New Trade $CMG – Burrito Bonanza

by Enis February 6, 2014 10:29 am • Commentary

Chipotle has been a major momentum leader for much of the past year.  The stock has more than doubled since its October 2012 low of $233.82.  That’s AFTER famous hedge fund manager David Einhorn said that he was short the stock back in mid-2012.

Chipotle has actually defied the predictions of more than one famous money manager.  Jeff Gundlach actually chose “Short Chipotle” as his top investment idea at the May 2013 Ira Sohn Investment Conference.  Forbes summed up Gundlach’s presentation:

Gundlach admitted to loving Chipotle’s product, but did suggest “a gourmet burrito is an oxymoron,” adding that he hates the company’s chart.  Barriers to entry aren’t all that high, Gundlach explained, when all that is needed to enter the market is a taco truck.  Indeed, Yum BrandsYUM -2.11%’ Taco Bell has put pressure on Chipotle, while McDonald’s and other fast food makers are also fashioning themselves as makers of premium products.

“I’m not impressed with [Chipotle’s] earnings growth,” Gundlach said, adding he also isn’t a fan of high price to earnings ratios, and of companies that are embraced almost religiously, like AppleAAPL +0.76%.  Therefore, Gundlach argued, it makes sense to short Chipotle, even if one likes their burritos.

Since Gundlach went public with his view in May, the stock has charged another 50% higher, defying many deified investors along the way.  In fact, the stock hit a new all-time high on Friday, after another strong earnings report.  That was CMG’s 4th straight gap higher after earnings, with the stock ending at least 8% higher in each instance.  

Dan and CC actually exited a bearish put fly position for a profit prior to the earnings event.  Since that strong earnings reaction, we’ve been watching CMG’s price action quite closely.  We’ve noticed a number of cracks in the stock’s technical situation, despite the new all-time high last week.

First, the gap higher after earnings on Friday was the first of the past 4 that did not hold its breakout over the pre-earnings highs:

[caption id="attachment_35908" align="alignnone" width="600"]CMG daily, Daily volume on lower panel, Courtesy of Bloomberg CMG daily, Daily volume on lower panel, Courtesy of Bloomberg[/caption]

I’ve marked with a green line the pre-earnings high for CMG before the earnings report on the Apr, Jul, and Oct reports.  In each case, CMG stayed above that green line after the report.  However, CMG stock has fallen back below the $550 breakout level this week, which I’ve marked in red.  The stock has regained $550 today, but the technical damage has been done.  The volume on the earnings gap was similar for each move (green circles, lower panel), but the most recent gap has had the least staying power.

Second, since CMG has been a high profile short for the hedge fund community, the stock’s short interest has been quite elevated for much of its trading history.  Recently though, short interest fell to around 5.77% of float, its lowest level since the IPO:

[caption id="attachment_35909" align="alignnone" width="600"]CMG short interest, Courtesy of Bloomberg CMG short interest in shares, Courtesy of Bloomberg[/caption]

On the fundamental side, men much smarter than us have already laid out their thoughts on the stratospheric valuation.  But sticking to simple numbers, CMG has generally been a good sale when the stock’s trailing 12 month P/E gets above 50:

[caption id="attachment_35910" align="alignnone" width="503"]CMG trailing 12 month P/E, Courtesy of Bloomberg CMG trailing 12 month P/E, Courtesy of Bloomberg[/caption]

Assuming analyst estimates are achieved (15-25% earnings growth for the next 3 years), CMG will still have a 30 P/E in 2016 if the stock price was unchanged.  That sort of valuation is very rarely assigned to a restaurant company, and for good reason.

Timing is the toughest part of trading.  Traders who have tried to fade CMG’s strength have had their heads handed to them on many occasions in the past few years.  But a confluence of technical and fundamental factors indicate a better-than-normal setup to fade the recent earnings strength.

TRADE:  CMG ($554) Bought Mar22nd 550/500 Put Spread for $12.25

– Bought 1 Mar22nd 550 Put for 15.20

– Sold 1 Mar22nd 500 Puts at 2.95

Break-evens on Mar22nd expiration:

Profits: Between 537.75 and 500, make up to 37.75, max profit of 37.75 at 500 or below

Losses: Up to 12.25 between 537.75 and 550, max loss of 12.25 at 550 or above

Trade Rationale:

The stock’s low last week before the earnings gap was around $481.  The rising 200 day moving average is around $443.  With those two levels of support, we have a hard time seeing this stock get much lower than the $470-$500 area on a move lower.  Meanwhile, the stock’s failed breakout has us targeting further weakness in the weeks to come, with a target around the psychologically important $500 level.