Why Investors Should Be Skeptical of the Recent Chipotle Rally

By Jeremy Bowman Markets Fool.com

After a year in the doldrums following 2015's E. coli outbreak,Chipotle Mexican Grill(NYSE: CMG) stock is surging. Shares of the burrito chain are up 20% in the last month.

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There was no major driver of the rally that pushed the stock to a 52-week high, but there were several smaller news items that seemed to contribute to it.

Image source: The Motley Fool.

  • Chipotle announced that it has become the first national chain to eliminate added colors, flavors, and preservatives from its entire menu. The achievement capped the company's years-long quest to make a preservative-free tortilla. Founder and CEO Steve Ells took a victory lap in the media to tout the accomplishment, taking a swipe at rivals like Panera BreadandMcDonald's for claiming to have "clean" items when they are still using additives.
  • The burrito chain launched a new promotion with the online game "Spot the Imposter," reinforcing its elimination of additives and rewarding players with free chips and guacamole. The company also kicked off a television ad campaign called "As Real As It Gets" also showing off the achievement.
  • Chipotle raised prices by 5% in about 20% of its markets. The decision seemed to indicate that the company is more confident about consumers coming back to the brand more than a year after the E. coli crisis. The decision should also supply a modest boost to profits -- and a much bigger one if the company rolls out the price hike nationwide.
  • Bullish sentiment on Wall Street for Chipotle rises as a number of analysts lift their price targets or ratings on the stock.Wells Fargo, for example, boosted its valuation range from $450-$470 to $495-$515. Both the upgrades and the rise in the stock come on anticipation for Chipotle's first-quarter earnings report due out on Tuesday, April 25. It's the company's first quarter to completely lap the sales slide falling the E. coli outbreak, and analysts are expecting comparable sales growth of 15.5%.

While those all sound like reasons to believe in the company and the stock's comeback, none of them offer evidence that consumers are returning to Chipotle any faster than they were before, which remains the key driver to its turnaround.

Why you should still be skeptical

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At this point, the food safety crisis may no longer explain all of Chipotle's problems. Fast-casual competition has increased significantly, and the negative press may have driven customers to try competing brands, which they may prefer. The restaurant industry itself is also in the midst of a "restaurant recession," and signs indicate that trend continued into the first quarter.

Foot traffic fell 3.6%, and same-store sales dropped 1.6% in the first quarter, according to TDn2K's Restaurant Industry Snapshot.

The decline comes as food costs have fallen, making prices cheaper at the grocery store, and as retail traffic is down thanks to the popularity of e-commerce. Most restaurants have not yet reported first-quarter results, butSonic Corp.(NASDAQ: SONC) said comparable sales for the period ended February 28 fell 7.3%, foreshadowing a worrying trend for its peers.

Even if Chipotle's results are better than expected in its first quarter, the burrito chain still has a high bar to overcome in order to boost the stock further. Management set $10 in earnings per share as a goal for the year, later saying it may be difficult to achieve that mark. With its stock price now hovering $480, that gives the company a forward P/E of 48. By contrast, a month before the E. coli outbreak began, Chipotle's trailing P/E was 43, at a time when its outlook was rosier than ever.

Management projected just a high-single-digit increase in comparable sales this year, meaning comps will still have fallen double-digits since 2015. That means, despite the recent bullishness, the company still has much work to do to bring customers back in the door. In other words, the burrito chain's recent stock run is getting overheated.

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Jeremy Bowman owns shares of Chipotle Mexican Grill. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. The Motley Fool owns shares of Panera Bread. The Motley Fool has a disclosure policy.