of E. coli poisoning have been linked to Chipotle across nine states (though it should be noted that the infections have been isolated to a period of less than a month, Oct. 19 to Nov. 13).

At 11:18 a.m. ET, the shares were at $500, for a 4.2% drop on the day, for a more than one-third (34.1%) decline relative to the 52-week high established in August. Not all of the latter decline is attributable to the food scare; since the outbreak was first reported, the shares are down by more than a fifth (21.9%).

The last time Chipotle's shares were under $500 was on May 21, 2014, which is an indication of the huge run-up they had enjoyed. At their August high, they were almost certainly overvalued and their fall has brought them down to earth, closer in line with their fair value.

While they don't yet look like a screaming opportunity, they are beginning to look interesting (purchasing shares of a superior business at fair value is a favorable proposition).

There is a precedent for this. In Dec. 2006, contaminated lettuce resulted in an E. coli outbreak that affected 71 Taco Bell customers in five states on the East Coast; eight of the customers subsequently suffered kidney failure. This bad news was compounded by a Feb. 2007 news report of a rat-infested KFC/Taco Bell restaurant in New York (video of the rats occupying the location went viral).

From their December high, the shares of Yum! Brands, which owns Taco Bell, fell 12.5%. By that standard, investors would appear to have overreacted to Chipotle's current woes.

Incidentally, by the end of 2007, Yum Brands' stock was 21% above its Dec. 2006 high. Five years on from its crisis low, the share price had compounded at 19.1% annually (the S&P was lower over the same period).

If you think that Chipotle's valuation multiples look prohibitive, even after the stock price has shrunk, here is a benchmark to ponder:

Over the 12 months to the end of September, Chipotle had revenues of $4.56 billion. To get to an equivalent figure for Starbucks Corporation, one has to go back to its fiscal year 2004 ending on Oct. 4, 2004, during which it had $4.46 billion in revenues. The following table shows Chipotle's valuation multiples today versus the average value of Starbuck's multiples during the last quarter of its fiscal 2004:

*EV: Enterprise value (the sum of market capitalization and net debt). **EBITDA (earnings before interest, taxes, and amortization -- a measure of cash flow). Data source: Bloomberg.

As a contrarian, I tend to believe the overreaction hypothesis is a genuine phenomenon. In this case, "overreaction" may be a bit strong, since the shares don't look screamingly cheap but rather reasonably priced. The overreaction may be more applicable to describe the enthusiasm that pushed the shares above $750 this summer.