Some Clear-Headed Thoughts On Chipotle

| About: Chipotle Mexican (CMG)

Summary

Both bullish and bearish arguments on Chipotle seem a little too opinionated to me.

Stepping back and analyzing three key issues, I believe there's no clear reason to be either long or short Chipotle at this price.

Thinking through the stock is a good exercise in remaining objective.

Since the outbreak, I've been following Chipotle (NYSE:CMG) because I thought that shares might get cheap enough to present a compelling long-term buying opportunity. Unfortunately, they haven't quite gotten there yet - but the furor around the stock (on both the bullish and bearish sides) has been somewhat interesting/amusing. Given the size and relative publicity of Chipotle, it's pretty much impossible to have a true "analytical edge" here. On the other hand, it's certainly possible to have a behavioral edge by being what Howard Marks would call a "second level thinker" and sense-checking media hysteria and your own initial gut reactions (whether positive or negative). As I've written before, being objective is one of the most important things you can do as an investor.

After reading through the earnings call a few times and giving it some careful thought, my conclusion is that Chipotle's business is probably stronger than a lot of armchair analysis (and pictures of empty restaurants on Twitter) suggests, but the valuation more than accounts for that. As such, I don't think Chipotle is either a good long or a good short here. I know that doesn't really make for a crowd-pleasing article, but A) that's not my job, and B) mathematically, this is not a surprising result. Almost by definition, for a long or short idea to be truly compelling, there can only be a few of them. Most stocks, then, will neither be conviction buys or clear shorts. Just because they're in the news and Cramer is shouting about them doesn't mean you have to do anything with them.

I'll address three issues here: food safety, brand image, and valuation.

Careful Not To Over-interpret Data On Food Safety

One of the major arguments/questions around Chipotle right now is whether its food safety failures were systemic (and perhaps even intentional). I think this, more than anything else, is an area where clear, rational, detached, objective thinking is critical.

The food industry's dirty secret is that it doesn't care if it poisons you. I mentioned it in my last article, and I'll mention it again: I've chatted with the CEO of a company whose products to improve food safety were outright rejected by major food companies because they didn't view reducing a few cases of food poisoning as worth the cost of the safety procedures. It was a pure risk-reward decision for them.

As shocking as this was to me, research suggests it's an open secret to those in the food industry. I thought this interview with Bill Marler, a lawyer who specializes in food-borne illness, was quite balanced. While Marler did state that "six outbreaks in six months...that's pretty unprecedented," on the whole he seemed to believe that this is less a Chipotle-specific problem and more an industry-wide problem. Just recently, some packaged salad that I'm quite fond of was associated with listeria. I found out after I'd eaten three bags in as many days. Wonderful! (Luckily, mine weren't contaminated.)

Indeed, even to the extent that there are a lot of food safety violations at Chipotle - whether known or yet to be identified - I think it's thinking through what this would really mean. The concept of "base rates" is important to consider here. This basically means that when you're looking at any given situation, you need to think about what the typical rate of incidence would be across other similar situations. (For more, read this post on Shane Parrish's wonderful Farnam Street.)

If you listen to people who are really experts on the food industry, reading between the lines, if you were to shine a bright spotlight on any given company, you would find a lot of faults in their food safety. To put it another way, if you open the door to your teenager's room, you're going to see that it's messy and rant and rave about it - but in all reality, it's likely that every other teenager on the street has a room that's just as messy. You just don't happen to be looking at their room.

I believe this is the scenario with Chipotle - to some extent, the food safety issue is reflexive. If you point a spotlight at a company, cases will materialize. How many times in your life have you felt queasy and suffered gastrointestinal distress after eating something? Happens a couple times a year, right? Most of the time you probably just write it off as something that happens - life goes on. But on the other hand, when it's all over the news that XYZ product/restaurant is making people sick, you draw that link. Today, that XYZ is Chipotle; if Chipotle hadn't been in the news, half of the cases likely wouldn't have come out into the open to begin with.

This is not to say that the current food safety paradigm is acceptable - and indeed, Chipotle is going complete overkill in fixing things. As a consumer, I actually like the honesty and forthrightness, and would be more rather than less likely to eat at Chipotle in the future because of it.

