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BILL ACKMAN, WITH 41% OF ASSETS IN QSR, CMG AND SBUX COMBINED, IS STILL NOT WELL POSITIONED

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BILL ACKMAN, WITH 41% OF ASSETS IN QSR, CMG & SBUX COMBINED, IS STILL NOT WELL POSITIONED

We wrote an article on October 11th, discussing the three major positions in Bill Ackman’s Pershing Square Capital portfolio, within our knowledge base, that comprise a massive 41% of his $8.3 billion portfolio.

At the close of business, October 11th, Restaurant Brands (QSR) was $56.26, Chipotle (CMG) was $434.06, and Starbucks (SBUX) was $54.87. Our conclusion on October 11th was that he should switch his QSR immediately into McDonald’s (then at $163.98), sell his CMG to take advantage of the huge move since new management has been installed, and hold his SBUX (which has moved up nicely).

We have no reason to think that he has made any moves in the last several weeks, but Restaurant Brands, McDonald’s and Chipotle have all reported third quarter results. Starbucks reports tonight.

From the close of business October 11th to last night’s closing price, Restaurant Brands, at 53.06 was down 5.7%, or $85M on the $1.5B position. McDonald’s, at $178.42 was up 8.8%, so would have made Ackman’s Pershing Square Capital a profit of $132M. Chipotle closed at $465 so Ackman would have foregone a profit of 7.1% or $63M on his $900M investment.

Our advice, less than three weeks ago, to Ackman can definitely be considered “theoretical” in terms of the practical ability to switch $1.5B positions instantly, or sell $900M worth of Chipotle on the spur of the moment, and Ackman’s positions are established on the basis of long term prospects. Acknowledging that three weeks doesn’t “make a season” or prove a thesis, Ackman’s portfolio would be ($132M+85M-$63M) a cool $154M better off, or 4.5% of the $3.4B in these three positions, especially costly when all hedge fund managers are fighting for every basis point in a difficult market environment.

Our points here are (1) too many multi-billion hedge funds, and other institutions are playing hunches rather than making well informed long term judgements. This is a function of not enough really attractive reward/risk investment propositions when trillions of dollars of capital are competing to generate “alpha” after nine years of a bull market (2) there is too much emphasis on short term performance, trying to “game” the monthly comps for example,  rather than evaluate long term strategic positioning (3) in too many cases, the self confidence of multi-billion dollar money managers is unjustified. They are very smart, hard working, in many cases have become very rich (which breeds inflated egos), and can’t be expected to know as much they should about every industry. Rather than make Bill Ackman an undeserved particular example: Eddie Lampert, still a billionaire, had no chance whatsoever to turn around Sears based on his strategies, and there were lots of highly experienced retailers that could have told him so. It has taken ten years to play out, but it was clear to many of us years ago that the brilliant and successful Lampert was wasting enormous time and money on Sears.

If we were speaking with Ackman today, we would suggest that it’s not too late to adjust the portfolio. The last three weeks are history.  Let’s see what happens over the longer term.

Roger Lipton

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CHIPOTLE (CMG) – Stock Is 300 points lower over last two years – What to do now?

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CHIPOTLE (CMG) – 2 yrs. later, stock down over 50%, getting hammered again, what now?

We’ve written repeatedly about Chipotle over the last two years, almost always from a cautious standpoint. Readers can use the search function on our home page to revisit the various articles.

Earnings were released last night, and the stock is down $48 as this is written, to $276. per share. Investors and analysts were obviously very disappointed with the results and the prospect for near term improvement. We will not rehash the quarter here, since you can get that elsewhere. We will instead focus on our view relative to current store level performance, and the likelihood of better results.

Our focus, as a potential investor, should be on the existing system and the new stores that are being built. The AUV is now running at a rate of about $2M. The systemwide store level margin was 16.1% and 17.6% over the last three months and nine months, respectively. New stores are apparently doing about $1.5M with a first year store level EBITDA margin of about 10%. The average investment in leasehold improvements and equipment runs about $800,000. If we assume 18% EBITDA store level return on the current systemwide AUV of  $2M, and 10% first year EBITDA return on $1.5M, we get a cash on cash return of 45% and 19% respectively. These returns are more than satisfactory for the mature stores, but less than exciting in the first year. The problem is that, charitably speaking, the AUVs and margins have been challenged for the last twenty four months, and the big question is whether volumes and margins will improve or not.  This is especially so, with the stock still trading at over thirty times estimates for ’18 that will probably settle in the $7.00-$8.00 EPS range.

