Chipotle's burrito bummer

None of this is good news for Chipotle, which faces a rough outlook for two reasons:

  • The Goldman Sachs survey found that restaurants are at the top of the list of things consumers are cutting out, and that when they do eat out, price is the one of the main factors in deciding where to go. This plays into the Taco Bell strategy of offering Chipotle-quality Mexican food, but at a lower price
  • Emboldened by its success, Taco Bell is not done taking shots at Chipotle with upscale Mexican. Chef Garcia is developing new burritos, a roasted tomato and garlic salsa and new steak offerings, as well as continued work as spokeswoman for the chain. 

Yummy sales

Garcia's success so far has been much-needed good news for Yum Brands. True, Taco Bells make up only about a third of the U.S. fast food joints run by Yum, which also operates Pizza Hut and KFC. And U.S. sales account for only 26% of operating earnings at Yum Brands, which has a big presence around the world, especially in China.

But Taco Bell's success matters because it moves the needle.

Indeed, given the surprising China slowdown that Yum just announced, the Taco Bell burrito wars are now more important than ever for the company. On Nov. 29, Yum surprised investors by saying China sales will contract 4% in the fourth quarter, compared with 21% growth a year ago. The stock fell from above $74 a share to below $68. Yum now expects to report 6% same-store sales growth in China for this year. Thus Taco Bell's 7% growth in the third quarter was not only better than growth at Pizza Hut (6%) and KFC (4%), but it's also doing better than China, once considered the sweet spot for the company.

The key investing takeaways

Once the dust settles in the current burrito battle, it will be clear that both companies still have solid potential.

Chipotle remains a great fast-food concept, with plenty of room to open new stores. It plans to open 165 to 180 restaurants next year, on a base of about 1,300.

"If you have a concept that has proven out and you can just keep opening stores with a rate of return that is reliable, that is a very compelling growth story," says Sarah Henry, an analyst for Manulife Asset Management. Chipotle has also hinted it may take a shot back at Taco Bell by introducing drive-through stores, long a favored Taco Bell format. Plus Chipotle is expanding its approach, with its ShopHouse Southeast Asian Kitchen fast-food restaurants. In short, Chipotle stock may well lose more ground as the ongoing burrito wars play out. So you'll probably be able to buy it lower. But Chipotle is not out of the game.

At Yum, the sharp downturn in China is more of a mystery. But my guess is that as China's economic growth shores up, Yum will be OK. It too has plenty of room to grow by opening new stores in China.

"We very much like the China story," says Di Zhou, an equity research analyst for the Thornburg Value Fund (TVAFX). One reason is that China has a population of 1.34 billion. "That is many mouths to feed." She says Yum has done a good job of adding local fare, such as soy milk, Chinese porridge and doughnuts, to its standard KFC chicken offerings.

Zhou also believes Yum will continue to benefit from China's growing middle class and ongoing urbanization. Morgan Stanley estimates that consumer spending in China will triple within a decade, which has got to be good news for Yum.

As investors wait for China growth to kick in again, Taco Bell's success in the U.S. burrito battle will continue to help support earnings, and Yum stock.

Fast-food stocks at slow-food prices

Neither of these stocks, however, will be hits with value investors looking for relatively low prices, even considering the recent stock declines.

Chipotle trades for 25 times its forward 12-month earnings. This gives it a price/earnings-to-growth ratio of 1.4. Developed by investing icon Peter Lynch, the PEG ratio adjusts a company's valuation for its growth rate. Generally, a PEG ratio above 1.5 makes a growth company look pretty fairly valued.

Yum Brands trades for 18.1 times forward earnings, and an even richer PEG ratio of 1.58.

In contrast, McDonald's (MCD) trades for 10 times forward earnings and a PEG ratio of about 1.

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These fairly rich valuations don't mean these stocks can't do well. They should, because of the bullish expansion potential. But Chipotle still may go lower because of the ongoing burrito battle, while Yum gets back on track and moves higher.

At the time of publication, Michael Brush did not own or control shares of any company or fund mentioned in this column. 

Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.