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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.

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.