Tuesday, July 25, 2017

Why is Chipotle Stock So Overpriced?

Why do people only look at share price when investing and not fundamentals?

The press has been gleefully reporting more setbacks for Chipotle Mexican Grill.  The latest is a viral video showing mice dropping from the ceiling of one location.   Earlier this month, at least one or two people were sickened by the Norovirus, usually something you see on cruise ships.

Coming in the wake of the major E. coli outbreak they had a couple of years back, you wonder why anybody would want to eat there.  I remember when a Chipotle first opened in Old Town Alexandria.  I believe at that time they were owned at least in part by McDonald's.  We went once, and never went back.  It really isn't Mexican food in my opinion, but rather burritos the size of your head.  This is what Americans think Mexican food is like.

You get this burrito thing which is almost the size of a football and it's on a plate and you have to cut it apart with a knife and fork.  You can't pick it up and eat it like a real burrito.  When you try to eat it with a knife and fork, all the stuffing comes out, and you're basically just shoveling this goop in your face - and it's not very appealing or tasty.  It's not even eating.  It's just fueling your body with stuff. But Americans like that kind of crap, I guess, and they've never actually been to Mexico so they don't know what food is like there.

But for some reason Chipolte stock has been really popular, particularly with amateur investors.  I'm guessing here, but I believe that the sort of people who sit on the computer all day and trade stock tips are the same kind of people who eat at Chipotle Grill.  You know, severely overweight IT types we're going to "make it big in the stock market" by stock picking, but for some reason, that never quite works out.

That must be the explanation, because I can't figure out for the life of me why Chipotle Mexican Grill stock has a P/E ratio of over 100.  And yes this is even after the stock took a nosedive after the mouse and norovirus incidents.  This is also years after the E.coli nightmare was cleaned up.

In case you were wondering, a P/E ratio of 100 is staggeringly high for a restaurant chain.  It means you have to wait over a hundred years to make your money back on Chipotle stock.  A pretty standard rule of thumb is a P/E ratio should be around $20 for most traditional Industries, this represents about a 5% rate of return on your investment.

The few exceptions might be in industries which are expected to grow exponentially very quickly, in which case the market is buying ahead of itself, proceeding that the company question has potential for huge growth.  Maybe some "dot com" company can get away with a P/E ratio of 100 or more, if it looks like they will expand by a factor of 10 in a few years.   A restaurant chain?  Be serious.

Given the crowded nature of the fast food and fast-casual dining, there's a lot of competition in this marketplace.  There are many other restaurants like Chipotle, including local chains and Mom-and-Pop shops.   We have a local chain here that is a clone of Chipotle, right down to the head-sized burritos.  The barriers to entry are low, and there is no protectable IP.  Anyone can make a burrito, there is no Patent on it.

In order for Chipotle stock price to make any sense, would have to increase in size by a factor of five, and that doesn't seem likely even if we didn't have the ecoli norovirus in mice incidents.

Failing spectacular growth, they would have to increase the profitability by a factor of five.  Or maybe they could slash prices to the bone, pay their employees in burritos, and raise prices through the roof, to achieve a P/E ratio at least less than 50.  But it doesn't seem like the profitability of the company is going to increase anytime soon - certainly not by a factor of five.

Compare Chipotle's stock price that at Mcdonald's. Or more precisely their P/E ratios. McDonald's has a P/E ratio that is somewhat high at 28, meaning you have to wait 28 years to make your money back. It also means that it's earning about 4% every year, which is pretty respectable, particularly compared to Chipotle.

Then consider dividends, or the case of Chipotle the utter lack of them.   They think their stock price is such a great deal by itself, there is no need to pay back shareholders:
Dividend Policy
We are not required to pay any dividends and have not declared or paid any cash dividends on our common stock. We intend to continue to retain earnings for use in the operation and expansion of our business and therefore do not anticipate paying any cash dividends on our common stock in the foreseeable future.
That's right, Chipotle pay no dividends whatsoever, whereas McDonald's currently cranks out about 2.44% in dividends and has a long rich dividend-paying history.  This means McDonald's is paying out more than half its earnings and dividends, which means the shareholders are being rewarded for the profitability of the company.

Chipotle is acting like it is some sort of dot-com tech company, instead of one of the most traditional of industries around - the restaurant business.   Restaurants are businesses of thin margins, regular profits, and predictable performance.   Chipotle is acting like it is Uber and that growth alone will sustain it, and the need to make profits or pay dividends is secondary.  That strategy may be backfiring.

