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A Meaningful Catalyst for a Stock

By Scott Chan on April 30, 2018

On Thursday, Chipotle (NYSE:: CMG) enjoyed its best one-day jump in more than 10 years. For only the second time in the last ten quarters, the company reported better-than-expected revenue (by a small margin). But earnings per share of $2.13 crushed the consensus estimate of $1.56.

Investors have been optimistic since Chipotle hired CEO Brian Niccol away from Taco Bell in February. The hiring lit a fire under the share price, which had rallied 35% since the hiring even before Thursday’s jump. The earnings beat further fueled optimism that new leadership will turn the ship around.

Turaround Plan in the Works

Niccol promised to unveil the details of his turnaround plan in a special call sometime over the next few months, but did reveal some hints.

Chipotle will seek to enhance digital experience and access, innovate its menu, and improve restaurant design. Translation: make it easier for people to order remotely, making changes to the menu, and make the restaurants look better.

Niccol emphasized making the brand much more “visible.” In other words, he views rebuilding the Chipotle brand as a high priority. After the repeated bad PR in recent years, the branding definitely needs rejuvenation.

When asked during the earnings conference call, Niccol was also open to the idea of expanding customer access via drive-thrus, an idea previous management had rejected.

All of those things are changes investors wanted to hear, further propelling the share price upward.

Credit to the CEO?

Since outbreaks of E. coli and norovirus outbreaks, the restaurant chain has struggled with stagnant sales and disappointing earnings. The change in leadership was a needed breath of fresh air. Yet, does the new CEO deserve the credit for the earnings beat?

Not quite.

Niccol’s hire definitely sparked a rally in CMG, but he did not officially take over until March, the final month of the first quarter. He did not have the time to have significant impact on operations.

The earnings beat was largely achieved thanks to lower-than-expected costs (food, beverage, supplies). While same-store revenue growth increased 2.2%—again, better than expected—it was driven by menu price increases (before Niccol). Even with the good same-store sales figures, overall revenue only beat expectations by 0.15%. Same-store foot traffic—how many customers actually go into Chipotle locations—declined about 3% year-over-year.

In other words, the new CEO had little to do with the first-quarter results. However, thanks to ongoing optimism since his hire, the earnings beat fueled another huge jump in the price.

Not a Mirage, But…

Last week, I highlighted a stock whose sudden spike in price was a mirage. In Chipotle’s case, it’s not a mirage. Well, not entirely.

The company was in need of change. And the hiring of Brian Niccol, a very qualified candidate who had success at Taco Bell, was a legitimate catalyst for the stock. He seems to have a comprehensive turnaround plan up his sleeve that the market is betting will work.

However, the stock now trades at very expensive levels. Even if we make a generous assumption and increase the current average 2018 EPS estimate by 25% to $10.30, CMG would still be trading at more than 40x estimated 2018 earnings. What’s more, even if we assume that earnings will grow 25% in 2019, CMG would still be trading at an earnings multiple of 33. Put simply, even if we really give Chipotle the benefit of the doubt, the valuation is still quite expensive.

Investors are enthusiastic about the changes Niccol will bring to Chipotle, but they have priced in generous assumptions and then some. Expectations are high. A misstep could send the share price downward in a hurry.

Management change is a significant move that could propel a stock upward for good, but investors should also be mindful of when a rally may be getting ahead of itself.

Editor’s Note: My colleague Linda McDonough has developed a system for identifying stocks that could be on the verge of making big upward moves due to catalytic events that could fundamentally propel a stock to a higher base. Anyone interested can find out more here.

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