There's nothing like food poisoning to ruin your day (and night … and next morning). And there's nothing like 60 instances of food poisoning in 14 states causing 22 hospitalizations in two distinct outbreaks to absolutely ruin public confidence in your brand. And there's nothing like a ruined investment to bring The Unintelligble Investor out of hibernation, hungrily in search of a new opportunity.
And so it goes with Chipotle Mexican Grill (NYSE:CMG), the latest fallen angel of the investing community, a low capex, low leverage, high-growth, high ROE restaurateur spawned of a Charlie Munger-Rich Bayless romantic encounter. There have been many articles written about the situation so I won't rehash the last 6 months in entirety. Suffice to say, CMG served food contaminated with the bacteria E. Coli and a number of their customers became ill. The discourse has been engaging at times, but in my mind the 2 most important questions have still gone largely unaddressed on SA.
1) What will be the long-term impact of the E. Coli outbreak on CMG's business? I discuss below.
2) Regardless of the impact of the E. Coli outbreak, aren't CMG shares overvalued? Look for that in Part 2.
E. Coli Acometh
"In the business world, the rearview mirror is always clearer than the windshield."
This article did a great job outlining just how common E. Coli and other public restaurant illnesses are in the day-to-day lives of Americans. Others have dropped hints of previous calamitous disasters that have befallen titans of business (Tylenol and JNJ, etc. etc.), only for those businesses to shake it off like Taylor Swift at a closing dinner. But a deep dive into history can be instructive and can help tease out similarities and differences that might prove out a conclusion that this time will be different, or in fact the same.
Of course, just because food-borne illness is common does not mean it is not serious. No one wants to spend a long evening in the bathroom, a long week in the hospital, and certainly no one wants to put their children at risk. Significance aside, what currently befalls CMG is not a once-in-a-lifetime event. It's not even a black swan. It's an absolutely predictable (though low probability) outcome of serving a vast quantity of food to a vast quantity of customers along a diverse and complex supply chain over a gigantic geographic footprint. And it isn't exclusive to poorly run businesses and bad management teams.
Ever heard of McDonald's? (NYSE:MCD) The restaurant titan isn't exactly known for food quality or health, but it has always been an excellent business: a great marketer, supply chain manager, real estate developer, and innovator of fast food ideas: the Big Mac, the Chicken McNugget, the Kid's Playground, Ronald McDonald and, yes, E. Coli.
It sounded bizarre to me when I first read it, but literally the first ever E. Coli outbreak occurred in 1982 at MCD locations in Michigan and Oregon. E. Coli is a modern bug caused by modern food preparation, preservation, and transportation. 47 people were struck ill from February through July. Astonishingly, the outbreak did not garner a shred of significant national media attention. I could locate only one small article from the Associated Press that was published in March 1983, a full year after the initial outbreak, and only after a scholarly article published by the Centers for Disease Control & Prevention ("CDC") outlining the never-before-seen bacteria.
How much was MCD's brand, financial performance, and share price impacted by its Dr. Frankensteinian creation of a new superbug sandwiched between layers of hearty Quarter Pounder patties? Financial information for the period isn't readily available, but MCD's share price increased nearly 250% during the 4-year period between 1981 and 1985 with nary a meaningful pullback along the way.
Have You Had Your Outbreak Today?
E. Coli is now everywhere. The CDC keeps a tidy list of major, multi-state outbreaks since 2006. I have included a few below. In all the CDC counts 25 incidents in a 10-year span.
The CDC list is not exhaustive either. Not included, for example, are a 68-person outbreak at Taco John's in 2006 or a 13-person outbreak at Pizza Ranch locations in Iowa in December 2015 (as per the Des Moines register). Since MCD first sprinkled E. Coli seasoning on its fries, literally dozens of companies have been sued for contamination including such food behemoths as Dole, ConAgra, Cargill and fast food stalwarts KFC, Olive Garden, and Wendy's (those baked potatoes always looked scary to me). And that's just the list of companies sued by one litigator.
It would be faster to create a list of major restaurant chains that haven't had a food poisoning outbreak. Yet, despite the tarnished brand, susceptible supply chain, distraction of litigation, and millions of dollars paid out in settlements, the businesses impacted 1) survived the initial impact of declining sales 2) improved their safety standards 3) repaired their brand and 4) went on to thrive.
E. Coli in the Box
This is even true of the mother of all E. Coli outbreaks. In 1992, Jack in the Box (NASDAQ:JACK), then trading under the parent name Foodmaker, Inc., set the low watermark for E. Coli disasters with a traumatic outbreak infecting over 700 people, causing 171 hospitalizations, and leading to the deaths of 4 children over a 2-month span.
This was an outbreak the likes of which the US had never seen and has never seen since. The crisis officially began on 13Jan1993 with a warning from Washington state health officials. JACK was mentioned publicly for the first time on 18Jan1993. Later, the CDC would indicate the outbreak actually began in Dec1992, and even with the eyes of the entire world watching, the outbreak continued with the last death occurring on 20Feb93.
At the time, JACK was the 5th largest restaurant franchise in the US with over 1,100 stores. Less than a decade after MCD invented the disease to nary a pin drop of protest, the JACK outbreak was a top story, receiving widespread, nightly national media coverage from top news networks and newspapers including the New York Times (which wondered allowed whether JACK would endure).
