On Oct. 2, 2012, Greenlight Capital’s David Einhorn described his latest short idea at an annual value investment conference. This time, Einhorn targeted Chipotle Mexican Grill, Inc. (NYSE:CMG). Einhorn outlined the bearish case for the company and focused on two points.
First, he argued that Chipotle Mexican Grill, Inc. (NYSE:CMG)’s business was vulnerable to competition. Jeffrey Gundlach, a famous bond investor, supported Einhorn and stated that “All you need to compete with CMG’s core business is a taco truck.” In other words, it doesn’t take a scientist to make burritos, and everyone can do it successfully enough to become the next Chipotle. This obviously implies that the company has no economic moat whatsoever.
The second point that Einhorn made was about Chipotle Mexican Grill, Inc. (NYSE:CMG)’s valuation. At the time Einhorn first disclosed his short recommendation, Chipotle was trading at an overly rich price-to-earnings of 60x. Einhorn claimed that this valuation was extremely high and unsustainable, especially for a consumer discretionary food business.
But in order to obtain a wider perspective on Chipotle, let’s look at it in the light of other two dominant quick-food-service chains – the giant McDonald’s Corporation (NYSE:MCD) and the tasty Panera Bread Co (NASDAQ:PNRA).
Chipotle will do just fine
I believe that in contrast to Einhorn and Gundlach’s beliefs, Chipotle Mexican Grill, Inc. (NYSE:CMG) will perform well over the next few years, and that’s for the following three reasons.
I think it’s plain silly to say that anyone with a taco truck can compete with Chipotle. It’s like saying all you need to compete with McDonald’s is burger patties and a flattop grill. The fast food sector, as a whole, is very competitive. But once you are able to establish your brand, distinguish it from the rest and make people return to you – then is when your business becomes highly lucrative.
For example, both McDonald’s and Chipotle Mexican Grill, Inc. (NYSE:CMG) enjoy a high profit margin of 30% and 20%, respectively. Such a high profit margin is a great indication of having a sustainable economic moat. In all other cases, such high profit margins aren’t supposed to exist in a truly competitive environment. Panera Bread Co (NASDAQ:PNRA), for example, lags in that aspect — it’s only able to show an operating margin of 13%, which means that some of its rivals are slowly biting into its bottom line.
It’s all in the growth
Chipotle’s business has been growing … and fast. Sales have doubled the last five years and earnings have risen 270%. Chipotle is consistently profitable, with double-digit net margins. The number of restaurants is up 30% in the last three years.
In the most recent quarter, the company reported earnings of $2.45 per share, beating the Zacks Consensus Estimate of $2.14 per share by 14.5%. The earnings grew almost 24.4% from the prior-year quarter, driven by higher revenues, lower taxes and share count.
True, the company’s high price-to-earnings is a bit stretched, but it certainly a far cry from the multiples of various social media companies like LinkedIn Corp (NYSE:LNKD) or Yelp. At a current price-to-earnings of 40x, Chipotle Mexican Grill, Inc. (NYSE:CMG) trades at a little more than twice the average S&P of 18 times earnings. It’s high, yes … but it also grows at four times the rate of an average S&P company. Whereas McDonald’s Corporation (NYSE:MCD), for example, increases its earnings by 1% year-over-year, Chipotle is able to show a magnificent 14% increase in earnings.
It makes sense to pay for that speedy growth. Panera is right next to Chipotle with an annual earnings growth of roughly 16%. But keep in mind that Panera is half the market cap of Chipotle. It’s easier to grow when you’re small. Things become more difficult as you grow in size.
Most people probably don’t remember this, but Chipotle Mexican Grill, Inc. (NYSE:CMG) was spun off from McDonald’s Corporation (NYSE:MCD). The people running it are some of the world’s best in the quick-service restaurant industry. And they’re also shareholder oriented — in the first quarter of 2013, the company bought back 164,000 shares worth $51 million. During February, the company announced the addition of $100 million to the existing share repurchase program.
Panera is also an aggressive buyer of its shares. The major problem with Panera Bread Co (NASDAQ:PNRA) is that its share buy back program is in a strong downtrend. In 2010, management bought $125 million worth of shares. In 2011, that number decreased to $95 million, and in 2012, it was a mere $25 million. I always like to find share buy back programs in an uptrend such as in the case of Chipotle Mexican Grill, Inc. (NYSE:CMG), and not in a downtrend as in the case with Panera.
Einhorn and Gundlach are shorting a highly profitable company with rapidly rising sales and earnings and great management. I believe that you can’t short a fantastic business run by great people just because the P/E ratio is a little rich, especially in the current bull market environment. Eventually, the market will decide who’s right.
The article Mr. Einhorn, You’re Wrong On Chipotle! originally appeared on Fool.com and is written by Shmulik Karpf.
Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill, McDonald’s, and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald’s, and Panera Bread. Shmulik is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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