Chipotle Mexican Grill: Beware of Value Trap

by: Zachary Scheidt posted on: July 15, 2008 | about stocks: CMG    

Shares of Chipotle Mexican Grill, Inc. (CMG) continue to trade lower as prospects for the overall economy become dim. The most recent catalyst for a lower stock price was a report offered by Morgan Stanley, which outlined concerns for the entire retail industry. In the report, Morgan named five stocks dubbed its “fading five” which were likely to see lower stock prices. The five names were Abercrombie & Fitch Co. (ANF), Nordstrom, Inc. (JWN), Chipotle Mexican Grill, Inc. (CMG), Sears Holding Corporation (SHLD), and Best Buy Co., Inc. (BBY).

One of the temptations during a bear market is to find beaten up stocks that are good values. The problem is that often good values become even better values as prices continue to drop due to investor fear, declining earnings, and sharply lower equity multiples. This scenario is often referred to as a “value trap” in which unscrupulous buyers become convinced that lower prices are indeed better values for companies they wish to own.

While a bear market is certainly an excellent time to pick up stocks at a cheap value, good timing can make the difference between the “trade of a lifetime” and slow, frustrating financial death. Besides timing, leverage is also a very important factor. If you want to get the most bang for your buck, it is very easy to rationalize buying a depressed growth stock on margin (borrowing half of the value of your purchase). However, this is a recipe for disaster as even a 20% loss in the stock will cut out almost half of your capital and likely trigger ugly margin calls. If you are correct in picking up a stock at the low, it is probably not necessary to use margin as the returns on the stock by itself will likely be very strong. The danger far outweighs the additional benefit.

CMG strikes me as a name that is likely to suck in bargain buyers. I have felt tempted myself as gains from being short the name have accumulated. Out of discipline, I have covered a portion of my short sale to book some profits, but more than half of the short position still remains on my books. Food inflation still remains a significant factor as the company struggles to keep its costs under control. The employment picture in the US is not pretty and that causes less in the way of discretionary spending.

These factors alone are concern enough, but with CMG trading at more than 20 times estimates for 2009, the stock seems to be pricing in an overly optimistic picture for the restaurant company. I would caution growth stock buyers to steer clear of this name until the multiple is much more of a bargain, and the earnings picture becomes clearer.

FD: Author has a short position in CMG.

This article has 7 comments! Add yours below...
Zachary Scheidt

Zachary Scheidt

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This article has 7 comments:

  •  
    jdspain
    Jul 15 08:02 AM
    "CMG strikes me as a name that is likely to suck in bargain buyers"

    it is attractive and have been sucked in to buy small amounts as the knife keeps falling.
  •  
    Daniel
    Jacome
    Jul 15 06:30 PM
    My Website
    We got sucked in, too and bought @ 99, or 40x trailing....now we are sufferring -- what do you see as a support level for this stock???

    I thought it was 80 but have to revist my EVA/DCFs, cause that's not it, at least in this tape where the risk is heightened ("higher R") and the mkt is pricing in lower "g" (denominator of the PE model, blah blah blah)...that is a recipe for compression...

  •  
    Daniel
    Jacome
    Jul 15 10:00 PM
    My Website
    so are you saying 25% earnings growth for the next 2 years is not happening?
  •  
    Chandler
    Lutz
    Jul 16 04:49 PM
    My Website
    I have to say, I really like chipotle's growth prospects and potential returns. I do have to agree that the stock is still too expansive. I do think that the company still has a tremendous competitive advantage in terms of pricing. After all, I can get a (natural) chicken burrito for about $5.70...a great deal. I do think that chipotle will benefit as many consumers trade down to lower priced restaurants. Nevertheless, I am waiting to enter a position at about 12 - 15 times earnings and once the knife stops falling...
  •  
    Ben S.
    Jul 17 08:34 PM
    There is no chance CMG gets down to 12 - 15 X earnings. If it gets to 25X that would be an incredible value and would be a buy. I agree that 33X earnings might be a little expensive given today's environment, but this is a company that can grow over 20% for a sustainable period of time. If it gets to 65 it is a BUY.
  •  
    j-dub
    Jul 26 04:38 PM
    look for this to hit the mid to high 50's.
    When? I don't know but it'll get there and as it falls through 60, keep a close eye on it.
    GREAT ARTICLE-even though the suthor has a position, he defends and supports his position with disciplined facts about investing combining both math and art to articulate the reason he is right.
  •  
    Stephjen
    Jul 31 10:07 AM
    My Website
    i called for CMG short way above 100 (on my blog, studentstocks.blogspot... there's no "value trap" aspect to CMG at this level, though! still ridiculous ratios.

    unfortunately i couldn't get any shares to short through either of my brokers... only institutions are allowed to short naked!
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