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Rebounding Prices: 3 Stocks That May Provide False Optimism

In light of factors such as measured undervaluation, cost-cutting efforts, sector growth and recent price rebound, investors may have reason to believe that companies such as Starbucks Corp. (NASDAQ:SBUX), Chipotle Mexican Grill Inc. (NYSE:CMG) and Alliance Data Systems Corp. (NYSE:ADS) will exhibit share price growth in the future. However, there are several factors that indicate this optimism may be misplaced. We will take a closer look at these three companies, focusing on their strategies for growth and some signals to keep an eye out for.


Starbucks

This iconic cafe was founded in Seattle in 1971. Since then, it has become perhaps the most well-known coffee chain in the U.S., with one or two stores in nearly every major urban or suburban neighborhood in the country. As of Nov. 13, the company has a market cap of $99.38 billion.

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Starbucks' share price shot up to a high of $98.15 after the closing of its 2019 third-quarter earnings, treading dangerously into overvalued territory before plummeting in a sharp correction. For the following fourth quarter ended Sept. 30, the company posted revenue of $6.75 billion versus analyst estimates of $6.68 billion and same-store sales growth of 5% versus the 4% expectation. The good news caused the stock to jump 2%, but since then, it has dropped into a decline again.

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Starbucks has been able to maintain consistent revenue growth throughout the U.S. by first expanding to the point of near complete market saturation, then by implementing loyalty programs. After revamping its rewards program during the fourth quarter, Starbucks' loyalty program provides more benefits for less frequent customers as well as regulars, causing the number of active rewards members in the U.S. to increase to 17.6 million.

The company boasts a three-year revenue growth rate of 14.5% and a three-year Ebitda growth rate of 12.3%. However, as its recent third-quarter correction shows, the stock is not immune to declines now that it is in the overvalued range (as measured by discount cash flow, Peter Lynch fair value and median price-sales value).

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As of the end of the fourth quarter, Starbucks has a total stockholder equity of $-6.232 billion, meaning that its liabilities heavily outweigh its assets. This is mostly due to the company investing in growth opportunities such as artificial intelligence in stores and 600 new locations in China, bringing its total number of stores in the country up to 4,000. Despite competition from Luckin Coffee (LK), Starbucks managed to grow its China sales by 6% during fiscal 2019.

All in all, Starbucks still has room to grow as it improves its loyalty programs and expands into foreign markets. However, it is steadily transitioning from a growth stock to more of a stalwart, and its price still has a ways to fall before it comes more in line with the company's intrinsic value. It will likely present a good buying opportunity again in the future, but at the moment, it may still be too expensive.

Chipotle Mexican Grill

Chipotle's stock price has been a series of dramatic ups and downs as the burrito chain's profitable business model has warred against strong negative publicity from a couple of food poisoning outbreaks. As of Nov. 13, the stock has a market cap of $20.94 billion.

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Last month, Chipotle posted third-quarter results that beat analyst expectations, with earnings per share of $3.47 compared to $1.36 per share in last year's third quarter. Despite its third-quarter success, the share price declined following the announcement, only to rise on Nov. 12 after the company announced that it will extend the run of its popular carne asada menu option through the beginning of 2020.

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Despite the ups and downs of the share price itself, Chipotle's only significant income decline occurred from 2015-16, when an E. coli outbreak followed the company's promise to provide healthier options than other fast-food rivals. Though increased risk for food poisoning is to be expected when the food is not laden with preservatives and the workers are paid close to minimum wage, this does not change the devastating effect of E. Coli on a company's image. News headlines from that time include "Chipotle's Decline is Unstoppable" and "No Comeback Yet: Chipotle Profit Tumbled 95% in 2016."

Of course, the stock eventually rebounded to a new high of $856.75 on Oct. 22, 2019, then began tumbling again following its third-quarter earnings announcement. It has a current price-earnings ratio of 68.67 and a return on capital of 14.62%, indicating that slow growth is to be expected in the near future.

In terms of future revenue growth opportunities, Chipotle has not yet achieved complete market saturation in the U.S., so it still has room to grow in that respect. The restaurant's menu options have few ingredients and no preservatives except for salt, and the build-your-own meal style holds strong appeal for customers who follow specific diets or want to personalize their food.

Chipotle's loyalty program got off to a bit of a slow start with the launch of Chiptopia in 2016, a complex summer-only that awarded customers for frequent visits and was not particularly popular with customers. It was only meant to be a temporary measure to spark profits after the E. coli outbreak. In March 2019, Chipotle finally announced Chipotle Rewards, a program that rewards points for each purchase and distributes cash rewards through mobile payment service Venmo.

"Chipotle is one of the first brands to utilize Venmo's technology to engage with customers through this pay-out feature on the Venmo app," Chief Marketing Officer Chris Brandt said in a statement. "Our customers have been asking for a loyalty program for a long time and we're excited to partner with Venmo to reach their highly engaged network of digital-first customers."

Though the rewards program shows promise for future growth, Chipotle is overvalued after reaching a new high last month. The stock is definitely worth keeping an eye on, though, as it historic price fluctuations and strong revenue growth mean that it has a high chance of trading at a discount sometime in the future.

Alliance Data Systems

Alliance Data Systems is in the loyalty rewards programs business. It analyzes the data that companies need in order to build lead-based marketing strategies and customer loyalty programs and issue co-branded credit cards. As of Nov. 13, the stock has a market cap of $4.95 billion.

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The price of Alliance's stock has had a rocky decline of nearly 200% since its 2015 high of $305.52. For the company's recent third quarter ended on Sept. 30, it posted revenue of $1.43 billion and net loss of $108 million. The share price is currently in an uptick following Alliance's Nov. 12 announcement that it will provide co-brand credit card services to Sony Corp. (NYSE:SNE) as part of a new customer loyalty program.

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To a value investor, Alliance may seem like a hard-to-find bargain at first glance. According to the Peter Lynch chart, the company is undervalued and it operates in an industry that promises strong growth in the coming years. According to data compiler Mordor Intelligence, the loyalty management market is projected to grow 23.3% annually to a total value of $9.28 billion in 2024.

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Most of the company's metrics look appealing on paper, with a price-earnings ratio of 12.65, an operating margin of 22.26%, a return on capital of 287.23%, a cash-debt ratio of 0.45 (higher than 63.56% of industry competitors) and three-year Ebitda growth rate of 15.4%. However, many metrics have been skewed by abnormal results in the fourth quarter of 2018, after which revenue dropped just as sharply as it rose and net income plunged into the negatives.

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To help combat recent losses, Alliance plans to implement an expense-reduction program, which mainly consists of firing employees, in order to save approximately $100 million. Much like a strong dividend company cutting its dividend, though, this move implies that the company is on rocky ground financially. It has an Altman Z-score of 1.44, meaning that it may be in danger of bankruptcy. With continued headwinds from the U.S. Federal Reserve continuing to cut the prime interest rate, Alliance desperately needs a shot in the arm.

According to the company's third-quarter 2019 earnings conference call, however, it expects revenue growth to continue in the mid-single digits. Since revenue has dropped approximately 34% since 2017, excluding the outlier in the fourth quarter of 2018, this means the company's earnings are not likely to return to their 2017 levels anytime soon. Thus, despite looking like a perfect value buy on the surface, Alliance's share price is unlikely to improve.

Disclosure: Author owns no shares in any of the stocks mentioned.

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This article first appeared on GuruFocus.