Hold the E. Coli -- Here's Why You Shouldn't Bite on Chipotle

Shares of the Mexican restaurant chain plummeted after customers got sick from contaminated food. Don't buy the notion that this bad news is a buying opportunity; the stock is overvalued.
By John Persinos ,

So, is this week's bad news about an E. coli outbreak linked to Chipotle Mexican Grill  (CMG) - Get Report restaurants just a "temporary blip" that's really an opportunity to buy the stock?

Nope. This overly hyped purveyor of burritos is cooked for the long haul.

Sigmund Freud is often credited with saying: "Sometimes a cigar is just a cigar." And sometimes, bad news is just ... well, bad news.

Shares of Chipotle plummeted 2.5% on Monday, a four-month low, after at least 22 people fell ill from E. coli linked to the popular "fast-casual" Mexican restaurant chain. The affected customers reported vomiting and bloody diarrhea.

The company voluntarily shuttered 43 of its eateries, and health officials expect more cases to arise. This crisis for the company is far from over.

Founded in 1993, the Denver-based company operates about 1,900 Mexican restaurants, including 22 Chipotle restaurants outside the U.S. The chain has received consistently fawning press and it enjoys particular cachet with hipster millennials who don't mind paying $7.50 for a no-frills burrito.

The stock already was overpriced and the chain overextended, even before yesterday's devastating health scare.

And now, cue the trial lawyers: One lawsuit already has been filed by a sickened customer, with more probably on the way.

Before yesterday's news, Chipotle had been a Wall Street darling and in the vanguard of the "fast-casual" dining trend. Over the past five years, the stock has gained 166.64%.

CMG data by YCharts

Fast food is losing market share to fast-casual chains such as Chipotle that occupy a niche in between traditional burger-and-fries outlets such as McDonald's and formal restaurants. Other leading fast casual chains include Brinker International, which operates Chili's Grill & Bar, and Panera Bread.

Popular with middle-class consumers who are feeling pinched by stagnant personal incomes, fast-casual chains are driving growth in the restaurant segment. According to the market research firm NPD Group, fast casual is the fastest-growing restaurant segment.

Chipotle management on Monday quickly went into damage control and announced that it's working with health department officials to determine the cause of the outbreak. Some analysts are now claiming that this bad news is merely a speed bump along the stock's long road to capital appreciation.

Don't bite. Even before yesterday's negative headlines, Chipotle was an overpriced stock looking for a trigger to fall. Rather than seeing the E. coli outbreak as a rare buying opportunity, you should see it as a warning sign.

In its third-quarter operating results, Chipotle showed signs that it had come too far, too fast,  and that growth was beginning to slow. The company missed third-quarter earnings estimates, and revenue growth slowed for the fourth consecutive quarter. Monday's store closures aren't the end of the story, and they're bound to weigh heavily on fourth-quarter earnings.

And yet, the stock's trailing-12-month price-to-earnings ratio now stands at 37, vs. about 21 for the S&P 500, 24 for McDonald's and 15 for Brinker. And Chipotle pays no dividend.

The public tends to remember E. coli outbreaks for a long time. However, this incident is a double whammy for Chipotle, because the chain has taken great pains to market itself as a good corporate citizen that only serves "responsibly raised" meat and unprocessed ingredients with no genetically modified organisms.

Chipotle had planned to open nearly 195 new restaurants this year and is testing a new tortilla with "super simple" ingredients. The company's marketing has even gone so far as to criticize the artificial ingredients and processed foods commonly found on the menus of its competitors.

The unfolding E. coli disaster at Chipotle certainly does underscore the dangers of buying a stock that's overvalued and ripe for a fall.

Chipotle's woes should rebound to the favor of fast-casual competitors such as Brinker, which is in the midst of sustainable expansion and sports a reasonable valuation. If you're looking to tap the fast casual trend, Brinker is worth a look.

And if you're concerned about other overvalued stocks poised for collapse, here's a list of the world's most dangerous stocks.

John Persinos is editorial manager and investment analyst at Investing Daily. At the time of publication, the author held no positions in the stocks mentioned.

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