Chipotle Mexican Grill © David Zalubowski, AP; Taco Bell © Steve Helber, AP

To most people, burritos are just a tasty lunch treat.

But to a couple of lunchtime giants, burritos are the weapon of choice in a fierce fast-food battle.

The battle broke out last summer when Taco Bell, a division of Yum Brands (YUM), rolled out its new Cantina Bell menu.

Developed by celebrity chef Lorena Garcia, of Bravo's Top Chef Masters fame, the Cantina menu features a premium burrito with black beans, cilantro rice and marinated chicken or beef for under $5, plus new sides like corn salsa. (Search for details on Cantina Bell menus on Bing.)

Based on recent company numbers, Taco Bell clearly scored a win with these upscale offerings. And it's no wonder. They are an unabashed imitation of the extremely popular offerings of Chipotle Mexican Grill (CMG), known for upscale burritos packed with fresh ingredients and hormone-free meat.

Yum Brands executives have no problem admitting they borrowed a key insight from Chipotle -- that customers will pay more for better quality, fast-casual Mexican food. "That's what Taco Bell can deliver, and at two-thirds the price of our fast-casual competitors," CEO David Novak said on a recent earnings call.

Now, this victory is probably not the only reason Yum's stock is up 5% since July 1, despite a drop last week, while Chipotle shares -- once hotter than jalapeños -- have fallen some 30%. But in the fiercely competitive world of fast food, consumer buzz is critical. And Taco Bell has it right now.

Chipotle's problem: A 'resurgent' Taco Bell

Many analysts -- and Chipotle itself -- maintain Taco Bell's new burritos are no threat to Chipotle, because their customers are so different. The customers who buy Chipotle's burritos, at $7 or so each, typically make more money. They appreciate Chipotle's ambience and careful sourcing of fresh ingredients, as a lifestyle choice.

Theoretically, at least, this is supposed to prevent them from crossing over to Taco Bell, with its more downscale, run-for-the-border, midnight-munchie reputation. There's also a been there, done that issue with Taco Bell, which can trace its history to 1946 (it went public in 1970); Chipotle got started in 1993 and is still fresh to many people, as it's still rolling out lots stores each year to new regions."We don't see Taco Bell as being a threat at all," Chipotle spokesman Chris Arnold told The Wall Street Journal in early October. "There's a lot more to what we do than grilled chicken and corn salsa, and we believe customers see the difference."

But legendary hedge fund manager David Einhorn disagrees. Einhorn, of course, is well known for highly successful negative bets against Green Mountain Coffee Roasters (GMCR) and Lehman Brothers before each tanked. At a New York City investor conference on Oct. 2, the Greenlight Capital hedge fund manager laid out his case against Chipotle, which he's had negative bets against this year.

The bottom line: A "resurgent" Taco Bell endangers once-hot Chipotle.

Einhorn says a survey his hedge fund conducted found that Chipotle and Taco Bell customers actually don't see much difference between the two chains. And his survey found that 75% of Chipotle customers go to Taco Bell. "Taco Bell has started to eat Chipotle's lunch," he said at the conference. "Less long exposure to Chipotle stock is a good idea."

Though fast-food experts -- and Chipotle -- dismissed Einhorn at the time, his case suddenly seemed to make a lot more sense on Oct. 19, when Chipotle announced a slowdown in sales that tanked its stock.

On the earnings call, Chipotle managers denied the slowdown had anything to do with Taco Bell.

"There was a lot of noise during the quarter about somebody taking market share away from us," said co-CEO Montgomery Moran. "We're not seeing any kind of loss whatsoever in our transactions moving from us to any other competitor."

But I think Chipotle and the analysts may be wrong, and that Einhorn is on to something. Here's why.

Driving diners loco

First, Chipotle's explanation that a weak economy caused its sales slowdown doesn't ring true, since the economy was weak a year ago when Chipotle growth was going gangbusters.

But more important, consider some interesting results from a survey of fast-food diners conducted by Goldman Sachs in late September -- almost three months after Taco Bell's new Cantina Bell burritos were launched.

The survey found that Chipotle's "brand equity" score among consumers fell sharply to 65.8 from 70.4. Meanwhile, Taco Bell's score rose to 64.8 from 62.1.

Two other insights stand out. One is that Chipotle's score fell "meaningfully" across all demographics. This seems to confirm Einhorn's findings that well-heeled customers who are supposedly loyal to Chipotle may have no problem defecting.

Second, Taco Bell is clearly on a roll in coming out with innovative dishes that customers love. Its brand-equity score was a lowly 58 a year ago. (All fast-food joints score in a range of 53 to 71.)

Taco Bell came out with a big hit in March -- it's Doritos Locos Tacos, which have shells made of Nacho Cheese Doritos. The chain sold an astonishing 100 million of these tacos in the first 10 weeks. And now the new Cantina Bell menu is obviously a hit. Taco Bell sales at stores open more than a year grew by 7% in the third quarter. In contrast, Chipotle's growth was 4.8%.

None of this proves Chipotle customers have turned to Taco Bell. But the ratings changes in the Goldman Sachs survey coincide with a sharp decline in growth at Chipotle and an increase in growth at Taco Bell, suggesting that something like this is going on.

Plus Goldman Sachs says Taco Bell's growth was driven by an increase in traffic, and not just increased spending and visits by regulars. "Taco Bell is now attracting more new customers than either Chipotle or Qdoba, its primary Mexican peers," concluded Goldman Sachs analyst Michael Kelter. The number of people saying they've eaten at Taco Bell rose sharply this year, while it declined at Chipotle, the survey found.

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Taco Bell's 2012 success is part of a larger trend. Over the past five years, Taco Bell customer satisfaction has jumped sharply, according to American Customer Satisfaction Index surveys. "Their improvement over the last five years is the biggest in the industry," says ACSI director David VanAmburg. "It's pretty impressive." 

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.