This was originally sent to subscribers of TheStreet.com Breakout Stocks on Feb. 8 at 2:10 p.m. EST. For more information on this newsletter, click here.
The initial public offering market can be extremely lucrative for investors, or extremely painful. While only a small percentage of individual investors can purchase shares in an IPO alongside the large institutions, investing in new issues can often yield big profits.
For example, shares of sports apparel maker
are up more than 50% from the closing price of its Nov.18 IPO date.
One recent IPO that is worth looking at is
Chipotle Mexican Grill
, a spinoff of fast-food giant
. As with many IPOs, shares of these stocks sometimes become overpriced quickly. Once this happens, it is crucial to know at what point investors should consider taking a position, or ignore the IPO all together. Chipotle's shares are overpriced now, but they could fall to become a compelling investment.
Chipotle's Jan. 26 IPO can only be described as a smashing success for those lucky enough to get in on the deal at the $22 offering price. Shared doubled on the first day of trading to $44, and were recently trading at $46.20, delivering a 110% gain so far.
However, we believe fundamentals trump near-term momentum trading when performing research, so we would like to present investors with our view of the numbers.
Chipotle was a small Colorado-based chain until it was acquired by McDonald's in 1998. Using McDonald's financial might and real estate savvy, Chipotle has now expanded to become the third-largest Mexican fast-food chain in the U.S., with about 500 stores, revenue of $582 million and $22 million in operating income over the past 12 months.
With only 500 stores, Chipotle most certainly has ample room to expand. Prudential Equity Group sees the company's potential at 2,200 to 3,800 stores within nine and 13 years. Prudential also notes that the company has only 3% of the Mexican food category, compared with 38% for market-leader Taco Bell.
Chipotle's higher-quality food, which includes healthier ingredients like vegetarian-fed chicken, positions it as the "upscale Taco Bell." This should allow it to take market share not only from other Mexican chains, but also traditional fast-food chains like
and even former parent McDonald's, whose customers may wish to switch to relatively healthier, but similarly priced, food.
We believe valuation should not be investors' main concern when analyzing stocks with organic growth stories. We are generally more interested in growth potential, the quality of fundamentals such as cash flow generation power, and the size of a company's addressable market.
However, some caution is warranted with Chipotle. At nearly 64 times Prudential's estimated 2006 earnings of 71 cents a share, the company is easily the most expensive restaurant/fast-food stock in the market. Even if Chipotle delivered 20% earnings upside, it would still be trading at 53 times forward earnings.
Chipotle can grow its store base at a 15% to 20% rate over the next five years. With 500 stores, it has not even begun to penetrate the U.S. fast-food market. However, same-store sales have already started slowing, from 24.4% in 2003 to 8.7% in 2005.
Assuming same-store sales increase 4% to 6% over the next few years, we don't see annual earnings growth exceeding 25%. Even if Chipotle earned as much as 85 cents a share in 2006, a 25% or even 30% growth rate on a 53 forward price-to-earnings multiple isn't particularly attractive relative to other high-growth names in our coverage universe, such as restaurant chain
P.F. Chang's China Bistro
, which trades at 30 times forward earnings.
The primary risk to our negative stance on Chipotle would be better-than-expected sales results. In addition, the company could experience a substantial margin expansion as the store base gets bigger and the company can better leverage its expenses.
Nonetheless, we are keeping Chipotle on our radar screen because of the company's long-term growth potential. Should shares come down to the $35 to $37 range, we will definitely consider adding a position in the stock to the Breakout Stocks model portfolio. But for now, we believe lucky IPO participants should book some profits.
The TSC Breakout Stocks Team is Michael Comeau and William Gabrielski, research associates at TheStreet.com. In keeping with TSC's editorial policy, they don't own or short individual stocks. They also don't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. For more information about Breakout Stocks, please