Predictably, JACKs quarterly sales were demolished beginning in the second quarter.
As a result, its stock collapsed from a high of ~$7 the day before the E. Coli announcement to less than $2 almost 2 years later.
Disastrous, right? Well, before you rush to short CMG, there's an important caveat. In the late 1980s, JACK was taken private by management in one of those MBOs that were more in-vogue in the 1980s than the phrase "in-vogue". A few years later, JACK was taken public again, only this time, saddled with a hefty $500MM worth of debt.
With $50MM in annual interest payments to satisfy, JACK generated annual losses that chewed up book value and left ZERO free cash available to satisfy ~$50MM per year in principal repayment. With leverage ratios at nosebleed levels and return of principal in doubt, JACK's long-term viability was an open question.
But not because customers quit going to its restaurants. Revenues bottomed in 1995 at just 18% below the 1993 peak (figures made somewhat noisy by Foodmaker's wholesale operation). JACK continued to add stores throughout the crisis, and per store sales actually began to improve in 1994 as per below.
Click to enlargeBy 1997 JACK was back, thriving again.
In fact, if you bought JACK at the absolute bottom in Jan1995, you would have immediately trounced the S&P500 and outperformed it by a staggering margin up to now.
But I'm arguing that the bulk of the share price decline was driven by debt, not demand. What if JACK was debt free, a lot like, say, CMG? JACK's interim low of $3.88 on 22Feb1993 would have likely been the bottom. If you'd bought then, you would have matched the S&P500 all through the 1990s and early 2000s (despite massive overvaluation in the tech sector) and gone on to trounce it over the entire holding period.
The JACK outbreak was an entire magnitude larger than CMG, the company was not nearly as strong a financial performer, and it was saddled with a mountain of debt. Still, it went on to future success.
BUT IT'S DIFFERENT THIS TIME
Despite the strong historical evidence that CMG's E. Coli outbreak will not be debilitating, there are 2 prevailing arguments for why things could potentially be different this time.
Fresh Means Faulty
One user fairly posited that perhaps CMG's supply chain is fundamentally flawed compared to its longer-tenured competitors; maybe fresh food from local sources is much harder to manage than the less nutritious versions on offer. CMG's supply chain is more complex, making it harder to identify hazards and even the source of causes. In fact, no source (single or multiple) has yet been identified for either of the CMG outbreaks.
So I would have to agree: there's no question that CMG's process is more susceptible than others … as of today. But the record shows that CMG's approach is no more inherently flawed than any other used historically. E. Coli began as a strictly beef-borne illness. MCD and JACK outbreaks were due to contaminated ground beef that was exposed in the processing plant, then undercooked at the service counter. Today, the majority of E. Coli outbreaks are caused by fresh produce.
What happened? Did E. Coli grow tired of beef and suddenly develop a taste for produce instead? No. The meat industry evolved, identified issues, developed solutions, and eliminated the risks to serve their customers better (and, yes, not get sued). That is what I reasonably expect CMG will do with its process.
A related, though much less well thought out, argument that must be addressed is the idea that, because CMG purports to serve "healthy" food, it will suffer a greater impact to its brand/image than a host of other diabetes-on-a-plate serving competitors would in a similar situation. We seem to be using "health" as a catch-all term that incorrectly equates nutrition and safety. Yes, CMG claims its food is more fresh (and thereby more nutritious), its menu items less likely to cause a host of insulin-resistance related issues, and its suppliers operate in a more moral and sustainable fashion. But it doesn't in any way claim to be any better at preventing food-borne illness. ALL restaurant purveyors EVERYWHERE make that claim! Otherwise, no one would eat at any restaurant! Even the dirtiest, most unprofitable, poorly serviced restaurant around the corner advertises it is a licensed establishment whose food safety practices are inspected on a regular basis.
Not a single person walked into JACK with their family in 1992 thinking, "I know the Jumbo Jack Cheeseburger is terrible for me, so I'm willing to accept a higher risk of E. Coli infection." In fact, you could just as easily argue the opposite: nutrition and sustainable farming-conscious consumers might be more willing to accept the risk of food-borne illness because they understand that these practices open up the supply chain to greater risk.
Millennials are taking heat from all sides these days. Mocked on live television by sportcasters during a selfie-orgie, criticized by an NBA owner for making his team bad, and, yes, fingered as the root cause of the demise of CMG. Somehow CMG's situation is "unprecedented" because young adults can Snapchat. Dr. Duru did a great job dispelling this argument. Millennials are no more fickle than any generation of the past.
We often act as though media itself did not exist before Social Media. As though ideas were impossible to spread among a large populace without Twitter. Media did exist in the 1990s. JACK was all over every major television network and newspaper at a time when everyone watched the same networks and read the same newspapers. And JACKs sales suffered greatly in the short term as a result.
Yes, information disseminates faster today than 20 years ago, but this fact cuts both ways. It's easier for bad news to spread, and its easier for good news to spread as well. And while information is much more quickly disseminated, it is also much more quickly forgotten.
E. Calm Down
Hopefully, I've convinced you CMG is likely to survive and, probably, thrive as usual going forward. For some of you, perhaps all I've done is convinced you to never eat anywhere but at home, and even then only after washing your lettuce in sulfuric acid. With CMG's future secure, now we must consider whether it is a viable investment opportunity ...
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.