It's Finally Time To Short Chipotle, Part II

| About: Chipotle Mexican (CMG)
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On June 17th, the first article in this series was published, outlining one reason (aggressive promotion at Qdoba) why I thought there was potential for Chipotle Mexican Grill (NYSE:CMG) shares to finally begin falling. Coincidentally, shares were up about $12 during the session on June 18th. For the next handful of sessions, shares moved relatively sideways =- until plunging on June 27th.

"Plunging" is an accurate way to describe the June 27th session's decline -- measured in dollars, it was the second largest drop in Chipotle's trading history. Confusingly, the drop did not seem to be not tied to any major news. There were two negative news items, but the Street seemed to be surprised that they did so much damage. One item was news about a lawsuit over Chipotle's assertions of natural/organic product use. The other was a cautious research note published by ITG, in which ITG stated that it believed that revenue would come in below expectations. Still, the shortfall ($700m per ITG vs. $706m consensus) is virtually immaterial.

To me, the market's reaction to these bits of news only further indicates that a downward slide may be imminent. Not only did shares fall $24 (6%), but they did so on nearly 400% of normal volume, indicating that major holders may have been lightening positions. I can't blame them for wanting to take gains, but if there's a continued rush to the exit, the share price will move in a downward direction.

But the primary reason why I believe that Chipotle shares will underperform over the next few months has to do with the launch of a brand new competitor -- the Taco Bell (NYSE:YUM) Cantina menu.

Taco Bell's Cantina items will be rolled out nationally on July 5. They were tested in multiple markets and did well. Items have generally been revewed favorably by early eaters. Taco Bell will offer new, upscale tacos, burritos, burrito bowls, and sides at pricepoints that are approximately half of what Chipotle charges.

I haven't tried the Cantina items myself, and I'm not even completely sold on whether Taco Bell regulars will enjoy them, or if they will pull customers away from Chipotle, Qdoba, and other fast-casual Mexican restaurants. However, I do think that people will try the Cantina items, and that alone may be disastrous for Chipotle's Q3 comps and earnings.

Taco Bell launched its extremely popular Doritos taco earlier this year, and 100 million were sold in 10 weeks. I do not expect the Cantina menu to achieve that level of success, but even a tiny fraction of that has the capacity to materially weaken Chipotle's results. I think it's possible that Taco Bell may sell 10 million Cantina entrees during the third quarter; this is less than 20 per store per day (based on 90 days and 6,000 stores).

For purposes of the following calculation, I assume that Chipotle currently sells about 70 million meals per quarter (based on approximately $700 million in revenue and a per-meal price tag of roughly $10). This translates into about 780,000 meals per day, or 650 meals per store per day. For the sake of conservatism, I will also assume that only one third of people that try a Cantina entree are doing so instead of eating at Chipotle that day.

Based on 3.33 million Chipotle meals (30 meals per Chipotle location/6 meals per Taco Bell location) foregone in the third quarter, the expected impact to Chipotle's revenue would be approximately $33 million -- about 5% of expected revenue. If 5 million Cantina buyers substitute a meal for Chipotle, Chipotle revenue will be impacted by about 7%. If consumers choose to skip 10 million Chipotle meals, Chipotle's revenue could come in $100 million below expectations, at approximately the same level as Q4 2011. To encourage trials, Taco Bell will surely be advertising heavily, and the allure of a half-price meal at a restaurant without a line will encourage consumers to try the new Cantina items as well.

It seems that even moderate consumer curiosity (the 3.33 million base-case) may be enough to cause Chipotle to miss earnings expectations. If consumer adoption is higher, the potential for an earnings disaster exists. Because of CMG's premium valuation, any miss will likely be punished by the market. There is also some chance that Chipotle management may temper third quarter guidance during the second quarter call (if they view the Cantina threat as being very serious) or sometime before the third quarter release (if trials at Taco Bell adversely affect Chipotle sales).

The major potential mitigating factor will be the quality of the Cantina items. If they are not tasty (or at least not an acceptable substitute for a Chipotle meal), there won't be many sold. Word of mouth (in real life, or on Facebook or Twitter) travels quickly and will discourage others from deviating from tried-and-true Chipotle. But if the items are good enough, many people will try them -- and there's a good chance that the college kid currently eating Chipotle three times a week might change his routine to save $15 for beer.

Chipotle shares have had an amazing run, but it seems like the story may favor the shorts over the coming quarters. Chipotle is currently facing an aggressive promotion from Qdoba ,and may soon face an even bigger threat from Taco Bell. Shares have now broken through important technical levels, and the market seems skittish and reactionary towards any bad news. Tougher comps in the second and third quarters (due to a price increase that went into effect last summer) will only make it more difficult for Chipotle to continue to show the impressive same-store sales growth that has propelled its shares to such heights.

Since my first article was published, I have purchased out-of-the money puts. Puts are definitely the safer way to play the potential downside in CMG shares; the $12 pop on the day Part I was published was a timely example of how shorting CMG has been painful for many bears over the past months and years. Unfortunately, put prices increased on June 27 due to the large drop, and volatility premiums will likely remain high through July 19, when second quarter earnings are reported. If shares don't do much before and after earnings, put buyers will lose their large premiums. But if bad news materializes, look out below. If there has ever been a time to be bearish on Chipotle, I think it's now.

Disclosure: I am short CMG.

Additional disclosure: I have a bearish position in CMG via September 2012 and January 2013 out-of-the-money puts.