Debate Over "Food With Integrity" Misses The Point

Another line of argumentation, on the bearish side, revolves around the idea that Chipotle's brand image is permanently compromised. As someone who lives in a state where F-250s are daily drivers, I have a slightly different take. There are certainly some consumers who choose to eat at Chipotle over another restaurant due to its practice of supporting local farmers and not using antibiotics - but around here, I would estimate that thought doesn't cross the mind of 95% of people ordering something and swiping their card.

Simply put, I think it's reasonable to assume that most people eat at Chipotle because A) it tastes good, and B) it's fairly inexpensive for what it is. For this reason, Chipotle has fairly wide demographic appeal. Walk into a location and you'll see a cross-section of America. Personally, I ate at Chipotle with my friends as a broke college student...and as a buy side analyst, I also fetched Chipotle for my multi-millionaire boss.

This value proposition has not changed, and will not change. Some commentators have charged that some of the food safety procedures, such as blanching, will impact the taste of the food. This is a reasonable concern; it is certainly possible that the texture of the lettuce or tomatoes would be changed. However, I would point out two things here: first, blanching has been done for a long time and is well studied; there are best practices for preserving flavor. Second, very few people are eating the lettuce or pico de gallo all by itself. Minor changes in flavor or texture due to blanching, when considered in the context of the larger burrito (bowl), seem unlikely to me to be noticeable. When you've drowned your salad in pinto beans, sour cream, and an extra helping of cheese, is your lettuce going to be crisp anyway? I think not.

Going back to the behavioral side of things, the vitriol from a certain section of the peanut gallery has been interesting. Frankly, I think some of it is driven by jealousy - if you've watched Chipotle's stock go up and it's offended your sense of proper valuation, or if you simply don't like the company's holier-than-thou moral code and are happy to see their noses rubbed in the dirt, then it's easy to get carried away.

I Like The Business...But I'm Not Alone

Great businesses usually get recognized sooner or later, and Chipotle's astonishing performance is in this category. It's been an expensive stock for a very long time, and - despite the sell-off - it has yet to get to a level I'd consider cheap, or even reasonable given the circumstances.

I stated in my last article that I thought it would be a very interesting long idea at around ~2x sales, but it hasn't come anywhere close to that. Near-term multiples will likely get very messy given comp-driven deleveraging (which could take four-wall margins down to low double-digits) but what seems to be important is that food safety initiatives will only take 200bps off restaurant-level margins in the long term. In other words, assuming that they can get back to their previous AUVs, four-wall margins will still be mid-to-high 20s.

This alone takes out half of the short thesis - it's no longer tenable to allege that margins will be dramatically lower in the long-term (unless you come up with good reason to believe the steps Chipotle is planning to take will cost more than 200 bps). On the long side, though, we're looking at a very ugly three or four quarters on both the revenue and margin side. The stock doesn't look cheap even on trailing numbers (which don't bake this in), let alone on forward numbers.

Adding to the reasons not to buy: there is obviously execution risk in getting people back into stores, and it may take longer (or cost more marketing dollars) than expected. But, on the bright side, social media works both ways - while the spread of information was faster on the way down, it's also much easier for Chipotle to engage with consumers on the way back up in ways that are cheaper (and possibly more effective) than blanketing TV channels with trite "We're Sorry" commercials. On that note, I actually like the fact that Chipotle's upcoming marketing campaign will be focused much more on the food than the food safety - beginning to shift the conversation back onto their ground, not the media, is exactly what they need to be doing.

Conclusion

Setting my personal feelings aside, Chipotle objectively has great food at a reasonable price point. "Food with integrity" is not the reason most people eat there - nor is food safety something that most consumers think about very often (other than when something like this isn't in the news.) Memories fade. Remember Ebola? Yeah, we were all scared to leave our houses, and now we're back to not washing our hands and licking doorknobs in our spare time.

Chipotle seems likely to continue to whipsaw and provide traders with opportunities. That's not my game, though. Chipotle is not nearly cheap enough here to be a compelling long-term investment given the execution risks - but on the other hand, the bear thesis appears to be more of a vendetta than a clearly thought through position. While I'm inclined to believe that there is indeed a lot more downside for Chipotle shares if February and March comps don't turn up in the wake of heavy marketing spend, I also think that shorting this stock for any length of time could prove to be dangerous, notwithstanding its expensiveness on fundamentals (valuation shorts rarely work).

Chipotle is a business I'd love to own - but there's not enough margin of safety at this price. I continue to believe it would be really interesting a few hundred dollars down from here, but I'm not very optimistic about the price getting there.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.