I think part of the extreme reaction by CMG stock this morning, is a result of what I would call encouraging commentary by Chipotle’s Chief Marketing Officer,  Mark Crumpacker,  and Bill  Ackman, a prominent institutional stockholder. In late September, Crumpacker’s internal email memo was somehow obtained, and  cited,  by Bloomberg, saying that “diners like its new queso dish, even though some dissatisfied customers took to Twitter and other social media outlets to trash it”.   Ackman, affiliated with two Board members, was quoted as saying that while “he hadn’t tried queso, people in his office had tried it and liked it” and the stock then trading around $312 “is extremely cheap”.  He also said “I’m beginning to believe that Twitter is filled with a bunch of Chipotle short sellers.”

What’s somewhat surprising to me is that,  though Crumpacker’s internal memo was presumably  not intended for public distribution, some observers would assume that Ackman had an informed opinion regarding the impact of the queso introduction. The hope that Queso was doing very well, brought back to reality by last nights discussion, has been dashed, and may be contributing to the dramatic stock plunge this morning.

While the Company claimed to be satisfied with results of the rollout, indicating a high single digit sales lift when launched, then “leveling off” after initial trial. “Currently 15% of our customers continue to order queso”. As an analyst and an observer with no  horse in this race (I’m not long or short CMG right now.) I’ve tried it, found it adequate, but far from a “game changer”. It may or may not contribute a few points to the comp, but it is not an “Oh, Wow!”

Remaining Strategic Issues

Many critics of the Company over the last two years have questioned the continued construction of 180-200 new stores, over 10% unit growth, at the same time retooling the system to prevent further operational problems. Announced last night was a reduction of unit growth, to 130-150 in ’18. Steve Ells, CEO, described the thought process on the conference call last night as follows: “..as Scott (new Chief Restaurant Officer) got involved…it was very clear that, the analogy I would use is we’re changing the tire while the car’s still moving and here we have a lot of people that we need to train or retrain how to run a great restaurant…….opening up new stores is a big distraction. You have to start thinking about hiring people months and months in advance….you’ve got to train people in advance of the opening..turnover in a new restaurant often is high…..so it’s a distraction in a lot of ways.” To which I say: “Really?”  and “Too Little, Too Late!” It seems to this observer that 130-150 new stores could still be reasonably “distracting” from the ongoing challenge to regain old customers and attract new ones.

Another “strategic” decision that has been made,  predicted, by myself and others, to be foolish and expensive has been the huge expenditure to buy back stock, at valuations that have been far from inexpensive. Prior to the most recent quarter, about ONE BILLION DOLLARS was spent to buy back stock in the mid $400 range, on average. I wrote over a year ago that the company was “out of their mind” to be buying stock back, at over $500 per share, especially when they knew the upcoming news would not be good. The folly continues. In the most recent quarter, $102.5 million was spent, at an average price of $341. An additional $100M has been authorized. There is still over $500M on the balance sheet and no debt. Could have been over $1.5B.

FROM THIS POINT FORWARD:

There are lots of initiatives that are in place, including the contribution from a number of highly qualified restaurant executives that have been added to the team. For details of this effort,  I  encourage interested observers to read the transcript of last night’s conference call. (https://edge.media-server.com/m6/p/izb7479f)  It’s all promising, but challenging, especially in an environment that is generally unforgiving. Over the last two years, as the Chipotle brand has been undermined, new and old competitors have not been standing still.

In summary: My conclusion is about the same as it was two years ago, when CMG was over 100% higher. There is no rush to invest here, even with the stock down so substantially. The valuation is far from “cheap”. There are better alternatives if an investor wants to pay well over 30x expected earnings in calendar ’18.

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CHIPOTLE MEXICAN GRILL

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Company Overview   (2016 10-K)

Chipotle Mexican Grill, Inc. is the owner and operator of a 2,339 unit fast casual chain of with a narrowly focused menu of burritos, tacos and salads generating $4.3B in sales in TTM through 17Q2. 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.  While the worst of the crisis seems over, the company experienced a norovirus incident in a Virginia store in mid-July 2017. The incident was an unwelcome reminder the company hasn’t fully put the past behind it, and its challenge is to sustain the recovery and re-attain the industry-leading store productivity profitability it generated previously.

Menu  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. The company is testing 2 desserts and queso cheese sides, which, if they make it to the menu, should boost the ingredient count slightly above 51.