And you have to ask yourself, why would they do this, and why do articles appear hyping the stock price?   Well, one explanation might be that some of the key employees might be paid in stock options, and thus have a motivation to keep the stock price sky-high.

So ask yourself this, if you are a Chipotle shareholder.  Where are you going with this?  What do you think is going to be the payoff for Chipotle?  Are they so flush with cash that the company is worth what the stock says it is?  Or is somebody else going to buy out the company and pay this outrageous price for it, even though it's not very profitable?  Or do you really think it's going to increase in profitability by a factor of five sometime in your lifetime?

Why would someone think this stock is worth over 100 times its earnings?  Oh, right, the financial press.  Online websites abound which offer stock "analysis" that amounts to little more than speculation.  Take for example, this "article" on "investorplace"
When I last discussed Chipotle, the technical expectation was bullish. The anticipation was that a smaller, first-stage weekly base would continue to hold support and resolve itself with a clean breakout above $500.

That was on May 8. As is apparent on the provided daily chart, CMG stock failed to comply.

Over the past few sessions, conditions have become increasingly grave for shorter-term traders as shares  broke below a fairly decent-looking hammer candlestick. [wtf?] More important in our view is the $425-$430 area — a critical support area for the current uptrend, and one that remains intact.
The highlighted words sound so technical and smart, yet they mean absolutely nothing.  The article is accompanied by a chart of the stock price, with lots of lines drawn on it.  No mention is made of profits, dividends, P/E ratios, or any other metrics.  Just stock price.   Read the entire article - it is gibberish.   What the author is saying is that the price should go up, just because of momentumOh, and because of a 2-for-1 burrito offer.

Note also, that this fellow seems to be suggesting leveraging yourself to make a "play" in the stock - using derivatives (going long and short).   This is very risky investing for the amateur.

People read gibberish online "stock reports" and bid up the prices of stocks into the stratosphere.    And in this case, that is exactly what happened to Chipolte stock.  In the last few years, the price has been bid up from $75 a share to $750 a share, for no apparent reason whatsoever.   And as the price has spiked so has the P/E ratio, form a more modest 29 to an outrageous 500, before settling down to the 103 we have today.   This looks like a classic example of a bubble, as it is too drawn out to be a pump-and-dump.

Granted, profits in the past were pretty good, but back then, the P/E ratio was at least rational.    The relationship between share price and profits seems disconnected.   And this tells me that people investing in this stock are not looking at anything but share price.

And sadly, this is how I invested when I started out, listening to idiotic advice like this, and trying to divine something about a company based on its stock price chart.   You have to look at the fundamentals.   You can't divine what a company is worth based on its price history.  A place that makes burritos is not a gold mine.

Or maybe you just bought the stock because you like the burritos, never really thought much about price-to-earnings ratios, dividend yields, or where the company might be headed.  And well it might seem there's a Chipotle on every corner near the tech sector of every large city, there really aren't as popular across the country as other fast food and fast-casual chains.

One of the biggest mistakes I made early on in investing was to buy stocks and companies because I liked their products.  And this is very typical, I think of a lot of young people.  We buy stocks in things which were familiar with because it gives us a level of comfort.  But we don't think about the basic financial soundness of the company involved.  A company could make a great product and still be headed for bankruptcy, or at the very least, be overpriced.

It doesn't take but a few people to bid the stock price of any company through the roof.  This doesn't mean the majority of the market thinks the company is worth that, only that a few people are willing to pay that much, and  a few more are unwilling to sell.

And it first, a fast food company might seem like a pretty safe bet, is they are making products and selling it and us are making profits and have very low risk of going bankrupt.  But as Chipotle is demonstrated three times now, unforeseen incidents can cause huge disruptions in their business.  The e.coli thing took at least a couple of years to die down - and profits really never recovered from that.  I think these latest incidents, particular the mouse one, will probably take at least 6 months to a year for sales to recover to even post e.coli levels.

And of course, it could just be that football-sized burritos are no longer a "thing" - the landscape is littered with the skeletons of fast-food chains that peaked and died, as people lost interest.  I miss Little Tavern.

But even assuming they could overcome these latest setbacks, the stock is still wildly overpriced.  It's P/E ratio is in tech territory, but it doesn't have the potential logarithmic expansion that some tech companies have.   Burritos are not tech. 

It just makes no freaking sense whatsoever.  And when things doesn't make any sense, one of two things is going on.  Either I'm too dumb to figure out what's going on, or maybe I'm smart enough to see that what's going on is idiotic.

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