by David Sterman
In the final stages of the dot-com boom, a number of stocks tacked on stunning gains day after day, in what's known as a "melt-up." These stocks were no longer logically valued on any sort of fundamental basis, and instead were squarely in the hands of momentum investors that know a happy stock chart when they see one.
I've been looking at three companies that looked fairly pricey a month ago, and now they're much more expensive today. You'd be crazy to buy these stocks now, and with a strong stomach, you're likely to make a tidy profit if you're willing to go against the tide and short them.
Netflix (Nasdaq: NFLX)
I thought this company looked overvalued at $170 in late October. A month later, its shares have breached the $200 mark. And at that price, it's unclear what investors think they're getting.
If you assume that cash flow for this video rental firm can grow +25% annually in the next five years, then you're looking at around $670 million in cash flow by 2015. The stock trades for around 15 times that figure. Find me another stock that trades for 15 times projected 2015 cash flow. There aren't any. And that +25% annual cash flow growth forecast implies that Netflix will keep finding more and more customers and more than double its revenue base in the next five years. That's the kind of logic that fueled tech stocks in the late 1990s, and we know how that turned out.
This is a great company with more growth ahead of it, but investors have simply gotten carried away. One bad quarter and Netflix could turn out to give back its +100% gain that it has posted since this summer. That's -50% potential downside.
Chipotle Mexican Grill (Nasdaq: CMG)
In a similar vein, a huge number of investors are piling into Chipotle Mexican Grill, pushing its shares past $100 in February, $150 in June, $200 in October, and $250 in the last few trading sessions. It has "gone vertical" as the trading pros like to say.
Yet at $250, the stock is no longer connected to any sort of fundamental logic, trading at roughly 40 times next year's earnings, even as earnings growth is starting to slow (click to enlarge).
Chipotle has recently extolled expansion plans that could take annual revenue to $3 billion by 2014 and earnings per share (NYSEARCA:EPS) to $10. Trouble is, that implies +15% to +20% sales and profit growth, hardly the kind of growth that justifies the stock's current scorching valuation.
Up until now, Chipotle has done a very impressive job of establishing a reasonable bar and then exceeding it. That worked fine while most analysts played the wait-and-see game with their estimates. Nowadays, the bar is set much higher as analysts seek to more accurately forecast the robust quarters to come. And that could be trouble as momentum investors own this stock for its habit of handily exceeding forecasts. Delivering quarterly results that are merely in-line with forecasts would likely be met with a harsh reaction by the mo-mo crowd that has been able to already post sharp gains in this name.
With the exception of the week of November 8, shares of Chipotle have finished every week with a gain since August 9. The key here is to watch those gains start to cool. If and when Chipotle's chart starts to move sideways, you'll know that buyers are fatigued. And that will be great time to either book profits if you own it or short shares if you are looking for a downside play. Realistically, shares deserve to trade at about 30 times next year's profits, which implies a -25% downward move.
Salesforce.com (NYSE: CRM)
November has been awfully kind to this purveyor of software that helps to track sales leads. Shares, which had already nearly doubled this year, surged from $110 in November to a recent $141. That's a +20% move in just eight sessions.
You can understand why investors have always loved this name: sales grew at least +40% every year from 2002 to 2009. These days, sales growth looks set to cool to around +25% in the year ahead. The bottom line is cooling as well, as per share profits are likely to grow around +25% in the fiscal year that begins next February. The fact that shares trade for an eye-popping 90 times projected fiscal (January) 2012 profits should give you pause.
Why such a lofty valuation? For starters, investors bandied the company around as a takeover candidate this summer, though the current $18 billion market value now makes that much less likely. Second, the company is seeing solid interest for its new "Chatter" software, which is a Facebook-like feature that works with the company's customer relationship management software. Chatter doesn't add to revenue, but it does help to retain customers that may think about defecting. Third, the company just delivered a very robust quarter and is firing on all cylinders. Fourth, CNBC's Jim Cramer keeps saying "buy, buy, buy" on his TV show, and that's what his loyal followers are doing. (A whiff of the Pied Piper if you ask me…)
As is the case with the Netflix example cited earlier, you'd have to make some pretty heroic assumptions for Salesforce.com's free cash flow growth in the next five to 10 years just to simply justify the current share price, let alone make a case for any upside. This is a very good company, but shares do not deserve to trade at 90 times next year's profits and 10 times trailing sales. The free cash flow yield is around 2.5%, which makes it very hard to make any sort of case for solid returns from here.
Netflix, Chipotle and Salesforce.com are all extremely vulnerable to profit-taking. As I said earlier, you'd be crazy to buy these stocks now. And if you hold any of these names in your portfolio, consider selling. Fast.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.