Bad Earnings Could Burst This Burrito

Posted On October 19, 2015 10:43 am

Chipotle Mexican Grill (CMG) is set to report earnings on October 20th and a disappointing report could leave investors with indigestion.

Shares of Chipotle (CMG) has been a tremendous success story. It has set the standard for redefining the fast food industry in both the food it delivers to customers and profits to shareholders. Since going public in 2006 shares have gained a whopping 1,300%. Which helps explain why just as every NBA draft tries to anoint the “next Michael Jordan” every IPO of a fast/casual chain since has tried to become the “next Chipotle.”

But just as neither has ever truly been matched and neither can still lay claim to currently being the best of in the game. Chipotle’s best days are behind it. Its growth rate no longer supports its high valuation and makes for an attractive short candidate. Especially in the current environment in which stocks carrying high valuations or p/e multiples have been taken sharply lower.

At $722 a share it currently trades at 45x forward earnings even though its earnings growth rate has dropped to 13.2% and expected to hover at that level for the next few years. Why would the forward multiple ramp higher when growth is clearly slowing? To stretch the analogy, it’s like when Lakers when gave Kobe Bryant $45 million after he ruptured his Achilles; they paid for what he did in the past with little realistic hope he could deliver the same performance in the future.

A few of the challenges facing Chipotle include that with over 1,800 locations in the U.S how many more can the market support? The company continues to open new stores but at a drastically lower rate of just 2.5% per year. Meanwhile the market seems to be pricing expectations for 5,000 locations by 2020. I just don’t see them getting to that number. There is just too much competition from names like Fiesta Grill (FGRI) that are delivering high quality at competitive prices.

A more disturbing trend has been that same store sales, which once ran at unheard of 18%-21% over the past few years declined precipitously to a more pedestrian 9% over the prior two quarters. And most of those gains came from price increases rather than sales volume.

Also, the notation that Chipotle is “healthy” has come under attack recently as various groups have noted not only the high calorie count of most of its offerings but also questioned the “organic” label of its ingredients.

Chipotle has seen the limits of its burrito based empire and has been branching out two new concepts, the Asian themed ShopHouse and artisanal Pizzeria Locale. But traction has been slow, since announced the two years ago they have a grand total 10 and 4 locations respectively. The company has been very quiet on those expansion plans suggesting they are still little more than drawing board distractions.

Despite a lackluster second quarter earnings report on July 21 that highlighted these challenges shares gapped up some $40 or 6% and then continued to hit a high of $758 in early August.

The price action following that earnings report seemed inexplicable to me but I wasn’t going to stand in its way.

But now the technical picture has turned bearish. The chart has broken trend lines and put in a double top when it failed to take out th $750 high last week. It offers a good risk/reward entry point for establishing a bearish position.


CMG Chart 10.18.15

If the company fails to earnings that exceed Street expectations the stock should quickly drop back to the old gap at $670 which is also the 200 dma.

The Trade:

I’m purchasing a put spread in the January 2016 expiration. Specifically;

-Buy January $710 puts

-Sell January $670 puts

For a $14 net debit for the spread.

Here is the risk graph and pertinent stats on the position.

CMG risk 9.3.15

My downside target is $670 a share. At which point the spread would be fully-in-the-money and worth $40 for an 185% gain.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.