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Putting it all together, barring  further poor publicity from customer illness, legal problems, or other corporate issues, the worst should be behind Chipotle.  It seems that there is a lot more that can go right than wrong at this point. However, based on a multiple of forward earnings and EBITDA, CMG is now priced toward the high end of its historical price range. Over the short to intermediate term, the next three to six months, we consider that the stock has more downside risk than upside potential, especially in the light of the weakening general economic backdrop and the well known industry challenges. Longer term, if the fundamental recovery persists, we think the stock could at least keep up with the earnings progress.

Company Overview  

Chipotle Mexican Grill (as of 9/30/18)  is the owner and operator of a 2,461 unit (2,424 in the US and 37 internationally) fast casual chain of with a narrowly focused menu of burritos, tacos and salads generating $4.7B in sales in TTM through Q3’18. Two Pizzeria Locale restaurants, a fast casual concept, are also operated but not currently being expanded, by a consolidated subsidiary.  The company has long been a top performer in the industry but in 2015 its progress was interrupted by outbreaks of food-related illnesses in its stores. It has been in turnaround mode ever since. An incident of a norovirus in a Virginia store in mid-July 2017 was an unwelcome reminder the company may have not fully put the past problems behind it. New CEO, Brian Niccol, formerly CEO at Taco Bell, was installed in early 2018, which has led to numerous operational and marketing changes that have been viewed positively by employees, analysts and investors and CMG stock recovered from a low close to $250/share in early ’18 to a high above $500 just six months later. As Part of the restructuring, the Company announced in May that headquarters would be moved from Denver to Newport Beach, CA, with certain administrative functions consolidated in Columbus, OH as well as New York, NY. As a result, total related costs would be $44-$58M, of which $28.5M was incurred as of 9/30/18. The opening rate was approximately 200 stores per year, maintained for the first year or so after the 2015, moderated to about 130 for ’18, expected to be 140-155 in ’19.


The vision of founder and CEO, Steve Ells, is “food served fast but not fast food.”  It aims to be distinct from typical fast food in being prepared from fresh, high-quality ingredients using classic cooking methods, or “Food With Integrity” (FWI).   The FWI objective includes serving meats from humanely raised animals, without non-therapeutic antibiotics or added hormones.  FWI extends to sourcing a portion of its produce that is locally and organically grown when in season, among other related aims.

The menu is simplicity itself. The several burritos, tacos and salad items are assembled to order from 4 proteins (beef, chicken, pork, tofu) prepared with just 47 other ingredients. Sides are masa corn chips with guacamole or salsa. Beverages consist of soft drinks, fruit juices and (in some locations) beer and margaritas. Under the new management team, the menu  being carefully expanded, with many items currently in a test mode.

Operational Model & Unit Level Economics

(Per 2017 10-K)The average cash outlay for the 2017 class stores  (size 2,550 sq.ft. seating about 58) was $735k, net of $100k from landlords, plus estimated pre-opening expense of $75k.  For this total cash outlay of $810k  cash-on-cash returns of 40.4% can be calculated based on calendar ‘17 AUV of $1,940K & store-level EBITDA margin of 16.9%. However, we should point out that new stores have been disclosed to generate $1.4-$1.5M in the first year, presumably with a lower EBITDA than the company average. If the first year EBITDA is 12%, for example, on $1.5M, that would generate $180k of EBITDA which would represent a first year cash on cash return of 22.2%, so the 40.4% described above could be considered a “target” return in year three. Obviously, the magnitude of returns described above, both year one and targeted, are still impressive relative to industry peers, especially considering the difficulties of the last several years which are hopefully in the rear view mirror.

Company Background

 In 1998, with only 14 units, the company was bought by McDonald’s (NYSE: MCD) which spun it off in 2006 to the public by which time it had grown to 500 locations. For the next 10 years CMG had an extraordinary run on the strength of its FWI brand promise.  The store count quadrupled (including establishing small beachheads in Canada and Europe).  Comps were consistently positive, averaging 8.4%, and Store AUV’s increased from $1.63M to $2.53M, driving 20% revenues CAGR.  Below the top line EBIT margin expanded over 1,000 bps to 18.8%, net income grew at a 29.8% annual pace and returns on invested capital hovered in the low to mid 20% range.

