Why Chipotle Mexican Grill Inc Stock Is Not A Buy For Now

  • Chipotle's premium brand is at a risk. It is not so much because of the e-coli outbreaks but because of how the company has responded to them.
  • Franchising has been touted as the next step for Chipotle following Ackman's stake. Scaling this business model would be difficult.
  • While the incentives will slow down, they will never disappear. Chipotle has lost crucial market share which may never come back.

Ok, forget Chipotle Mexican Grill Inc.'s (NYSE:CMG) earnings at present as every bit of gross profit and cash flow is being pumped into cleaning up the restaurant chain's image and getting bums back on seats. However, what we can focus on is the chain's sales multiple which currently stands at 3.5. Now for any true value play, value investors usually look for a sales multiple of less than 1. We just are not there yet with Chipotle. In fact, even when you compare Chipotle with competitors in this space, it is still overvalued as the industry average is 2.6. The stock caught a bid on Wednesday, the 7th (rose by almost 6%) when news broke about a well-known activist, Bill Ackman, doubling down on the stock.

Also Read: Should You Follow Bill Ackman Into Chipotle Mexican Grill Inc. Stock?

I would caution investors here in not getting long this stock at this stage despite the $300+ price drop its share price has undergone. Why? Well, there is a real danger that its brand has been permanently impaired here. This stock was the prize jewel of the fast casual segment. Its margins and earnings growth propelled the stock to well over $700 a share last year but the e-coli breakouts stopped the company's momentum in its tracks. I for one believe we will never see former margins return due to the magnitude of the damage done by the health scares. Here are more reasons to stay away from this stock at the present moment in time.

Also Read: Chipotle Stock May Never Return To Its Former Highs

Entering The Burger Market Was A Big Mistake

Offering burrito coupons or giving kids free meals at weekends is one thing but selling burgers and pizzas is another. Burgers especially is a hugely competitive market and this is where I see its brand weakening over time. Why? Because Chipotle will find it very difficult to compete in terms of price/quality in this area. Furthermore, the chain hasn't started out very well. Also, over time, if customers feel they are getting value for money with their burgers, they will also demand it with their burritos.

Franchising Is Not The Answer

Although some investors bought last week when news broke of the Ackman stake, you can bet there are more waiting in the wings to see what comes out of his pending meeting with the board. One of the areas being touted as being definitely up for discussion will be franchising. The franchising business model would allow Chipotle to scale out its restaurants at a far quicker rate but it in no way guarantees overnight success. Yes, it would improve cash flow in the short term (something Chipotle needs badly as its cash reserves have been shrinking). However, where I see the risk in franchising is the "loss of control" which may not affect the likes of McDonald's or Burger King that much but would definitely affect the likes of Chipotle. Why?

Also Read: Chipotle Mexican Grill Inc Stock A Great Pick For 2016 And 2017

Well, it is a traditional fast casual restaurant meaning its prices are typically much higher than typical fast food chains. Therefore it's not just price that matters but also the experience where value and speed are huge priorities

Chipotle Would Lose Control Of Its Employee & Food Culture

Moreover where I feel Chipotle would lose control if it adopted the franchising model would be in its employee culture and food culture. On the employee side, Chipotle being in full control of its people means the company itself hires the right people for the job. Working for a franchise is totally different from working for a company and I believe this shows up in the service.

On the food side, Chipotle even more so in the wake of its e-coli problems has prided itself with its "food with integrity" mantra. Would these standards hold up in franchised restaurants where the sole aim of the owners would be to make a profit every month? For me, it is difficult to see how franchise owners wouldn't cut corners here. Remember their vision is always short term compared to the long term vision of the company. A company will usually make a long term investment for the right reasons but a franchise owner would want a return on the initial investment immediately. Themes such as partnering with local grocers will come under pressure if this chain scaled too quickly. All these factors would gradually erode the brand in my view which is not good for Chipotle in the long term.

Same Stores Sales Growth Is Only Improving Because Of Incentives

Before the market is going to become seriously interested in Chipotle again, it has to demonstrate meaningful same stores sales growth first. Investors need to take into account the elevated spending Chipotle is undergoing to get traffic numbers up. Yes, traffic has been returning but is it core traffic that the company had before or customers only coming in for freebies and discounts? Furthermore, traffic is one thing but margins are another. Trailing twelve months operating margins of 8.2% are now half of what they were before the outbreaks struck. I just believe that management is not going to be able to turn off the drug (loyalty programs & discounts) here. Top line fell by $202 million last quarter on a rolling year basis and cash reserves fell by $609 million. These numbers alone tell the story.

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Chipotle Stock Continues To Make Lower Lows

On the technical front, Chipotle is probably going to be helped in the short term as the S&P500 is about to rally out of oversold conditions. Technical traders will be looking to see if the stock can take out its July highs and May highs. However, even if it does temporarily make higher highs, I feel the stock will once again roll over when the market realizes that core fundamentals are not going to improve for this stock.

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To sum up, Chipotle stock is still not a buy despite Bill Ackman's recent $1.2 billion investment. Its sales multiple is still too high compared to the industry and its margins I feel will never return to their former glory. One of the main reasons why this stock rallied so strongly up to 2015 was that the company owned and controlled all its restaurants. However, with cash reserves dwindling, re-franchising may be on the cards which will not suit this company due to its food quality constraints.

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  • I do not have any business relationship with the companies mentioned in this post.
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