Is Einhorn Out to Lunch on This?

 | Oct 15, 2012 | 11:00 AM EDT
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The latest short idea from billionaire hedge fund manager David Einhorn, Chipotle (CMG), was met with nearly immediate market gratification. The stock has lost 7% since Einhorn's presentation, and the intraday price graph from that day screams, "You've been Einhorned!" At the value Investing Conference in New York, Einhorn's major contention for the stock was this: Taco Bell, one of the restaurant chains owned by Yum! Brands (YUM), has introduced new products, such as the Cantina Bell rice bowls, that directly compete with Chipotle's central business. This, along with the stock's overvalued price, are what make Chipotle a short candidate.

We have recently indicated that Chipotle is not an attractive buy candidate on a quantitative basis. The company's shares are priced at around 27x forward earnings, a higher multiple than Yum! Brands' forward P/E ratio of 18x. In fact, Chipotle looks more expensive than Yum! Brands based on a number of different valuation ratios. Einhorn noted that "reception for Cantina Bell has been mostly positive . . . and Chipotle is at risk of losing its frequent customers," thereby making the growth-centered company more of a valuation bubble.

The basic question is whether we should accept that Chipotle and Taco Bell are really comparable restaurants. During an interview on MSNBC Damon Vickers, chief investment officer at Damon Vickers & Co., argued that Einhorn's "assertions" do not hold water. Though Vickers holds long positions in both companies, he thinks "there is a place for both of them in the market place." He points to the fact that Taco Bell's quality is low while Chipotle, which had been founded by a professionally trained chef, has fresher, locally sourced food -- and all for no more than about a $1 price hike. Taco Bell will, in his words, "never be Fresh Mex."

So is this really just a valuation call? Maybe not. After the release of Taco Bell's Cantina Bell and Doritos Locos offerings, U.S. locations did see a 13% second-quarter increase in same-store sales. Yum! Brands additionally has a number of growth catalysts that are not tied to its Cantina Bell offerings. The company, as it's often cited, is looking to take advantage of growth in China. Between its Kentucky Fried Chicken and Taco Bell franchises, it plans to open 700 units there in 2012. Though Yum! Brands already has about 4,800 total franchises in China, it has yet to enter India in as meaningful a way. It has only 479 India locations in that latter country -- meaning its just-announced plans for a further 100 stores there represents a significant source of growth.

However, there are competitors in this space, too. McDonald's (MCD) plans to open 250 locations in China in 2012, and these quick-serve restaurants operate at the same price points with similar clientele. Unlike Taco Bell and Chipotle, McDonald's menu offerings are by no means niche. The classic hamburger joint has recently become more sophisticated, offering cafe items like frappes, new salads and healthier options. The McDonald's store count is expected to increase about 2.4% in 2012.

Einhorn's Chipotle call seems spot-on from a valuation standpoint -- investors should only buy good companies at the right price. But another possibility, aside from McDonald's, Yum! Brands and Jack in the Box (JACK) -- the last of which we consider here -- is Dunkin Brands (DNKN). Dunkin shares have taken a tumble since July. As with the other restaurants, aside from Chipotle, the stock is priced at between 17x and 19x forward earnings. Dunkin's stores have successfully gauged market needs and, as a franchisor, the company passes on a significant portion of its costs to its franchisees. Store counts are expected to increase 4% in the coming year.

We should note that none of the stocks mentioned is a clear "value" buy based on the usual basket of valuation metrics. Jack in the Box trades at a comparatively low price-to-sales ratio, but we are not ready to go headfirst into quick-serve restaurants at the moment.

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