By 2015 the rapid growth outstripped the company’s ability to manage the quality of a widely disbursed supply chain consisting largely of small producers.  Early in the year, a pork supplier had to be eliminated due to quality issues, so pork products were not available in the stores for nine months.  Later in 2015 and in early 2016 outbreaks of food-borne, e-coli related illnesses among its guests were widely reported.  The reports triggered criminal and SEC investigations, and an investigation by the Centers for Disease Control and Prevention (CDC).  While the CDC investigation ended in June 2016, remnants of the other legal issues, including class action lawsuits are still pending.

Customers fled in the wake of these developments, voting with their feet that their belief in the FWI brand promise had been broken.  Needless to say, comps fell abruptly, dropping as low as a shockingly negative 29.7% in Q1’16 after which they recovered quarter by quarter, finally returning to positive territory, posting +17.8% in Q1’17 against the bottom in the prior year’s quarter (8.1% in Q2’172).   AUVs followed suit, dropping steadily in 2016 before rebounding to $1.957K in Q2’17 in sync with the bounce back in comps. As sales had risen through the years, quarterly corporate operating margins peaked at 19.3% (with 28.3% store level EBITDA) in Q3’15, before plunging to -5.6% (with 6.8% store level EBITDA) in Q1’16, after which they recovered somewhat steadily to 9.1% by Q2’17 (18.8% store level EBITDA), with store level EBITDA relatively stable since then, at 18.7% in Q3’18. Net income most recently has been materially affected by adjustments such as asset impairments and restructuring costs. Investors are not minding the adjustments, focusing on the slow but steady recovery in comps.

As indicated by the numbers, the worst is probably over and the company, under Brian Niccol’s leadership, continues to shift from damage control to sustaining a turnaround.  To this end the company is simplifying its operations. Despite the vision of simplicity for the model, management concedes operational procedures had accrued unnecessary complexity over the years, particularly in hiring and developing employees. The company has also overhauled its digital platform, making it more user-friendly, aiming to halve order fulfillment time. It has installed second make-lines for on-line sales at 750 locations as of Q3’18, expected to be system-wide by the end of ’19. These second lines can produce as many as 130 additional entrees in a typical 3 hour peak without additional labor. CMG is also expanding its catering business and exploring delivery.

The company believes these initiatives will propel it back to $2.5M AUV’s over time, 20%+ store level EBITDA margins and EPS comfortably above $10 in 2019, more like a $15.00 run rate longer term, but no timetable has been provided.

 Shareholder Returns

In the last 10 years, since a low of around $50/share in early 2009, CMG has appreciated about 9x in value to this point. While down from a high of $749 in July 2015 at the onset of its food-borne illness crisis, bottoming at around $250 in early ’18, the recovery has been dramatic since new management has been installed. CMG has always been richly valued with the forward P/E trading pre-crisis in a range between 25X and 55X, so the stock is currently assuming a successful turnaround and resumed growth. The company does not pay a dividend, but has long made modest repurchases of its stock. In the wake of the crisis, there was a material increase in repurchases, spending well over $1B to repurchase shares, mostly in the high $400 range. In Q3’18, a comparatively modest $19M of stock was repurchased, at an average price of $474, leaving $100M in the current buyback authorization. The Company remains debt free with over $300M of cash equivalents and an additional $300M of “investments” (not specifically defined).

Recent Developments (Per Q3’18 EPS Report and Conference Call)

Earnings in Q3’18, after adding back adjustments of $0.80 from charges related to asset impairment, corporate restructuring and other costs, was $2.16 vs. $1.33, up 62.4%. Comps were up 4.4%. Transactions declined by 1.1%, but a 3.8% price increase and menu mix upgrade provided the comp gain. Store level EBITDA increased from 16.1% to 18.7%, driven by lower marketing costs, partially offset by repair and maintenance. Since store level EBITDA was 19.3% for nine months, Q3 obviously represented a sequential downtick, from 19.5% in Q1 and 19.7% in Q2. Cost of goods declined 160 bp to 33.4% of revenues. Labor costs were flat YTY, at 27.2%. The price increase offset wage inflation of 4-5%. G&A expense increased 10 bp to 8.9% of revenues. Digital sales grew to 11.2% of sales, increasing 48.3% YTY. New restaurants in the quarter totaled 28, with 32 closed or relocated. A new marketing strategy, “For Real”, was unveiled, accompanied (of course) by continued operational focus. Guidance for all of ’18 continues to be comps in the low to mid single digit with new openings at the lower end of the previously announced range of 130-150 units. The only formal guidance for 2019 is for 140-155 openings.

