I've Never Seen an Earnings Collapse Like This - Time to Move

I've spent years studying junk bond issuers, so I always get suspicious when I see a restaurant company, of all things, trading at high multiples of earnings, cash flow, or debt.

The restaurant business is notoriously risky, you see; there are few barriers to entry, fickle and economically sensitive consumers are at every turn, and it's extremely difficult to maintain high quality at any point on the price spectrum.

Still, it's not often you find a grossly overvalued (and overripe) company lying smack in the middle of the intersection of every single one of these very specific woes.

Yet that's exactly what I've found here.

In fact, I've just issued detailed trading instructions for profiting on this clunker to my Zenith Trading Circle readers, but this company is in such bad shape - such a perfect example of almost everything wrong with Corporate America today - that I had to let everyone know, so you can get the chance to profit now and later on if a similar situation unfolds again.

Let's have a look at what my research has turned up - so long as you've got an empty stomach...

This Company Was Ready to Fall Before It Poisoned Dozens

I had my eye on Chipotle Mexican Grill Inc. (NYSE: CMG) for a while - even before this fast-food darling suffered an E. coli and norovirus outbreak in the fourth quarter of 2015. Incredibly, the outbreaks hit restaurants in 15 states, well into the first quarter of 2016.

Such a far-reaching food safety problem indicated serious management and operational problems that struck at the heart of the business and sent customers fleeing.

company earningsSince then, CMG stock has fallen hard from its 52-week high of $632.98 per share, but is still trading at a ridiculous P/E of 150 times earnings.

Now, some Wall Street firms like Barclays are trying to tell investors that the multiple is a much lower but still exorbitant 40x "estimated" earnings for 2017, but even that is too generous a multiple for a company that slings fancy burritos - when it's not making customers ill.

I shouldn't even have to say this, but the market being what it is, and analysts being what they are, it bears stating: Restaurant companies should never trade at high multiples.

In recent months, half a dozen restaurant chains that issued high-yield bonds have filed for bankruptcy, which is absolutely typical of what happens in this industry.

Chipotle is a grossly overvalued stock trying to recover from betraying its customers, and what I've found out about Chipotle after digging through its financial menu is alarming, to say the least.

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Chipotle Has Been Overvalued for a Long Time

earningsThe collapse of Chipotle's business over the last year is truly breathtaking, but what's ahead is worse. The company just released third-quarter results and the numbers should give its investors serious indigestion.

Third-quarter sales dropped 14% from a year earlier to $1.04 billion (from $1.22 billion), while sales for the first nine months dropped 18.1% from the same period a year earlier to $2.9 billion (from $3.5 billion). Same-store sales dropped 21.9% for the quarter and 24.9% for the nine months compared to the same periods in 2015. The third-quarter same-store sales loss was marginally better than the second- and first-quarter figures (23.6% and 29.7%, sequentially), but still horrendous.

Remember: Fast-food restaurant operations run on thin margins, so if their volumes decline sharply, their profits vaporize.

That is exactly what happened to Chipotle.

While revenue suffered as a result of the poisoning scandal, profits were wiped out. For the third quarter of 2016, the company earned a mere $7.06 million (or $0.27 per share), compared to $143.2 million (or $4.59 per share) a year earlier. Through Sept. 30, 2016, the company earned only $6.96 million (or $0.23 per share), compared to $403.0 million (or $12.92 per share) a year earlier - before customers started worrying about what kind of microbes might be hitchhiking in their burritos.

The truth is, in percentage terms, this represents one of the sharpest earnings collapses in American business history - a 95.1% decline for the quarter and a 98.3% drop year to date. You rarely see this kind of earnings collapse outside the commodities sector, but this is what happens when customers lose confidence in a product that can make them sick or, in the worst-case scenario, kill them.

The reason for the collapse is clear: People just stopped eating at Chipotle. The company saw 15.2% fewer transactions in the third quarter and 17.9% fewer transactions overall since the beginning of 2016.

Trends are improving slowly, but the company has a lot of work to do to regain consumer confidence. It expects single-digit declines in same-store sales in the fourth quarter, a forecast that seems a tad optimistic in view of the fact that this number was still running at over 20% in the third quarter.

Counting on the short memory of the American consumer in the highly competitive fast-food industry is a dubious proposition, especially when the media loves to report on bad news.

While management has done its best to reassure customers that its food is safe, with mixed results, it has chosen a risky strategy with respect to managing the company's finances.

One advantage the company had in dealing with the crisis is that it is debt-free. But the company will still need a significant cash cushion to survive this crisis.

It entered 2016 with $663 million of cash and liquid investments and ran them down to $359 million by the end of September, due to a decision to buy back $747 million of its (grossly overvalued) stock.

Most likely, management figured the company could borrow money if necessary since it has a debt-free balance sheet.

But, like the rest of the greedy idiots running Corporate America, management wanted to try to prop up its stock and protect the value of its stock options at precisely the time it should have been preserving cash to deal with what is clearly an existential crisis for the company.

This demonstrates poor judgment that could, and likely will, come back to haunt the company.

This company has another insidious problem...

E. Coli Isn't the Only Parasite Afflicting Chipotle

Chipotle is reportedly starting to spend significant amounts of money to fight off activist investor Bill Ackman, whose Pershing Square Capital Management bought a 9.9% stake in the company a couple of months ago.

Ackman has been on a bad run of late, with his hedge fund down 20% for the second consecutive year due to a particularly bad bet on our other high-profit short play, Valeant Pharmaceuticals International Inc. (NYSE: VRX), and poor performance across most of the rest of his highly concentrated portfolio.

Ackman has suffered large losses on recent investments in consumer-related companies like Target Corp. (NYSE: TGT), where he lost $1 billion, and JCPenney Co. Inc. (NYSE: JCP), where he lost hundreds of millions of dollars, cost many people their jobs, and seriously damaged the company.

His investment in Burger King has fared better, but Chipotle is a turnaround investment now from an already elevated stock price, plus there are reports he has already antagonized management (something for which he appears to have a special gift).

The last thing Chipotle's management needs is a know-it-all activist hedge fund manager, desperate to repair his own battered reputation, taking out his frustrations on them. Chipotle's stock is significantly overpriced and, despite the company's operational problem, presents an odd choice for an activist investor.

I do not expect this shotgun marriage to end well for any of the parties involved - including the rest of the shareholder-bystanders, who would be better served by exiting the scene rather than sticking around in hopes that management or Ackman might pull a rabbit out of their hat.

(Don't worry, Chipotle doesn't serve rabbit... as far as we know.)

At the end of the day, Chipotle is extremely overvalued. It faces a very difficult battle to gain back customers who don't want to end up in the hospital after going out for a meal.

The stock is headed much lower and is a prime candidate for you to profit from.

There Are Lots More Rotten Companies: As you've seen, Michael doesn't sugarcoat anything. In fact, he's one of the bluntest, most politically incorrect voices in investing today. So when he showed us he could take on the greedy stooges running American companies (and, let's face it, the entire economy) into the ground and make some serious money doing it, we wanted to take his message "big." Click here to check out this (extremely explicit) interview he agreed to do with us...

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About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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