Wednesday, August 12, 2009

This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the worst ...
Shares of Chipotle Mexican Grill (NYSE: CMG) (NYSE: CMG-B) are sitting out of the market rally today. The apparent reason: A bearish note issued this morning by investment banker Jesup & Lamont. Initiating coverage on the stock with a "sell" rating, Jesup worried aloud over the stock's 39% rally off its March lows. Jesup suggested it would only like Chipotle at a price of 20 times next year's earnings, which it estimates at about $3.75. Jesup's key concerns are:

  • New store growth might "moderate" as the recession creeps along.
  • Comps have been weakening due to negative foot traffic growth.
  • Restaurant-level profit margins may have peaked, at least until comps can pick up the slack.

In this banker's view, the stock has become priced for perfection, with investors assuming that the company will produce "continued positive EPS surprises" -- a dangerous assumption. Long story short, unless Chipotle hands it a 20%-off coupon, Jesup's not eatin'.

Let's go to the tape
Curiously, however, this may be good news for Chipotle investors. Why? Because among the professional investors we track, Jesup & Lamont consistently proves itself to be among "Wall Street's Worst".

Not much better at making airline picks than acting the restaurant critic, Jesup at least has some familiarity with meals delivered via heated tins than plastic bins:

Stock

Jesup Says:

CAPS says:

Jesup's Picks Beating (Lagging) S&P By:

AirTran Holdings

Outperform

*

36 points

Delta Air Lines (NYSE: DAL)

Outperform

*

(37 points)

Continental Airlines (NYSE: CAL)

Outperform

*

(41 points)

US Airways  (NYSE: LCC)

Outperform

*

(73 points)

Moreover, according to our CAPS records, along with its simultaneous recommendation of Starbucks (Nasdaq: SBUX) this morning, Chipotle became the very first restaurant recommendation Jesup has made public since we began tracking the analyst two years ago. The closest recommendations elsewhere reside in the Specialty Retail sector, often grouped with "restaurants" due to each business model's reliance on same-store sales to drive growth. But even there, Jesup's record is sparse ... and uninspiring:

Stock

Jesup Says:

CAPS says:

Jesup's Picks Beating (Lagging) S&P By:

Lowe's  (NYSE: LOW)

Outperform

***

12 points

Pier One

Outperform

*

(37 points)

All of which adds up to a chance that when Jesup tells us today that Chipotle will under-perform the market, the stock could very well outperform the market instead.

Surprises abound
Now, personally -- and notwithstanding its reputation -- I happen to agree with some of the points that Jesup makes. Jesup's 100% right that Chipotle looks downright expensive at its current valuation of more than 30 times trailing earnings. In my mind, the 22% five-year earnings growth that most analysts posit for Chipotle just doesn't justify today's price.

But I've got a sneaking suspicion that I -- and Jesup -- might be wrong about this. So for the Chipotle bulls out there, let me sketch out a hypothesis showing how Chipotle just might beat the odds and outperform after all.

Start with Jesup's assumption that Chipotle is only worth a "20x target multiple" to next year's earnings. If the company's growing at 22% per year, it would seem that the stock should fetch a 22 P/E multiple at worst. Consider too that Jesup's concern

that investors are counting on "continued positive EPS surprises" out of Chipotle. Well, why shouldn't they? Chipotle has beaten earnings estimates in each of the last three quarters.

I also cannot help but notice that Chipotle's free cash flow continues to lag its reported earnings. But there's a good reason for this. The company has been using cash flow to build out its new stores. Open 136 new stores using internally generated cash, like Chipotle did last year, and that uses up cash flow pretty handily.

Foolish takeaway
Make no mistake -- the valuation on Chipotle looks high to me, and I have no plans to buy the stock myself. Meanwhile, Jesup & Lamont worry that this stock is on an unsustainable trend of outperformance and earnings beats.

But from where I sit, there may be good reason to wonder if the trend is actually Chipotle's friend. With a rock solid balance sheet, improving cash flows, and a stellar growth rate, Chipotle just might surprise us -- by continuing to surprise us.

 
 

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