Chipotle: Great at Upsetting Investors' Stomachs

NEW YORK (TheStreet) -- As a value investor, there was a point when I would have considered a 25% to 30% drop on a stock due to an earnings miss an overreaction. In fact, it would signal that it just might be time for me to buy because there is fear on the street.

However, when it becomes clear that the stock is yet facing some valuation challenges after the fact -- particularly with the metrics that matter -- it forces me to wonder if that reaction was drastic enough.

This scenario seems to be especially relevant to Chipotle Mexican Grill ( CMG) after having dropped from $404 per share just prior to its earnings report to just slightly over $300 in what seems like a blink of an eye.

While its came as a surprise to most, it should not have been the bombshell that many have made it out to be. If one took time to carefully study the stock, it could have been seen a mile away -- or at least a couple of days ahead of the report.

The questions on investors' minds are, when will the bleeding stop and at what point does the stock become a buy? Before we try to answer, let's take a look at what caused the indigestion.

Some Upset Stomachs

For the quarter ending in June the company reported a net income of $81.7 million, or $2.56 per share, on revenue of $690.9 million. This compares with having earned $50.7 million or $1.59 per share in the same period of a year ago.

Essentially its total revenue soared 21% due to an increase in new store locations as well as higher foot traffic at its existing restaurants.

In fact, the company said it saw an 8% increase in revenue from its stores that have been opened at least one year. In the restaurant business, this is one of the best indicators of strength and a critical appraisal of fiscal performance as it removes potential outliers from newly opened or closed stores.

Clearly the company is doing well in all facets of its business. So what exactly was the problem? Investors wanted more.

According to FactSet and a recent poll of analysts, expectations were for the company to earn $2.30 per share on revenue of $704.8 million. If you are keeping score at home, on Wall Street this is called a miss -- causing many upset stomachs.

Another concern during the quarter was that the company's comps appeared to have slowed -- breaking its string of double-digit comps that has lasted almost two years. This was my biggest concern when I recently issued the sell recommendation ahead of its report.

What's more, management did very little to assure investors that this was a one-quarter trip-up -- suggesting comps for Q3 would likely arrive at the low single digit range.

Moving Forward

This has to be troubling for Chipotle as the entire sector, which includes McDonald's ( MCD), Starbucks ( SBUX) and Yum! Brands ( YUM) earn their valuations broadly due to their comps.

So in asking earlier, when will the bleeding stop and should investors buy in on the current weakness, we have to also consider to what extent will the slowdown in comps last, because outside of that it is a straight gamble.

As much as I love eating at Chipotle, its stock price has never really made sense to me. I've never believed in companies that are priced for perfection as it has been. It has to continue to execute flawlessly in order to maintain its lofty valuation.

So to that end, the company must demonstrate that not only that it can maintain its high margins, but it has to convince the street that this is not the start of a new trend -- proof that can only be seen from execution of more than one quarter.

So it is understandable and justifiable in the punishment that the stock has received. But that does not mean it is a bad company, only that caution is now advised.

With that in mind, I think investors should look to alternatives such as Starbucks and McDonald's -- particularly the latter as it should be one of a handful of value alternatives that benefits over the long term.

Interestingly, the word "value" comes in to play here not only for the advantages presented by having a "value menu" in tough economic times, but also because, relative to its peers, its stock continues to trade significantly undervalued levels.

Bottom Line

Chipotle is by no means a terrible company -- that much is clear based on its earnings report. As always the case, what drives valuations continues to be expectations and to what extent they are being managed and met by the company.

Unfortunately Chipotle fell short in a couple of areas. But as I have warned previously, this is not the fault of the company, but rather the inherent risks with dismissing value for growth.

From an investment perspective, as the stock currently sits just above $300, I would consider adding moderately as part of a long-term position but would not advise throwing all of my capital into the stock at this point. It will take at least another week before the bad news subside and is fully priced into the stock.

I think it is also realistic to expect shares to return to $320 to $340 by the end of the year. But this is all predicated on the company's ability to demonstrate that it has its comps in order.

At the time of publication, the author was long AAPL and held no position in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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