On the conference call: management talked about the encouraging attitude by managers at the annual All Manager’s Conference. The Company is making a conscious effort to participate with their millennial customer in terms of “cultivating a better world, seeking to disrupt the current food landscape, etc.” In addition to the expanding list of 750 second make lines, digital pick up shelves are in nearly 350 restaurants, with an aim to be in all stores by mid-’19. App downloads increased 25% QTQ, and there is strong momentum with delivery. Doordash has been a new partner since Q2, delivery service can also be made through the CMG app and website, and there seems to be “very little customer overlap”. There is a digital pick up lane at restaurants that physically accommodate the feature, and it will be expanded where possible. A loyalty program launched in September in three test markets looks promising. Lots of new products are being tested and key management personnel are still being added.

October sales started strong, up 4%, but Q4 comp is expected to be “penalized” by about 100 bp since a price increase last November is being lapped in about 1,000 restaurants. No guidance for 2019 comps is being provided since there are so many product and operational initiatives in progress. New stores have “opened at stronger levels” and the pace of new stores will be up modestly in ’19 vs. ’18. As mentioned after Q2, about 55-65 underperforming restaurants will be closed in the current year, 32 of which took place in Q3, a total of 38 for the YTD, so another 17-27 are targeted for Q4. Lower marketing expense of 2.5% in Q3, down 70 bp YTY was due to a timing shift into Q4 for the “For Real” campaign, which began in late September, and Q4 will therefore be in the low 4% area. Calendar ’19 is expected to be in the range of  3%. Depreciation in Q3 was 4.3%, an increase of 60 bp, due to accelerated depreciation on the closures. It was indicated that the relatively modest share repurchase program will remain at the current level until the restructuring program is completed.

When questioned about store margin objectives, management responded that it is a function of higher AUV’s. “When we get to $2.1M, we can be in the 21% margin. $2.2M is a 22% margin. Wage inflation is a bit of a wildcard. We can’t overcome that with transaction growth alone. That will require some careful timing and place in a menu price increase…..and there’s efficiencies of moving our customers from the front line to the second make line. And then it’s a matter of working with our delivery partners to make sure that the economics work for both of us and them.”

SO THAT’S A PRETTY GOOD WRAPUP !! (with thanks to CFO, John Hartung)

Conclusion (provided at the beginning of this writeup)

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cmgOur Conclusion:

We believe the evidence is increasingly clear that the recovery at CMG will be slower than management or CMG stockholders have been hoping for. Sales will look better over time, but margins may not recover to previous levels for a very long time, if ever.  We have written extensively on our website about CMG, which readers can locate with the “search” function. While investors may produce the Battle of the Bulls and the Bears over CMG, customers of Chipotle (who built their business on Food With Integrity) will wage the “Battle of The Loyalists vs. The Betrayed”. 

CMG: Company Overview 

Chipotle Mexican Grill, Inc. (CMG), bought with 14 units in 1998 by McDonald’s, then sold to the public with 500 locations in 2006, has grown stores and profits steadily to the point of operating 2,010  locations as of 12/31/15 (including 11 in Canada, 7 in the UK, 3 in France and 1 in Germany).  Average volume per store was $2,424M (Because of its health crisis—discussed below— this metric is down from the $2.5M AUV achieved earlier in the year and virtually the same as the $2.474M in 2014.  Obviously, AUVs will be materially lower in 2016, as CMG works through its well known issues. Store size is a modest 2,550 square feet (seating about 58), on average, costing $843,000 for leasehold improvements and equipment. As a result (with sales at $970/ft.) their store level profitability has historically been among the very best in the restaurant industry. Again, the current objective is to regain traffic, sales, and historical return on investment.  There were also 11 fast casual ShopHouse Southeast Asian Kitchen restaurants and 3 fast casual Pizzeria Locale locations.