Operational Model & Unit Level Economics The average cash outlay for the 2016 class stores (size 2,550 sq.ft. seating about 58) was $865 (per 10-K + est. preopening expense).  For this cash outlay we estimate cash-on-cash returns of 33.9% assuming TTM AUV of $1,931K & store-level EBITDA margin of 15.2%. 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 20.8%, so we could consider that the 33.9% described above is a “target” return in year three. Of course, the Company expects sales to continue to recover and EBITDA to improve substantially from the 33.9% of ’16. Presumably, first year cash-on-cash returns would ratchet upward as well.

Company Strategy 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.

But in 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.

In the wake of these developments customers fled, voting with their feet their belief the FWI brand promise had been broken.  Needless to say, comps fell abruptly, dropping as low as negative 29.7% in 16Q1after which they recovered quarter by quarter, finally returning to positive territory, posting +17.8% in 17Q1 against the bottom in the prior year’s quarter (8.1% in 17Q2).   AUV’s followed suit, dropping steadily in 2016 before rebounding to $1.957K in 17Q2 in sync with the bounce back in comps. Quarterly operating margins continued rising to 19.3% in 15Q3, before plunging to -5.6% in 16Q1, after which they recovered somewhat steadily to 9.1% in 17Q2. The plunge was caused by deleverage and the expense of initiatives to recover public trust.  The chart below tells the same story in terms of AUV’s, comps and restaurant-level EBITDA margins.

The company scrambled to recover with massive (and expensive) quality control initiatives in its supply chain and the stores.  It also undertook extensive food promotions and massive public relations campaign to communicate the initiatives. Among these initiatives (aside from investigation and inspection of the entire operation) were: a $10M commitment to training and support of its specialized network of farms and ranches, including product barcoding to trace all food supplies to its sources; sophisticated ongoing supervision regimens; and overhaul of store food handling procedures.  To entice customers back in the stores the company offered free entrees in early 2016 followed by its “Summertime Chiptopia” BOGO type program.  The company broadcast its initiatives with extensive advertising.

As indicated by the numbers, the worst is probably over and the company is shifting 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 is introducing new second make-lines for on-line sales in many of its stores after testing demonstrated they could produce as many as 130 additional entrees in a typical 3 hour peak without additional labor.  It has hired 2 new advertising firms and recently launched a broadly based brand building campaign. And it is also expanding its catering business and exploring delivery.

The company believes these initiatives will propel it back to $2.5M AUV’s, 20%+ store level EBITDA margins and EPS of $10 in the near term.  It has not provided a timetable for reaching these targets, acknowledging progress will be uneven, but indicates they are the first milestones on its path to growth at its former pace.

Operating Metrics  CMG has no debt but after accounting for debt implied by operating leases, the company’s ratio of lease adjusted debt to EBITDAR, at 3.3X, is only slightly above the 3.1X average of its peers (PNRA, SHAK, SBUX, CHUY and ZOES).  Prior to the food/trust crisis, the company’s level of profitability ensured it compared much more favorably by this measure.  However, the company’s still ample cash flows and reserves provide the capacity to engage on multiple fronts simultaneously without resort to debt.  TTM free cash flow through 17Q2 was $167.3M (CFO $413.21M, CapEx $248.8M) or a FCF margin of 3.9%. Still, this was down from FCF of $458.6M or FCF margin of 10.3% in 15Q2, just before the crisis. Importantly, the company has not slowed its annual capex spend (about $250M) due the crisis, though it is allocating slightly more for food safety infrastructure, digital initiatives and slightly less to store growth (in 2013-2016 average new store investment was about 210 per year, and in 2017 management is guiding to 195-205 new stores. Another sign of the concentration of management focus was the announcement of the closure of all 15 of its ShopHouse chain (although management remains committed to its embryonic Tasty Made burger concept and majority investment in Pizzeria Locale).

Shareholder Returns  In the last 10 years CMG has appreciated 323.7% or 15.5% annually.  Its high of $749 was reached in July 2015 at the onset of its food-borne illness crisis.  It had begun to recover in the last 2 quarters, but the stock had been drifting down following 17Q1, with all the recent gains lost following the July 2017 norovirus incident.  As the chart below indicates the stock has always been richly valued with the forward P/E trading pre-crisis in a range between 25X and 55X.  Post crisis, the market is clearly discounting a successful turnaround. Even so, as of this writing (2 weeks after the Virginia store norovirus incident and 2 days after the 17Q2 earnings release) the forward multiple hasn’t slipped below its current level of 38X.  The company does not pay a dividend, but has long made modest repurchases of its stock.  However, since the crisis it has materially stepped up repurchases, spending some $1.26B since 15Q2 to repurchase some 2.7M shares at an average price of $472. The repurchases were financed by drawing down cash balances and with the proceeds from sales and maturities of longer term investments in U.S. treasuries.

