One of the Hottest Stocks of the Past Decade Could Plunge 20%

Nearly a decade ago, the best thing going for McDonald’s (NYSE: MCD) was its 90% stake in Chipotle Mexican Grill (NYSE: CMG). But the burger chain decided that burritos weren’t in its future, and it spun off its stake in 2006 in an IPO. 

Since then, shares of Mickey D’s are up a respectable 200%, while CMG is up an eye-popping 2,600%. I’m guessing few people at McDonald’s ever dreamed Chipotle would eventually have a market value exceeding $18.5 billion. No other fast-casual dining chain has been able to grow at a 15% to 20% annual pace as Chipotle has, and investors have come to deeply admire such strong growth.

A quick glance at the financial forecast tells you the Street expects this growth to continue. Analysts anticipate revenue will grow in excess of 20% this year to around $3.9 billion, and rise another 17% next year to $4.6 billion. Per-share profits are expected to reach a record $16.07 next year, roughly triple what the company earned in 2010. Chipotle’s management deserves recognition as one of the most focused and disciplined executive teams of the 21st century.


Yet despite Chipotle’s impressive accomplishments, investors have growing reason for concern, namely market saturation and operating costs. 

Chipotle now operates more than 1,600 stores across North America and the U.K. Those stores are typically placed in high-traffic, middle-income neighborhoods. Part of this company’s success stems from identifying these neighborhoods, and finding those first 1,600 was the easy part. The next neighborhoods won’t be such low-hanging fruit. This suggests that it will be harder to replicate Chipotle’s historical track record of sales per square foot.

Market saturation comes from a different angle as well. Rivals such as Rubio’s, Qdoba Mexican Grill, owned by Jack in the Box (NASDAQ: JACK), Baja Fresh and Moe’s Southwest Grill are all expanding. (Moe’s, for example, is embarking on rapid expansion, signing 120 new franchise deals in the first six months of 2014.) And according to data analytics firm Statistica, each of those chains garner a 7.4 to 7.7 taste rating, just a tick below Chipotle’s 7.8 rating. 

Smaller burrito chains, such as Freebirds World Burrito and Costa Vida, which offer similar meals at similar price points, are also opening up in locations that may bump up against a nearby Chipotle. Chipotle has simply out-marketed them until now, but this is a business model that is easy to mimic.

CMG bulls suggest that the company has another card up its sleeve: a new Asian food chain known as ShopHouse, which has been discussed with investors for several years, but still has just seven restaurants opened. The slow pace of development could be a sign that management doesn’t see the same kind of runway for growth for ShopHouse as it did for the core burrito business. 

At the end of the day, investors need to grasp that Chipotle is already quite large, and growth later in this decade will range from merely respectable to good, but not meteoric, as has been the case in the past. 

It’s fair to assign a premium valuation to a stock with such a great track record of execution, and likely respectable growth ahead. But this has become a “must own at any price” kind of stock. It’s currently trading at a forward earnings multiple nearly double that of its peers.

Perhaps the greatest threat to Chipotle — beyond saturated markets and lofty valuations — is a steady march higher in operating expenses. In the most recent quarter, management noted an unexpected uptick in both food and general overhead costs. 

“Chipotle experienced worse than expected commodity inflation during the quarter, with beef, avocado and cheese undergoing the most pressure,” note Merrill Lynch’s analysts, adding that “these pressures have accelerated in 2Q.” That helps explain why 2014 EPS forecasts have been steadily falling over the past few months. 

Indeed, CMG missed Q1 EPS estimates by around $0.20, and another quarterly shortfall may be looming. “Very high food costs and another heavy quarter of stock based compensation (non-cash) expense will pressure 2Q EPS,” predict Merrill’s analysts.  

To offset rising costs, Chipotle is in the midst of raising prices. But to a great extent, the fast-casual dining segment is price elastic. Management can’t simply assume that it can retain full traffic levels while pushing higher prices. 

A few months back, this was not a good stock to own going into quarterly results. With the next earnings announcement scheduled for July 21, I believe this is again the case, especially when you consider that reflexive buying has pushed CMG back toward the $600 mark after the springtime swoon. 

All of these issues aren’t to suggest that Chipotle is anything less than a great company. But it’s increasingly clear that it is wrapping up a remarkable decade and is poised for greater growth challenges in the future. It’s getting hard to justify a forward P/E multiple approaching 40. A range of 28-30 seems more suitable, which suggest a downside target in the $450 to $480 range.

Recommended Trade Setup:

— Sell CMG short at the market price
— Set stop-loss at $625
— Set initial price target at $480 for a potential 20% gain in three months