Chipotle's Moat Is Showing Signs Of Wear And Tear

| About: Chipotle Mexican (CMG)

Summary

I had previously initiated a position in Chipotle for my Project $1M portfolio.

Chipotle's anemic same store sales numbers have left me questioning whether its moat has suffered irreparable damage.

I have decided to exit my position in Chipotle.

I first invested in Chipotle (NYSE:CMG) early this year as part of my Project $1M portfolio. I bought a $5000 holding at an average price of $415 a share.

My logic with my Chipotle purchase was pretty basic. I reasoned that Chipotle had effectively created the category of fast casual food. It's simple and effective meal choice drove a continuous streak in revenue and earnings growth for pretty much the last decade at very healthy rates of return on equity, at well over 20% in fact .

The business was generating significant free cash flow and very healthy margins which is somewhat of an anomaly in the retail space.

My thinking was that a food scandal that was largely an anomaly which wouldn't permanently tarnish Chipotle's brand or it's standing with consumers. This was based on the recovery of other restaurants and even incidents such as Tylenol's contamination scandal and recall.

However close to a year since the initial outbreaks began and more than six months since it was declared "safe" by the CDC, Chipotle's traffic numbers are still anemic and show few signs of recovery. This is in spite of aggressive promotions that the company has been pushing which have been at a significant cost to its operating margin.

In Chipotle's most recent earnings the company again reported same-store sales numbers that continue to be down in excess of 20% year on year. Improvements in store traffic appear to be limping along rather than consumers once again embracing Chipotle as they had done in the past. Worse still, even the initial indications for July and the start of Q3 suggest that same store sales continue to see declines of around 20%.

Chipotle has made much fanfare around Chiptopia, its new loyalty program. I'm not convinced that this is going to be a magical panacea to restore customer visits overnight. Loyalty programs can help accelerate sales where customers have confidence and conviction in your product. However where there seems to still be an issue of bringing foot traffic through the door from a result of a crisis of confidence, the underlying issues need to be fixed first before you can start to see the flywheel effects from a good loyalty program.

My thesis to invest was that Chipotle would have substantially recovered lost consumer traffic within the year of its food safety scandal taking place and report traffic in excess of scandal level within 18 months. I had thought that Chipotle's product was fairly unique in the marketplace, and a reduction in virus outbreaks would bring customers back into the stores.

What is clear given the level of same-store sales declines is that sales recovery is likely to be far longer than what I expected. That gives rise to the question in my mind of whether then maybe some permanent loss of consumers from the Chipotle franchise.

I think one of the key mistakes that I made in my investment thesis on Chipotle was the weakness of its brand position. If the brand was truly strong and the value proposition that unique, traffic levels should have shown a more discernible improvement given the level of promotional activity.

However the fact that same-store sales are so strongly down a full six months since the store were declared safe by the CDC leads me to believe that consumers have more readily substituted Chipotle with one of the many alternative that now exist in the fast casual space.

I also believe that Chipotle sales were showing some evidence of fatigue immediately prior to the food safety scandal. Sales growth was trending down in the first few quarters in 2015 even prior to the virus outbreak. Q2 2015 in fact saw same store sales declines of close to 4.5%. In hindsight, that makes me think that consumers who were already beginning to show signs of fatigue with Chipotle and looking for an opportunity to decrease visits found their excuse to do so with this safety scandal breaking.

I've decided to exit my investment Chipotle and recently sold my holding at roughly $425 per share. While Chipotle will likely come back from its food safety scandal, the fact that this may take far longer than anticipated leads me to believe that its brand is no longer as strong as what I believed and its future sales growth is also likely to be muted.

While Chipotle's likely eventual recovery should still lead to respectable returns, I think its more likely to lead to returns in the solid single digits rather than the double-digit growth that it had historically provided investors.

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.