Chipotle: A Dangerous Short

| About: Chipotle Mexican (CMG)

Summary

Chipotle comps continue to struggle badly, and margins have followed them down.

The good news is this: the brand does not appear at all impaired.

Behind the scenes, Chipotle has other strategic endeavors that will allow the company to emerge from the crisis as strong as it was before - or better.

While there's certainly plenty of execution risk here and the stock hasn't fallen enough to be a good buy, it looks like an absolutely terrible short.

There's no way to sugarcoat it: fast-casual burrito chain Chipotle (NYSE:CMG) has a lot of work to do to earn back consumer trust after several well-publicized food safety issues. Based on a combination of data related to previous food scares such as Jack In The Box (NASDAQ:JACK), Chipotle's spare-no-prisoners approach to ensuring safe food, and Chipotle's strong brand image, good user experience, and high quality food for the price point, I expected comparable store sales to recover faster than they did.

That hasn't been the case, and comps continue to be pretty ugly into the spring despite Chipotle's significant marketing push. The good news is that things don't look as bad as many bears predicted; multiple data points suggest the brand is far from impaired, and margins should recover to a reasonable level relatively quickly.

Chipotle stock is still not cheap enough to be a compelling turnaround play, but shorting it looks very dangerous. If this earnings report doesn't kill the multiple, it's hard to believe that anything ever will.

The Bad: Comps Still A Very Big Struggle, Margins Following Them Down

You know things are bad when "sales were only down 22%!" is actually good news. So it is at Chipotle, where after a horribly January (which saw comparable store sales fall 36%), the ensuing months have been going better... sequentially, anyhow. At one point in February, Chipotle was actually back to comps that were down merely 9%, but heading into April, we're still down in the negative 20s. Some of this is due to check size rather than transactions - Chipotle has seen very good conversion on its free-burrito offers - but sales are probably a more helpful metric than transactions, as it's not very hard to sell someone a free burrito.

What's going to grab the biggest headlines here are the margins, which got massacred on a combination of occupancy deleverage and increased costs relating to the food safety initiatives and marketing campaigns. That said, management believes that margins can recover to the mid to high teens even with comps down 20%, and if comps recover to negative 10%, margins can get back into the low 20s.

The Good: The Brand Isn't Impaired

If you're looking for a more optimistic angle, there are a few good signs. The first is that the threat of substitution - which has been part of the bear thesis on CMG since Einhorn's ill-fated Taco Bell (NYSE:YUM) argument - seems overblown.

Some data points: even after everything that's happened, Chipotle's average unit volumes still utterly smoke Qdoba - Chipotle's AUVs at this comp level are $1.9 million (per CMG management on the call), versus under $1.2 million for Qdoba (per JACK filings). From what I understand, Chipotle stores tend to be about 10% larger, but even on a sales per square foot basis, Chipotle at its worst is still bludgeoning Qdoba at its best. On a variety of brand perception metrics, Chipotle is actually doing quite well - leading Chief Creative Officer Mark Crumpacker to note on the call that:

One of the good really good pieces of news in our research is that the differentiation of Chipotle from our competitors really has not suffered, or to the extent that it did, it recovered fully.

More quantitatively: at a Barclays conference last December, JACK CEO Lenny Comma responded to an analyst question about potential benefit from Chipotle weakness in overlapping geographies by saying:

Where they exist and we exist, too, they have a large enough amount of share that when they donate it back, the consumer isn't going to give all those sales to us. They're going to give it to a lot of people in the marketplace who are competing in the fast casual space.

So I'm sure there's going to be some impact, but it's not the type of impact that I think would be a direct one-to-one impact from one company to the other.

Indeed, it doesn't appear that consumers are ditching Chipotle for Qdoba in any meaningful level. While JACK hasn't reported yet, Comma's commentary on JACK's Q1 2016 call in February did suggest that Chipotle's struggles weren't positively impacting their comps:

A couple of things to think about when Chipotle ran into some of their difficulties. We didn't see immediate changes in our sales that would tell us that there was a direct impact, and I think we shared that in previous communications. And then more recently, as they have gotten more aggressive in the marketplace, we also didn't see an impact that would tell us that is having a direct impact.

Now I'm sure there is some impact, but it's not to the degree that we are seeing a huge shift in our sales, our sales trends. So I would say that the risks to our comps going forward would be some aggressive activity that we didn't foresee that did start to have an impact. And obviously, we can't predict that.

Finally, while I would never base an investment solely on my personal experience, it is helpful to keep your eyes and ears open. While this is admittedly a very small sample size, I've eaten at Chipotle at least three times (not counting one stop for free chips and guac) since January, and only one out of the three times did the food taste any less-good than usual, which was probably placebo effect. Traffic did seem lighter than it used to be at the multiple local shops I've passed by, but there were certainly people there - it wasn't like some of the scary pictures you see on Twitter.

The Forgotten: Food Safety Isn't The Only Strategic Thing Going On

Perhaps lost amidst all the (justified) concern around food safety, consumer perception, and comps, is the fact that Chipotle was working on other endeavors prior to the crisis - and while some have obviously taken a backburner, many continue to go on today.

The one that impresses me the most is the company's focus on digital/mobile ordering. The company recently completed an integration with their largest delivery partner, Postmates, which leads to orders being sent to a separate line from the normal food preparation line. While it may be hard to imagine right now, a more robust ordering/takeout system could eventually drive AUVs significantly higher than where they were pre-crisis.

These initiatives are one of the two factors that makes shorting Chipotle so dangerous - although it may take quite some time, when Chipotle recovers from this crisis, it will likely emerge an even stronger company than it was going in.

The other danger factor, of course, is that if you're not a frequent diner (like Einhorn), it's easy to make downright inaccurate comparisons or bash the food. On the other hand, despite alarmist claims that food quality would never be the same, Chipotle is implementing new measures that allow lettuce to be cut in store, and is even planning to roll out new items such as chorizo at some locations.

Wrapping It Up

It's frustrating, but the situation at Chipotle is much the same as what it was a few months ago - not a clear buy or sell. There's still a lot of execution risk here and the stock, astonishingly, has not fallen nearly far enough to be considered a value buy - but shorting Chipotle because of its multiple has burned a lot of investors over the years, and that's a dangerous road to traverse.

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.