Chipotle: Ready To Crash At The First Sign Of Bad News

| About: Chipotle Mexican (CMG)

With a market cap of $12.03 billion and current share price of $380, Chipotle Mexican Grill (NYSE:CMG) is a fast-growing company that offers what it calls "Food with Integrity." Chipotle has been successful, because it offers healthy high-quality food, in a fast and efficient manner. Chipotle's success has made many investors a lot of money. Over the last three years the stock price has increased by 377%. It is obvious that investors like Chipotle's growth potential and have been willing to pay up. Chipotle's price-to-earnings ratio is 52.19 and its price-to-book ratio is 10.47. These are exceeding high price multiples for a restaurant stock. As a result of the high multiples, some analyst have the opinion that Chipotle is overvalued, and that any bad news will cause the stock price to crash. So far these types of dismal analyst predictions have been wrong. While it is true that Chipotle's stock has had some bad days, the company's long-term stock price has held up pretty well. Over the last year the stock price is up by 16.7%.

Despite Chipotle's high price, investors have continued to support the stock because of its above-average growth. Chipotle has had seven quarters of double-digit same-store sales growth, and in the first quarter it increased same-store sales by 12.7%. In addition the company increased first-quarter year-over-year revenue by 25.7% and first-quarter year-over-year net income by 35%. Chipotle currently has 1,230 restaurants, and in the first quarter it opened 32 new restaurants.

Despite the fact that Chipotle's is still growing at a remarkable rate, I have reservations about investing in its stock. One of the reasons that I have reservations about Chipotle is because its stock is priced for perfection. The price-to-earnings ratio and price-to-book ratio, are far higher than any of its competitors.

For instance YUM! Brands (NYSE:YUM), which hosts Taco Bell has a PE ratio of 19.9 and a PB ratio of 13.5, while Jack in the Box (NASDAQ:JACK), which hosts Qdoba, has a PE ratio of 17 and a price-to-book ratio of 2.7. In terms of the more upscale restaurants that compete with Chipotle, Panera Bread (NASDAQ:PNRA) has a PE ratio of 29.9 and a PB ratio of 6 and Darden Restaurants (NYSE:DRI) has a PE ratio of 14 and a PB ratio of 3.5.

Chipotle's valuations have risen to such lofty levels based on its rapid growth and near perfect execution. The problem with investing in Chipotle, is that in order for it to maintain its high valuations, it will have to continue growing at a pace that is similar to the pace that it achieved over the last three years. I believe that will be difficult for the following reasons.

Competition

When I look at look at the difference between Chipotle's valuations, and those of its competitors, I get the feeling that Chipotle's super high valuations are unsustainable. Other large and successful restaurant chains, which are not that much different from Chipotle, have been unable to maintain valuations anywhere near Chipotle's. Chipotle also carries the burden of being the market leader in Mexican dining, which means that competitors will be shooting for it. On July 5th, Taco Bell unveiled its new Cantina Bell menu. The Cantina menu will include much more upscale, "Chipotle-like items." YUM Brands, which operates Taco Bell, "hopes to chip away at Chipotle's stranglehold in the gourmet Mexican market." Jack in the Box is also taking aim at Chipotle through its Qdoba product line. Qdoba provides customers with a wide choice of Mexican cuisines, and has been offering discounts at many of its stores.

Economy

Chipotle could also encounter problems as the economy now seems to be slowing. Investors know that in order for Chipotle to maintain its high valuations, it needs to continue its rapid growth. Flat earnings or anemic growth would probably cause investors to shun Chipotle. In an effort to continue its rapid growth, Chipotle has begun opening restaurants in Europe (England and France). If the recession continues in Europe, and the U.S. economy continues to slow, it is unlikely that Chipotle will be able to maintain its current growth levels.

Momentum

Since its IPO in 2006, Chipotle has been a new and exciting restaurant alternative for many Americans. The restaurant offered delicious Mexican cuisine, in an upscale environment for about $10.00 per meal. I think Chipotle had a wonderful idea, but I believe that it is inevitable that the novelty will wear off. In the first quarter Chipotle's same-store sales increased by 12.7%. On June 27, analyst Steve West of ITG said that "revenue at restaurants open at least a year seemed to be decelerating, with his forecast for second-quarter growth between 7 percent and 8 percent." If Mr. West is correct, then same-store sales growth will fall, and so will the company's earnings growth.

Conclusion

Chipotle's stock has had a really great run. Since July of 2009 the stock price has risen from around $80 to its current level of around $380. However, almost all good things come to an end. I think the stock is overvalued and could crash whenever the company reports bad news. In some ways, Chipotle reminds me of Netflix (NASDAQ:NFLX), another company that had unsustainable valuations. The stock skyrocketed to a high of around $305, then fell to around $61 within one year, after it failed to meet earnings expectations. I think Chipotle has a much more stable revenue base than Netflix, and I am certainly not suggesting that Chipotle's stock will take that kind of hit. However, I do think that it is risky to invest in stocks that have extremely high valuations, which are based on highly optimistic growth expectations. As I mentioned earlier, Chipotle's stock is priced for perfection, and that makes investors nervous. Potential investors should take note of what happened on June 27 and 28, when Chipotle's stock price dropped by $38.46 or about 10% on two minor bits of bad news.

Chipotle reports second-quarter earnings on July 19. If the company meets earnings and growth expectations, the stock price will likely move higher. However, if earnings come in below expectations, the stock price will probably take a nasty hit.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.