- Momentum is a key factor in this industry. Mcdonald's currently has it while Chipotle is breaking down.
- I'm expecting dollar weakness in 2016, which should bring more inflation to food. If this were to take place, it would affect Chipotle more than a cheaper restaurant chain such as McDonald's.
- For MacDonald's to keep its momentum going, it has to report better than expected earnings for the fourth quarter. Success of its all day breakfast campaign should help its numbers here.
Chipotle stock is now down a whopping 35% since the 13th of October, which mainly is as a result of the E.Coli outbreaks the restaurant chain has experienced in recent months. Many analysts thought that the October and November cases were the end of this story but the announcement on the 21st of December which stated that the CDC is investigating another outbreak of e-coli among Chipotle Mexican Grill (NYSE:CMG) customers demonstrates that this problem is not going to go away anytime soon for the company.
The duration of these investigations and the current lack of transparency with respect to the source of the problem illustrates to me that Chipotle will see significant comp declines next year which will impact its operating margins. I still find it perplexing that analysts, despite the downgrades, are stating that the current Chipotle stock price level presents an exciting buying opportunity.
Furthermore the pullback in the Chipotle stock price has spiked the implied volatility rank to 93%, meaning that option premium is at historically expensive level. Nevertheless earnings is in 32 days meaning that option premium will stay elevated so premium sellers should stay out for the time being (as one won't be able to buy back premium for considerably cheaper prices). Could taking a position here end up as a bear trap? Chipotle stock, after its huge run, definitely has more risk to the downside. Let's go through them so you can make an informed decision.
Chipotle's Valuation Is Expensive Despite Recent Correction
Firstly if we look at the valuation of McDonald's and Chipotle, we see that despite the recent rally McDonalds (NYSE:MCD) has enjoyed, it is still trading with a lower forward price to earnings ratio than Chipotle (22 compared to 29). Chipotle still commands a premium price on the street as a result of its relentless growth over the past 4 years where its price to earnings average was over 50.
Momentum is a huge factor when trying to determine the value of these companies at the present moment in time. With Chipotle's close to 2,000 restaurants and Mcdonald's close to 37,000, its hard to change public perception or underlying trends at such short notice. We saw this especially in Mcdonald's in the last 2 years where the company reported declining same store sales for 7 quarters before finally reversing the trend last quarter. Even if Chipotle stops the bleeding with regards to its e-coli issues, its stock chart will look ugly and I project more losses in the near term.
In fact, I wouldn't be surprised if Chipotle stock dropped all the way back to its next major support level which is at its 2012 highs (around $440 a share). You are going to see substantial lower earnings in 2016. In fact, Chipotle has already guided that same store sales would drop double digits in the fourth quarter. This is the problem with momentum stocks. The rug can be pulled out from under the stock price at any time as momentum investors look for greener pastures. Mcdonald's p/e ratio is still trading at a discount compared to its industry which is why investors who still want capital deployed in this sector would favor Mcdonald's going forward.
McDonald's Can Make Inroads Into Chipotle's Market Share
Secondly where Mcdonald's can really make inroads into the market share it lost to Chipotle over the last few years is in its fresh food alternatives. Initiatives such as "create your taste" is a service that is directly intended to compete against the fast casual restaurant sector where restaurants have the customers sold on the quality, and freshness of its food. Mcdonald's need to push hard in the states where Chipotle has been adversely affected the most.
Promotions and marketing involving its "create your taste" offering should bring Chipotle customers to its doors - at least until Chipotle sorts out its own problems. Another area where Mcdonald's can make inroads is the pricing of its "fresh" offerings. What would really help Mcdonald's here would be if the price of the soft commodities rose (corn, wheat, etc - which I'm expecting in 2016) as these commodities are linked to the prices of beef and pork. Just look at the chart below of Wheat (NYSEARCA:WEAT) to see how Chipotle (which is selling its products at a premium compared to the fast food sector) has benefited from subdued grain prices over the last few years.
Some analysts state that recent price hikes which took place at Chipotle stores this year didn't affect sales comps and this may be so. But I can only see grain prices increasing going forward. A low cost restaurant like Mcdonald's would be able to withstand rising meat prices compared to Chipotle which if they keep increasing its prices will definitely alienate some of its customers.
McDonald's Likely To Beat Earnings Estimate
Now that Mcdonald's fourth quarter has come to an end, all eyes point to its fourth quarter earnings which will be announced on the 25th of January. The consensus EPS forecast is $1.22 and I feel the company will announce a beat which sustain the company's present momentum. Why? Well just look at the company's third quarter results. It beat expected forecasts by over 10% which powered the stock price forward by over $20 a share since late September.
Secondly the dollar index was more or less flat over the 3 month period which should mean international sales were not affected that much. The ECB meeting on the 21st of January (4 days before) will be crucial to Mcdonald's for 2016. If Europe can continue its hawkish stance, it should mean the dollar wont make new highs which long term is bullish for Mcdonald's due to its international markets. Also the fourth quarter should demonstrate the success of the "All Day Breakfast" initiative which is definitely gaining traction since it was implemented a few months ago.
To sum up, Mcdonald's has the potential to win back market share from competitor Chipotle. Chipotle stock would witness a disaster in my opinion if the US were to enter a recession, its e-coli problems persist and food prices rise meaningfully. If any of these scenarios play out, Mcdonald's will be the restaurant chain to benefit despite the stock trading at all time highs. It seems to be getting its house in order. Earnings for the fourth quarter will reveal if momentum hasn't stopped.