This Restaurant Stock Will Either Make You Sick or Make You Rich

Having spent years studying junk bond companies, I am always suspicious when I see a restaurant company trading at a high multiple of earnings, cash flow, or debt. The restaurant business is notoriously risky – there are few barriers to entry, consumers are fickle and economically sensitive, and it is extremely difficult to maintain high quality at any point on the price spectrum.

Especially when it comes to this disaster.

Zenith Trading Circle members have already received my detailed trading instructions for this stock, and those, of course, don’t go outside our circle.

But I want to give Sure Money readers a look at some of my research on this company. I’m pretty sure you’ll find it valuable.

That is, if you haven’t died in agony first…

So I had my eye on Chipotle Mexican Grill Inc. (NYSE: CMG) for a while even before this darling of fast food suffered an E. Coli and Norovirus outbreak in the fourth quarter of 2015 that extended into the first quarter of 2016 and ultimately struck restaurants in 15 states. Such a far-reaching food safety problem indicated serious management and operational problems that struck at the heart of the business and sent customers fleeing. Since then, CMG stock has fallen hard from its 52-week high of $632.98 per share but is still trading at a ridiculous P/E of 150x. Some Wall Street firms like Barclays are trying to tell investors that the multiple is a much lower but still exorbitant 40x “estimated” earnings for 2017, but even that is too generous a multiple for a company that sells tacos. Restaurant companies should never trade at high multiples. In recent months, half a dozen restaurant chains that issued high-yield bonds have filed for bankruptcy, which is typical of what happens in this industry.

CMG is a grossly overvalued stock trying to recover from betraying its customers, and what I’ve found out about Chipotle after digging through its financial menu is alarming, to say the least.

Chipotle Has Been Overvalued for a Long Time

The collapse of CMG’s business over the last year is truly breathtaking, but what’s ahead is worse. The company just released third quarter results and the numbers should give its investors serious indigestion.

Third quarter sales dropped 14% from a year earlier to $1.04 million (from $1.22 million) while sales for the first nine months dropped 18.1% from the same period a year earlier to $2.9 billion (from $3.5 billion). Same-store sales dropped -21.9% for the quarter and -24.9% for the nine months compared to the same periods in 2015. The 3Q same store sales loss was marginally better than the 2Q (-23.6%) and 1Q (-29.7%) but still horrendous.

Remember that fast food restaurant operations run on thin margins, so if their volumes decline sharply, their profits vaporize. And that is exactly what happened to Chipotle.

While revenues suffered as a result of the poisoning scandal, profits were wiped out. For the third quarter of 2016, the company earned a mere $7.06 billion (or $0.27 per share) compared to $143.2 billion (or $4.59 per share) a year earlier. Through 9/30/16, the company earned only $6.96 billion (or $0.23 per share) compared to $403.0 billion (or $12.92 per share) a year earlier, before customers started worrying about what they might be ingesting in their burritos. In percentage terms, this represents one of the sharpest earnings collapses in American business history – a 95.1% decline for the quarter and a 98.3% drop for the year-to-date. You rarely see this kind of earnings collapse outside the commodities sector, but this is what happens when customers lose confidence in a product that can make them sick or, in the worst case scenario, kill them.

The reason for the collapse is clear – people stopped eating at Chipotle. The company saw 15.2% fewer transactions in the third quarter and 17.9% fewer transactions overall since the beginning of 2016. Trends are improving slowly but the company has a lot of work to do to regain consumer confidence. It expects single digit declines in same store sales in the fourth quarter, a forecast that seems a tad optimistic in view of the fact that this number was still running at over 20% in the third quarter. Counting on the short memory of the American consumer in the highly competitive fast food industry is a dubious proposition, especially when the media loves to report on bad news.

While management has done its best to reassure customers that its food is safe, with mixed results, it has chosen a risky strategy with respect to managing the company’s finances. One advantage the company had in dealing with the crisis is that it is debt free (one reason that it passes most of my stress tests). But the company will still need a significant cash cushion to survive this crisis. It entered 2016 with $663 million of cash and liquid investments and ran them down to $359 million by the end of September due to a decision to buy back $747 million of its overvalued stock. Most likely they figured management figured the company could borrow money if necessary since it has a debt free balance sheet. But like the rest of the greedy idiots running Corporate America, management wanted to try to prop up its stock and protect the value of its stock options at precisely the time it should have been preserving cash to deal with what is clearly an existential crisis for the company. This demonstrates poor judgment that could come back and haunt the company.

The company also has another problem – it is reportedly starting to spend significant amounts of money to fight off activist investor Bill Ackman, whose Pershing Square Capital Management bought a 9.9% stake in the company a couple of months ago. Mr. Ackman has been on a bad run of late with his hedge fund down 20% for the second consecutive year due to a particularly bad bet on our friend Valeant Pharmaceuticals International Inc. (NYSE:VRX) and poor performance across most of the rest of his highly concentrated portfolio. Mr. Ackman has suffered large losses on recent investments in consumer-related companies like Target Corp. (where he lost $1 billion), J.C. Penney Corp. (where he lost hundreds of millions of dollars and caused many people to lose their jobs and seriously damaged the company). His investment in Burger King has fared better but CMG is a turnaround investment now from an already elevated stock price, plus there are reports he has already antagonized management (something for which he appears to have a special gift). The last thing CMG’s management needs is a know-it-all activist hedge fund manager desperate to repair his own battered reputation taking out his frustrations on them. CMG stock is significantly overpriced and despite the company’s operational problem presents an odd choice for an activist investor. I do not expect this shotgun marriage to end well for any of the parties involved including the rest of the shareholders who are bystanders and would be better served by exiting the scene rather than expecting management or Mr. Ackman to pull any rabbits out of their hat (don’t worry, Chipotle doesn’t serve rabbit… as far as we know).

CMG is very overvalued and facing a very difficult battle to gain back customers who don’t want to end up in the hospital after going out for a meal.  The stock is headed much lower and is a prime candidate for you to profit from.

If you’re a Zenith Trading Circle member and you missed my detailed profit recommendation on this stock, go here now to get it.

Sincerely,

Michael

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