The Company’s mantra since inception has been “Food With Integrity”, with the objective of serving meats raised without non-therapeutic antibiotics or added hormones, also promoting animal welfare. Additionally, a portion of the produce is organically grown and/or sourced locally when in season. Additional methods of raising and sourcing raw materials also work toward the FWI objective. These standards are also used in the Shophouse and Pizzeria Locale restaurants. As the Company has become larger, problems in terms of the Company’s sourcing objectives have surfaced. In early 2015, a pork supplier had to be eliminated, so pork products were not available in the stores for nine months. In late 2015 and early 2016 food borne illnesses, apparently contracted at CMG restaurants, triggered criminal and SEC investigations, and an investigation by the Centers for Disease Control and Prevention (CDC). While the CDC investigation ended in June, remnants of the other legal issues, including class action lawsuits, seem to remain.   The company’s balance sheet is “bullet proof”, with no debt and $270M of cash at its 16Q2. The ratio of its capitalized leases (8X rent) to T12M EBITDAR is a comfortable 2.6X and T12M cash flow from operations was $462M, which net of $270M cap ex, left free cash flow of $192M. In the same period the company spent $1,046M repurchasing its stock, a nearly tenfold increase over the year ago pace, before its stock price plunged in reponse to illnesses at its stores. Over the last 5 years, the company has purchased 3.7M shares for $1.6B, or an average price of $445/share. The company may spend an additional $140M on share repurchases under its current authorization. 

CMG: Recent Developments 

When the company reported its 2015 annual and Q4 results on 2/2/16, the results were in line with its earlier pre-release. Most stunning, however, was that comps were down 34% in the last 4 weeks of December (following the last of the illness outbreaks in Boston) and down 36% in January.  The poor sales results drove the disappointing results in every other metric from restaurant margins to EPS.  Since then, the focus by the company and investors alike is how long, if ever, it will take the company to  recover its former momentum. The company’s guidance for 2016 has been very limited: while continuing to expand the store base with 220-235 new stores, G&A will increase both from recurring expenses such as food testing and marketing, as well as shorter term expenses such as higher legal costs. There has been no comp or top line guidance and certainly not EPS guidance.  Instead it is periodically describing the recovery in sales as it is taking place, and reiterating its objective to be the world leader in food safety. The plan continues to include extensive upgrading and testing of food sourcing, preparation and serving and handling procedures, and more intensive marketing than ever before.

Comp sales in Q2’16 were down 23.6%, an improvement from the negative 29.7% in Q1. Traffic in Q2 was a bit better than sales, down about 20%, due to price promotion efforts. Management indicated on the Q2 conference call, on 7/21, that comp sales had improved early in Q3, down about 20%, and traffic had improved to the mid-teen level.   The aggressive couponing and discounts had brought some customers back in April, May and June, and. “Chiptopia”, an aggressive loyalty program, was instituted for three months starting July. In its simplest form, Chiptopia offers a free burrito after the customer visits four times in a month,  then again next month with the free item counted as a visit. So the first free item comes at a 20% discount, subsequently at a 25% discount. There are additional benefits such as free guacamole and chips when you sign up, and a “banquet” for 20 people for a very heavy user. Our “channel checks” indicate that Chiptopia generated a substantial increase in traffic at the outset in July, but that traffic and sales did not build materially from that level.

Most recently, the Goldman Sachs analyst lowered the comp estimate for Q3 to a negative 21.4%, and, more dramatically, a negative 5% in Q4, which many analysts have hoped would comp positively against the beginning of the dismal numbers in 2015 (-14.6%). The Street consensus, as shown in our table above, is a negative 17.2% in Q3, plus 1.6% in Q4, then continuing recovery to plus 7.7% for full year 2017. As far as earnings are concerned, Goldman Sachs now estimates $2.26 in 2016, $7.65 in 2017, and $12.08 in ’18. These numbers are materially lower than the current Street consensus of $3.71 in ’16, $10.24 in ’17, and $14.09 in ‘18. Obviously, the further out we go, the less certain are everyone’s numbers.  We will know a lot more on October 18th, when CMG reports their Q3.

It is worth mentioning that Bill Ackman’s Pershing Capital has taken a 9.9% position in CMG, obviously his vote of confidence that the Company will regain its previous investment standing. We don’t believe he has a material “edge” here in terms of the timing or likelihood of CMG’s recovery. Ackman is very smart, and especially persistent (e.g. his battle with Herbalife, stumbles at JC Penney and Target, his long term vindication with MBIA, and his amazing success with General Growth Properties) but there is no underlying real estate play here, balance sheet or  cash flow characteristics that are not transparent to everyone, and CMG still trades at 3 times trailing sales and a very high multiple of expected (uncertain) earnings. We view Ackman’s involvement less as an indication of the value in CMG, more as a commentary on the state of the current equity environment that this (uncertain in our view) is one of the best situations he can find.

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