Recent Developments

The norovirus incident ten days ago, so widely reported in the press, which loves a bad story, has modestly affected the 18 month recovery in sales that had already plateaued over the last several months, down about 17% on a two year basis after being down as much as 37% during Q1’16. Management indicated that most recent sales seem to have been affected by 5-5.5 points from the previous trend, which matches our own personal anecdotal observations of modest declines. The Company obviously hopes that there will be no further incidents of this kind, and minimal further news coverage, and the recovery in sales that has taken place over the last year or so can resume. We have no doubt that operational executives are “all over it” in terms of doubling down on store level (and supply chain) policies to prevent another disastrous situation.

Q2’17 Results

While the recent norovirus incident dominates everyone’s thinking, earnings per share in Q2’17 were $2.32 per share, up sharply from the depressed $0.87 a year earlier and $1.60 in the previous quarter. Food costs increased 30 bp to 34.1% due to higher avocado prices, which have started to improve. Guidance is for food costs to improve by 40 bp in Q3 and move to the low 33% in Q4. Labor costs were 26.2% of sales, better than ’16 by 160 bp in spite of wage inflation of about 4%. Other operating costs were 14%, down from 15.2% in Q2’16, out of which Marketing and Promo was down 70 bp to 3.7%. In the second half of ’17, M&P are expected to be about 3.1%. G&A was 6% of sales, down from 7.1% a year earlier, helped by lower legal expenses, but increased by bonus accruals and stock comp expenses. Stock repurchases have continued, $77 million spent at an average of $423/share, and $167 million remains within the authorization. Though the Company has spent a cool $940 million buying back stock over the last eighteen months, there is still $569M of cash on the balance sheet and no debt. At least they haven’t (yet) gone into debt, as so many other companies do, while buying back all that stock at an average price of $458. You could say that buying back stock even at 20x EBITDA provides a 5% cash on cash yield, on presumably depressed EBITDA, and 5% is a lot more than treasury securities. The cash was available, and the share reduction did not affect expansion plans which have been maintained, to the consternation of some critics. Relative to the expansion plan and other issues, my role here is not to be a critic or presumed strategist. I leave that up to Steve Ells & Co., for better or worse, and I don’t mind pointing out that some observers feel that the Company has outgrown his capability. On the other hand, there aren’t any other restaurant executives that have built a company operated store system as rapidly and successfully as he.

There are lots of operational initiatives that could improve store level, and corporate, economics, some of which I will discuss below, but in Q2’17 the store level EBITDA margin was 18.9%, up from 15.5% in Q2’16 and, sequentially, 17.7% in Q1’17. Though down from about 28% a couple of years ago, a store level EBITDA margin that is approaching the 20% near term corporate objective is not shabby relative to other restaurant concepts, and generates a more than acceptable 30% cash on cash return.

Ongoing programs, and initiatives, that provide a high probability of contributing to improved results include: price increases for the first time in several years, continued emphasis of the increasingly successful mobile order and pay app, new products, more effective marketing including TV, a new loyalty program, further emphasis on operational training, improved existing products, rollout and advertising of a delivery capability, further reduction of unit development costs. Each of these programs can contribute in a materially positive way, so it seems to us that the sum of these initiatives could be very substantial. The second “make line” that is now part of the operational approach provides the attractive attribute of not affecting in-store ordering and dining, and building new businesses on existing real estate.

Conclusion

Putting it all together, barring a great deal of further poor publicity from customer illness, legal problems, or other corporate issues, the worst should be behind Chipotle. We suspect that the most recent setback will not be as large, or long lasting, as the E-Coli problems from eighteen months ago. It seems that there is a lot more that can go right than wrong at this point, and the $10.00 per share earnings level is achievable within the next 12-18 months. Building on that base, from new locations as well as steady same store sales gains, even without eye-catching increases, could establish an earnings trajectory of 15-20% annual gains and a reasonable P/E of 25-30x forward earnings. CMG at $343 (at 34.3 times the $10.00/share that is still a “reach”) is no bargain yet, but a long term investor is more likely to be rewarded than badly hurt. “Headline Risk” is the biggest danger, out of everyone’s control, but most of the operational mistakes should be behind us.

 

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CHIPOTLE – 2 Yrs. Ago – Everybody wanted to be the next Chipotle – Today, Not So Much!!

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INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.

WALL STREET JOURNAL – MONDAY 7/18 : WILL CONSUMERS STEP UP SPENDING ? – OUR TAKE

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INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.

CHIPOTLE MEXICAN GRILL

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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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