Chipotle: A Classic Solvable Problem And Why The Company Is Misunderstood By Investors

| About: Chipotle Mexican (CMG)

Summary

The best investments are often stocks with temporary, solvable problems.

Chipotle's E. coli and other scandals over the last few months have created a great buying opportunity.

Consider what makes Chipotle great and it's clear this company will come back from these problems.

The best investments are often those companies with temporary problems that can be solved, put in the past, and eventually forgotten. One famous example is Buffett's investment in American Express (NYSE:AXP) in the 1960s after the "Salad Oil Scandal" had knocked American Express' shares down 50%. Buffett knew that the loss wouldn't bankrupt the company and would eventually be an irrelevant footnote, so he used the opportunity to buy into a great business at a steep discount.

One of my favorite examples is the Netflix (NASDAQ:NFLX) price hike in 2011. It's hard to imagine now, but people were furious at the company back then. It lost hundreds of thousands of subscribers and its stock price dropped from a high of $40 to under $10 in 2012. Now, of course, the stock is $100+. It was a temporary, solvable problem that wouldn't affect the product or the company years down the road.

Will Anyone Even Remember This in 5 Years?

Which brings us to Chipotle (NYSE:CMG). Like countless E. coli issues at other companies in the past few decades - most of which have been far worse in terms of the number of people infected, if not media coverage - this too shall pass. In 10 years, or even 5 years, will anyone even remember this? Doubtful.

Here is a reasonable worst case scenario: 2016 and 2017 comps stay bad and the company struggles. Then in 2018, it is back on its feet. If that happens, you are probably looking at $30-$35/share earnings in 2018. Here's how: It adds 200 stores in 2016 and 250 stores in 2017. By the beginning of 2018, you have 2,500 stores, a 25% increase from now. Meanwhile, the company has no debt and is buying back stock aggressively with its $1 billion cash position, zero debt and operating cash flow. Keep in mind estimates for 2016 before the scandal were well over $20 per share, it may buy back 10-15% of its stock in 2016 and 2017 and have 25% more stores.

And even then, the company will have decades of runway ahead of it, both in the US and abroad, and with the Shophouse brand to compound returns.

Think about this - at the end of Q3, it had $1 billion in cash and no debt. It bought back 2% of its stock in Q4. The current remaining authorization is for $416 million, good for 3.2% of its stock at current prices, which we can assume it will spend in Q1. That's an over 5% reduction in shares in six months, and the reduction will only accelerate with these lower share prices. The company is still quite profitable (although exact figures are difficult to predict with comps falling so far) and can easily afford to go into a net debt position to continue buying back a ton of stock this year and next.

Consider What Makes Chipotle Popular

One of the bear arguments right now goes something like this: the local sourced, food with integrity model is what caused the health problems and Chipotle will have to switch to a more processed, nationally sourced model, which will diminish its appeal with its customer base.

I think this grossly misunderstands the company's appeal. Sure, some customers care that the food came from a local farm versus a national, corporate farm. Or at least it makes them feel nice when they eat the food. And some of that will have to change now to ensure there aren't any more outbreaks.

But the appeal of Chipotle's is not the fact that it has local produce. The big appeal is: (1) its fresh and real food; (2) it fills you up; (3) it's no more expensive than fast food when you consider portions; and (4) it tastes good.

You can see that the meat is real. That's part of why it places the chicken grill in plain sight. It's not processed with additional ingredients into the shape of a chicken nugget. It's just 100% chicken. Same goes for the peppers, tomatoes, corn, etc. Everything is 100% what it's supposed to be. And, partly as a result of the fact that it's real food like rice, beans, meat, corn, it fills you up. And as a side note, comparing the calorie count of a burrito to a Big Mac probably even more totally misunderstands Chipotle's appeal. At Chipotle, you are getting real food, and that food may have some calories to fill you up. But it's not processed and its not battered with unknown items and it's not fried. It's also no more expensive than fast food if, like most people, you end up ordering multiple items at McDonald's (NYSE:MCD) so that you're not hungry after 2 hours. Consider that two burritos/bowls, chips and guac at my location is about $17.50. I don't know how, but every time I go through the McDonald's drive through I end up with the same bill or even higher once you factor in meals with fries and drinks, multiple burgers/nuggets, etc.

I don't mean to push the point, but if you don't get the above reasons why Chipotle is fundamentally different from the other fast food chains and isn't even really competing with them at all, you should ask a millennial. It's not the fact that the food is locally sourced. It's that it's the best value for money when you're looking for real food.

Chipotle is a great buy at these levels. It's proven to be capable of internally compounding fantastic returns with 10%/year store count growth and healthy comp and margin growth, all without incurring any debt. Operating leverage is going to work against it this year, but this company is going to come roaring back. There are too many young people who eat there regularly for all of the reasons identified above. This stock may go down further and that only makes it more attractive. This is a classic opportunity to purchase a great company at a more than fair price because of a very fixable problem.

Disclosure: I am/we are long CMG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.