David Emami's  Instablog

(previously published on royalnotecapital.com)

I am by nature an optimistic person. This inclines me to be a bull. I find great joy in pouring over financial statements and finding hidden intrinsic value in companies that are under valued. Unfortunately however, during the course of my research, sometimes I come across a stock that is grossly overvalued. This was the case with Chipotle. I first looked at CMG when it was trading at 430. I looked at its financials not as a prospective short, but as a prospective buy. After some initial analysis, I realized that CMG was significantly overbought. I did not short CMG at the time however. It was in the middle of a tremendous stretch. Rich Hogan, a Merrill Lynch money manager once told me "You're dead right", regarding one of my value investment ideas. "You are right, "He clarified. "But by the time the market realizes you are right, you will be dead broke." With his words of wisdom etched into my brain, I remained an interested observer on the sideline. After CMG's disappointing earnings, the time to short is now. The momentum is broken and the hedge funds are dumping CMG in droves. Now CMG should retreat to levels supported by the fundamentals. What levels are these you may ask? I answered this very question in an internal company memo about a week ago when we were discussing shorting CMG. Below, you guys can see a rare glimpse of part of our Due Diligence process. This position and strategy is designed to be maintained for a few months, so despite the fact that we started this trade last week, the method can still be used at current prices.

Memo: RE: Short strategy for CMG

Intro: Chipotle Mexican Grill (CMG) is a chic quick service restaurant chain specializing in Burritos. Their ethos is all about treating their animals, customers and employees right. CMG operates 1316 restaurants (all but 5 in the USA). In the last quarter, CMG opened 55 new restaurants including their first in Paris. For the 2nd Quarter of 2012 (ending June 30), CMG reported earnings of 8.32 per share. CMG currently trades at 298 a share, and has a 52 week range of (271-442) per share.

Brief call and why: I thought this was a short at 430 and I think it's a short at 300. CMG is a food company trading at multiples of a growth company. As evidenced when they disappointed the Street by missing revenue targets by 16%, growth stocks are punished severely if there are any signs that growth is stagnating. CMG also reported the growth in same store sales slowed to only 8%, their slowest growth since 2010. In the earnings call the CFO said that "we are seeing a slowdown. Not a significant slowdown but there is no other way to put it." For his candor, Wall Street dropped CMG by over 20%. Due to macroeconomic pressures - most notably the drought that is projected to raise food costs by 3-4% in 2013, and a stagnant economy that is making consumers unwilling to accept the higher costs, I believe CMG will experience slower than expected growth, which will prove catastrophic on the stock.

Recent News: CMG reported revenue growth of 21%, Net Income growth of 61% and same store sales growth of 8%. In the facing of rising food costs, CMG raised prices last quarter and that is being blamed in part for the slower growth. This will prevent CMG from raising prices again and force them to absorb the higher costs. Analysts in the recent conference call raised questions on whether management could be trained or hired fast enough to keep pace with the expansion of stores and whether the opening of new stores would continue to be as profitable as it had been in the past in light of the current economic situation.

SWOT ANALYSIS

Strengths: Posted Earnings of 6.76 per share, 2011- just had strongest Earnings per quarter $2.56 (still growing but slowing) revenue growth, plans to open even more stores and spread to emerging markets

-limited exposure to Europe

Summary: their strengths? - recent success. What forward looking strength do they have? They were first to the healthy/hip burrito market, they have growing brand name recognition, strong company culture. Low debt .35 debt to equity ratio gives them the capital needed for aggressive expansion

+6

Weaknesses: priced higher than other quick order competitors.

-1

Opportunities: will open many new stores and are exploring emerging markets such as Peru

+1

Threats: Rising food costs due to a record drought will cut profit margins by around 3%. Slowing same sales growth will force the company to seek growth thru capital-intensive expansion. In the past quarter there were some signs that newly opened stores were not doing as well as in the past. CEO admitted that expanding into emerging markets where they are less established may cause new restaurants there to have slower launches. Company's stock price is vulnerable due to high P/E multiple and classification as a growth/momentum stock. Company is owned by many institutional investors (most who have already made large profits) who will dump the company if it is no longer considered a growth stock. CMG must continue to wow Wall Street with earnings growth to justify their high multiple.

-6

SWOT total= 0

Bearish/neutral.

Financials:

(to view the charts more clearly, view the original article at www.royalnotevalue.com/2012/08/chipotles... )

Motley Fool Value+Growth Buffett test:

Comments: There is no question CMG is a growth stock. It has the revenue growth to justify its high valuation but it is still a food company trading with a technology company's P/E multiple. As demonstrated this quarter, 21% revenue growth with rising costs is not sufficient to remain a growth company and continuing to justify its high valuation.

Growth Model:

http://www.editgrid.com//publish/calc/user/wikiwealth/Stock-Research-Summary-CMG?savebar=0&show=tb%2Cfb%2Crh%2Cch%2Cmb%2Csl%2C&bookid=5419426&version=2&frame_style=border%3A9px%20solid%20%23666%3Bheight%3A380px%3Bwidth%3A100%25&edit=1

I raised total COGS as a % of sales from current levels- 73.5% to 75% as a result of the drought and every single valuation model predicted negative long term returns. I allowed the company to still grow at a similar pace (albeit declining) and reach mature company status in 2019. These models show company value and don't reflect the temporary effect of price shocks (i.e Earnings beats/misses). This shows that true to a value play, we have a margin of safety by shorting a company that is over valued. My expectation that CMG misses earnings next quarter and the ensuing negative price shock will present an opportunity to make an outsize profit with limited risk.

Trading Strategy:

Current Share price: $298

Bearish Risk Reversal Option:

Buy X CMG 295 Jan 14 Puts for $52.00 a contract

Sell X CMG 300 Jan 14 Calls for $52.30 a contract

Trade results in a $30 debit per 100 share contract.

Exit points: Stop loss will be set at 5% above Call Strike Price ($315.00)

The greater stop loss is set because CMG is heavily traded and may get days of heavy volume where it rallies. A tight stop loss leaves us at risk of being stopped out.

Target Price= $202.80 March 2013.

Although CMG should continue to grow EPS. Growth at 20% year over year would give them earnings of 8.11 a year for 2012 but would again disappoint Wall Street, which has come to expect yearly growth over 20%. With earnings growth at 20%, it will be difficult to justify CMG's P/E of 35 and it will be brought to a more reasonable multiple like 25x earnings. 25x earnings of 8.11 would give CMG a valuation of $202.80. Earnings for first half of 2012 are 4.53 (historically CMGs strongest 6 months. Expected stagnation coupled with rising costs could conceivably see earnings for the 2nd half of 2012 fall to the 3.6-4 range.

Consensus analyst estimate for 2012 is 9.02 according to NASDAQ.com. However, the consensus yearly growth rate for EPS 2012 is 33%. I think that CMG falls close to or under the EPS number, but misses growth projections. For a growth company, it is more important to be seen as growing than current profits.

Risk Profile of Trade:

Behaves as a synthetic short - Break even is between 295 and 300.

We profit as the price of the underlying security declines

We are exposed to Primary market risk- if the stock goes up, we lose money

We have limited climate risk- the drought has done its damage to this years crops for the most part

We have very slight dividend risk- it is unlikely CMG announced a dividend as it is a growth company

We have some economic risk- QE3 could lower interest rates and flood the market with easy money bringing up the market in general

We also have sector risk- if restaurant stocks are up during the course of the trade, while CMG will under perform, it may not fall. A strong market or strong sector can mask the weaker fundamentals.

Disclosure: I am short CMG.