Investment Menu Is Changing for Chipotle, Other Restaurants

I took a big risk this weekend. Our eldest daughter was home from college and hungry for Chipotle (CMG). She hadn't heard about the E. coli issues the company is facing, which have affected dozens at CMG stores in several states.

The company even temporarily closed 43 stores in Washington and Oregon; all have since reopened. We took our chances; while I am not a big fan of Chipotle fare, I am happy to report no ill effects.

The stock, however, is suffering the effects. Shares were down more than 12% on Friday, and are down 16% since the E. coli announcement, and 22% year to date. This likely is a temporary situation that the company will fix. It is casting a huge shadow on the shares, however, and that shadow appears to be growing. In isolation, this outbreak is a great example of how fear can overly damage a stock. In this environment, however, it may not be that simple.

Chipotle is one of the great restaurant success stories of our time. It's also commanded some big multiples at times, well beyond what I considered reasonable. But the company continued growing, and was able to justify those lofty valuations. Leave it to a value guy to try to comprehend a growth story.

The issue now may be a bigger one for the restaurant sector as a whole. It's been lights out ever since the 2008-09 market calamity. Restaurant stocks tend to be a top-performing sector in the years following a recession, but this rally is a bit long in the tooth.

We are a long way from the single-digit price-to-earnings multiples we saw at the bottom. The number of restaurant names trading at 25x or 30x earnings and beyond is staggering. The "easy" money, if there is such a thing, has already been made.

A number of restaurant names are taking it on the chin year-to-date, not just Chipotle. Blooming Brands (BLM, -30%), Brinker (EAT, -21%), Del Frisco's (DFRG, -40%), BravoBrio (BBRG, -25%), Arcos Dorados (ARCO, -39%), BJ's (BJRI, -12%), Buffalo Wild Wings (BWLD, -14%), El Pollo Loco (LOCO, -44%), Kona Grill (KONA, -41%). The list goes on.

Granted, several of the aforementioned names are somewhat new to the publicly traded arena, which has become quite crowded. That has not helped the sector, and investors have been adjusting expectations, causing some names to be repriced.

The headwinds are there. There are growing input costs, not just in beef and other commodities, but also in labor costs. The specter of a $15 minimum wage may not bode well, either.

Just five years ago, you could virtually select any decent restaurant name trading at a relatively low PE multiple, and were likely to rack up huge gains. Those days are gone. The sector is crowded with new names and overheated. I would not be surprised to see some consolidation, and perhaps a bankruptcy or two in the coming year.

There may still be some opportunities in certain special situations, but the "dartboard" days are done for now.

More in future columns.

At the time of publication Heller had no positions in stocks mentioned but holdings can change at any time.