Every so often, a stock comes along that trades at such a rich valuation that it becomes a "no-brainer" short. The big story of last year was Netflix (NFLX). A number of far-sighted investors, like Rocco Pendola, called the stock the "short of the century" even as it rallied past $300. Meanwhile, the market seemed to be ignoring the growth challenges Netflix was soon to face. Slowing growth, compounded by execution blunders and cost pressures soon brought the stock back to earth. The stock currently trades in the low $60s and may have more downside to come. A similar story unfolded this spring at J.C. Penney (JCP). While J.C. Penney was not a revenue growth story, investors pushed the stock above $43 in February, believing that Ron Johnson would swiftly cut costs and improve margins. At the same time, I was calling J.C. Penney "The Netflix of 2012"; sure enough, the price had been cut in half by early July. J.C. Penney has bounced back over the past month, but I think it is primed for another drop lower as the recent spike in gas prices starts to dent consumer spending.
This brings us to Chipotle Mexican Grill (CMG). I love Chipotle food as much as the next 20-something yuppy. However, offering a desirable product is not always enough to drive a company's stock price higher. After hitting a 52-week high around $440 earlier this year, Chipotle has recently slumped to $290. The worst thing for long-term Chipotle investors was that this drop was entirely predictable. In spite of broad-based economic weakness, Chipotle was priced for perfection this spring, trading at nearly 50 times analyst estimates for 2012 earnings (the current average estimate is around $9/share).
In May, I wrote the following: "Analysts are currently estimating over 22% annual sales growth for 2012, which implies perhaps 9%-10% comp sales growth. This seems like a stretch. Because Chipotle trades at a high valuation of nearly 50X expected 2012 earnings, even a small slowdown in the growth trajectory could lead to a large drop in the stock price due to multiple contraction." Sure enough, after Chipotle missed Q2 revenue expectations and offered a conservative forecast last month, the stock tumbled over 20% in one day. It didn't matter that Q2 EPS blew by expectations, at $2.56 (64% higher than Chipotle's Q2 FY11 profit). Analysts and the market focused on slowing revenue growth rather than margin expansion because of the company's rich valuation.
With the stock now trading below $300 and within striking distance of 52-week lows, some investors believe Chipotle shares now offer good value. I am certainly more positive about Chipotle today than I am about Netflix or J.C. Penney. However, while the stock is fairly valued at this point, I would be cautious about jumping in on the long side for now. On the one hand, Chipotle currently trades at a sub-30 forward P/E. This gives the company a chance of growing into its multiple by opening additional stores and increasing same store sales through additional menu price increases and throughput improvements. On the other hand, Chipotle still faces risks to its growth trajectory if the U.S. economy weakens or competitors manage to offer more competitive products in the future.
Chipotle has a relatively affluent customer base, but that does not fully insulate the company from economic weakness. In 2009, the company posted 2.2% comp store sales growth. This was a strong result considering the state of the economy back then. However, the company needs stronger growth than that to justify even a $290 share price. Furthermore, while Chipotle has a large crowd of very loyal customers, it is not immune to competition. Taco Bell (YUM) has been rolling out a more upscale "Cantina Bell" menu in recent months. Chipotle missed revenue estimates in Q2 even without meaningful competition from the Cantina Bell concept. While some reviewers have panned the Cantina Bell menu, others have given it favorable mentions. Many Chipotle customers will never walk into a Taco Bell, but others would "trade down" if Taco Bell can put out a good product. At this point, it's hard to predict how much business Chipotle might lose to Taco Bell.
Ultimately, I think the biggest risk for Chipotle today is a potential confluence of economic weakness and stronger competition. In a recession, customers are likely to be more price sensitive, and this is what could potentially drive customers toward lower-price alternatives like Cantina Bell. Therefore, I would wait until after Q3 earnings before opening a long position in Chipotle. At that point, we will have a better sense of where the economy is headed, as well as some initial data on whether sales growth at Chipotle is holding up.