Chipotle Dual Share Class Arbitrage: Spread Has Widened Considerably

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Includes: CMG
by: David Simms

An interesting relative value play has emerged in the Chipotle (NYSE:CMG) Class A and Class B (CMG.B) shares. These two share classes are economically identical expect for one difference. The B shares have ten times the voting power of the A shares.

One can argue that having superior voting rights would afford the B class shares a premium over the Class A shares. However, in reality that is not the case and the Bs have historically traded at a discount to the As. One reason for this anomaly has to do with the liquidity of the two share classes. The As on average trade 715k shares a day. The Bs, on the other hand, trade a total of 125k shares a day or less than 20% of the A volume.

What is interesting now is the fact that the spread between the two share classes has widened to 23% from a low of 4% on 2/9/2009. This spread is near its previous historic extremes. Historically, the spread has ranged between 7% - 10%. What is throwing off this spread trade now is the run-up in the A shares triggered by a short squeeze given the heavy short interest with approximately 13 days to cover.

Many hedge funds that are trying to play this spread have been caught on the wrong side of the trade with the run in the markets, and specifically in CMG Class A shares. This has caused them to unwind the trade, i.e. cover the As and sell the Bs, which has only made the spread increase.

The Company has been taking advantage of this misprcing and continues to buyback its Class B shares. Further, the Company is considering collapsing / combining it's dual share class structure into one single class. Timing however remains uncertain.

But, if you want to look at history as a precedent for things to come, than look no further than Mueller (NYSE:MLI), a spin-off from Walter Industries (NYSE:WLT), which recently collapsed its dual class share structure.

Excerpts from Chipotle Management on this dual share class structure are below:

Now that we're past the second anniversary of our separation from McDonald's, we are assessing the possibility of collapsing our dual class structure. It's important to understand that we face significant and complex hurdles which we may not be able to overcome. In order to take any action to modify the separate classes, we have to receive an opinion of counsel acceptable to McDonald's or work with McDonald's to receive a ruling from the IRS that a collapse of the two class structure won't compromise the tax-free nature of the split-off from McDonald's and its shareholders.

We can't make any guarantee that either of these routes will be available to us. And if we took any action in violation of these requirements, and even if we do meet these requirements and the transaction is subsequently deemed taxable to McDonald's shareholders, we could face liability to McDonald's that we estimate could be as high as $400 million to $500 million. So obviously we need to honor our contractual obligations and not make any decisions on the dual class structure that could adversely affect our shareholders.

I think this trade is worth monitoring very closely as the spread is likely to widen from here providing for a compelling entry point. In the 2 1/2 year history of this pair, 34% was the biggest spread on October 10, 2008 so we may still have further widening of the spread especially if the market continues to rally and the shorts continue to get squeezed. In any event, the way to play this arbitrage is to go long the B shares and short the A share. An example will illustrate this:

Let us assume that both classes trade down. Then the trade is as follows:

  • Long 1 share CMG-B
  • Cost of purchasing B share: -$66.74
  • Short 1 share CMG-A
  • Proceeds from shorting 1 A share: $81.97
  • If spread narrows from 23% to 10%
  • 1 share CMG-B now trading at $60.00 (assumption)
  • 1 share CMG-A now trading at $66.00 (assumption)

Profit from trade:

  • Sell CMG-B share at a loss of ($60.00 - $66.74) $6.74
  • Cover CMG-A share at a profit of ($81.97 - $66.00) $15.97

Assuming cost to borrow CMG-A shares is 12% per annum, and the spread returns to historical range within 2 months, total gain on trade is:

  • Loss from selling B share: -$6.74
  • Gain from covering A share:$15.97
  • Cost to borrow A share for 2 months: (12%*81.97)*2/12 = $1.64

Total Profit: -$6.74 +$15.97 - $1.64 = $7.59.

Total Profit as a percentage of initial investment: $7.59 / 66.74 = 11.37% over 2 month period or a 5.7% monthly return.

Let us look at another scenario:

  • Long 1 share CMG-B
  • Cost of purchasing B share: -$66.74
  • Short 1 share CMG-A
  • Proceeds from shorting 1 A share: $81.97

If spread narrows from 23% to 10%:

  • 1 share CMG-B now trading at $70.00 (assumption)
  • 1 share CMG-A now trading at $77.00 (assumption)

Profit from trade:

  • Sell CMG-B share at a profit of ($70.00 - $66.74) $3.26
  • Cover CMG-A share at a profit of ($81.97 - $77.00) $4.97

Assuming cost to borrow CMG-A shares is 12% per annum, and the spread returns to historical range within 2 months, total gain on trade is:

  • Profit from selling B share: $3.26
  • Gain from covering A share:$4.97

Cost to borrow A share for 2 months: (12%*81.97)*2/12 = $1.64

Total Profit: $3.26 +$4.97 - $1.64 = $6.59.

Total Profit as a percentage of initial investment: $6.59 / 66.74 = 9.87% over 2 month period or a 4.9% monthly return.

Disclosure: no positions