Chipotle: Be Greedy, Go Long

| About: Chipotle Mexican (CMG)


Chipotle has been a strong performer over an extended period of time.

The e-coli crisis has left stock at valuation levels not seen since 2009.

Precedent suggests the brand should recover.

I believe investors buying stock at these levels will be handsomely rewarded and recently bought the stock.

I've had my eye on Chipotle (NYSE:CMG) stock for a while now, in fact close to 10 years. I viewed the business as one that had got away. The company had rarely been at a price that I felt comfortable enough to take a swing at the stock, but it finally reached a level earlier this week that I wasn't able to resist.

Chipotle has all the things that I look for in a great growth business. It has managed to strong, revenue growth, progressively increasing margins, strong earnings growth, and a strong return on invested capital. Best of all, the business has done this consistently over the last decade through a variety of economic conditions with negligible long term debt.

A rare business of high quality

Chipotle has managed consistent revenue growth at close to 20% annually over the last decade. This also isn't a case of a business with growth that has started strong and been progressively declining. The business has seen 3 year average revenue growth top 20% for each of the last few years.

Chipotle gross margins and operating margins have been responsible for juicing earnings growth. It's amazing that gross margins have increased from 18.5% to almost 27% in the last decade. Even more impressive is that operating margins have grown from 4% to 18.5% in that same time. I don't believe this is the end of the operating leverage story either. Chipotle's margins are likely to continue steadily increasing over time.

The result of steady, consistent revenue growth of close to 20% annually, and consistent operating margin expansion has been earnings per share growth that has averaged almost 30% on a 5 year average basis, for each of the last 5 years. The business picture is complete when you look at Chipotle's return on invested capital. For my mind, this is what distinguishes really great businesses and drives long term value creation. A business with high ROIC operating in a growth market has the unique ability to drive more of the capital invested into the business direct to the bottom line and see strong long term earnings. Chipotle has delivered returns on invested capital in the 20% range for each of the last 6 years, which is quite a commendable achievement.

The summary of all of the operating data to this point suggests a very strong business with great fundamentals and strong underlying demand, earning very healthy returns on invested capital.

However the quality of this business wasn't lost on investors, who would routinely price Chipotle stock at a significant premium to the S&P. In fact, over the last 10 years, there were only 2 years in which Chipotle's P/E wasn't at least double that of the S&P 500. Those years were 2009 and 2015. It was this valuation premium that historically had given me pause before taking a swing at this business. However the e-coli epidemic that has decimated foot traffic at Chipotle stores has brought the company to a much more palatable valuation for me. In fact Chipotle now trades at the lowest premium to the S&P 500 since 2009.

Other great brands have recovered from crisis

Chipotle's e-coli crisis brought back parallels for me of Johnson and Johnson's (NYSE:JNJ) Tylenol crisis in 1982. JNJ's crisis was without question far worse than what Chipotle is facing. Cyanide laced Tylenol caused 7 deaths in the Chicago area. The damage to the consumer brand was arguably irreparable and could have crippled Tylenol forever . But JNJ's playbook to the crisis was exemplary. It recalled 31M units of Tylenol, gave replacement product free of charge and drove an extensive media campaign around how Tylenol was restructured to be much safer and what checks and balances were in place to prevent a recurrence.

Chipotle's crisis management has been good to this point. Interestingly, the franchise has also noted that it will be kicking off an extensive media campaign in February to get customers back into the stores, and indicating corrective actions they will take. Restaurants will be giving away free food to get customers back and win their trust. Chipotle's supply chain will no doubt also see process improvements to prevent such a recurrence of an event of this scale occurring again.

Chipotle management indicated recently that they expect a year long recovery, and that lost customers should be back in the stores by 2017. There is some reason to believe that they may not be too far off the mark here. Johnson & Johnson saw its share of the analgesics market fall from 37% to just 7% immediately after the Tylenol scandal. That market share recovered remarkably well within a year back up to 30%.

If consumers can overcome their fear of potential death and go back to a brand that saw such devastating impacts on consumers, there is arguably hope for Chipotle long term. While various marketing surveys have indicated swathes of Chipotle consumers with no intent to go back to the store, I'd suggest that consumers generally have much shorter memories and that all will be forgiven if Chipotle can get this under control quickly. This is particularly the case given the demonstrable evidence that the underlying product is in high demand, as demonstrated by the strong sales growth.

If Chipotle can maintain a period of several months where no new incidents are reported, and emerge with minimal damage from the CDC investigation and finally convince the public that they have taken clear measures to rectify their supply chain, my expectation is that sales will show steady recovery to be substantially where they were pre crisis with 18 months. Of course, the longer term brand risk is that selective e-coli epidemics keep randomly occurring with management having no explanation for the outbreaks. That will cause irreparable long term brand damage.

Recent buy for my growth portfolio

I initiated a position in Chipotle shares earlier this week at $415 for my growth portfolio, with the intent of buying another couple of tranches of stock if the shares hit $350 and then $300. While I have no idea if the stock will hit these lower levels, I believe that anyone buying at current prices should be handsomely rewarded in several years time.

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.