Chipotle: The New Normal

| About: Chipotle Mexican (CMG)


Poor management thwarts turnaround.

Increasing labor costs to crush margins.

Single-digit revenue growth to be new normal.

By now everyone reading this article is aware of Chipotle's (NYSE:CMG) disastrous 11-month stretch of more than -20% YoY same-store sales declines, so I will not bore you with the details or its origins. Of greater interest is Chipotle's response, or lack thereof, and investors' seeming delusion that CMG is worth $395 per share, at last check.

In tech investing, it is often said that you invest in people, not in products. While that is particularly good advice for early-stage companies where the product often morphs into something completely different over time, it is still good advice even when investing on the open markets. Chipotle's management has been awful in handling this crisis. The response was slow and not comprehensive enough. In the age of social media where events can trend on Twitter and Facebook within a matter of minutes, Chipotle needed to play offense, but it was behind the curve.

It certainly did not help Chipotle's image when a member of its executive team was arrested for cocaine possession in New York City. Everybody makes mistakes, many on Wall Street even do cocaine, but compounding a severe PR crisis with poor personal behavior is ill-advised. So, imagine my surprise when the same executive returned to Chipotle in early September. Strike 1.

Further, it is difficult to respond to a crisis succinctly with two leaders, in this case, two CEOs. The United States does not have two presidents. Football teams do not have two coaches, and companies should not have two CEOs. There are very, very few companies with the co-CEO model, and even fewer that are successful. Oracle (NASDAQ:ORCL) uses two CEOs to a mild effect, but the founder maintains a powerful role within the company. Whole Foods (NASDAQ:WFM) has two CEOs, but it had a crisis of its own not too long ago, and its response was not particularly impressive. A CEO is hired to lead. He or she may not be the best marketer, product guy or finance wiz, but their job is to delegate. For better or worse, a company needs one voice to clarify direction. Strike 2.

And, if a board is going to approve of having two CEOs, do not pay each double what the comparable pay for a CEO of a similarly-sized, industry-comparable company is. Chipotle should be spending one-fourth of the $26M it spent on executive compensation in 2015, which would amount to adding back almost $1/share or about $20M per year. The board needs to sort out the management situation even if it means firing all three of the aforementioned executives. Strike 3.

For 2011-2014, Chipotle averaged almost 22% compound growth, which is quite good, especially for a company in the food services industry with a brick-and-mortar presence. It is no wonder investors bid up shares of the burrito maker 200% in that time frame! Consumers could not get enough of its bowls and chips. Operating margins hovered around 20%, which, considering Chipotle does not franchise, is as good as they were going to get. The company's food costs, which approach 34% of revenue, are at the higher range of the spectrum, and will not be made better if avocado prices stay high.

But Chipotle faces an even scarier margin crusher on the horizon: wage hikes - the involuntary type. As a case study, we will use Chipotle's California operations, where, according to Statista, the company had 351 eateries in 2015. California has been leading the nation-wide push for a $15/hr minimum wage. The state has a wage hike schedule in place, which will see wages rise to $15/hr by 2022. Assuming an even distribution of employees, Chipotle employs almost 7,000 people in the state of California. A very conservative back-of-the-envelope calculation assuming an eight-hour workday (it's more), a five-day workweek (it's more), and $10/hr yields labor costs of around $145M/yr in California. Adding $1/hr increases Chipotle's California labor costs by more than $14M/yr or greater than 10%. By 2022, those labor costs will increase almost 50% or by $70M, and California represents only around 18% of all Chipotle locations. Rumblings have been made with regards to automated ordering and fast-food kiosks, but this technology is not far enough down the pipeline to make a difference. Chipotle's margins will suffer significantly as the result of wage hikes, and will account for far more than the 27.6% of sales it accounts for now.

Chipotle's food was once a hot new commodity, but that is no longer the case. The food crisis put a stop to years' worth of uninterrupted growth, but CMG has lost its luster. Customers finally realize that just because Chipotle does not serve fries, does not mean it is all that healthy. Introducing chorizo can only do so much to bring in customers. And despite spending tens of millions of dollars on promotions (BOGO, Chiptopia), ad agencies, and PR firms, the company forecasts only single-digit percentage growth at its stores in 2017, and believe me that is optimistic.

Chipotle would garner my interest if a couple of factors were in play. To start, get rid of anything that is not core to the brand. It's distracting. I was pleased to see that Chipotle wrote off ShopHouse this past quarter, its misguided attempt at entering the Asian food market. I would also advise that CMG pull out of Pizzeria Locale, and totally drop this hamburger nonsense. Chipotle will not get out of its situation by making hamburgers (do I really need to list all of the companies that make good hamburgers?); it is going to do so by making quality Mexican food, and delivering an awesome customer experience.

Second, I would like to see the company expand more aggressively internationally. It recently announced the hiring of a managing director for Europe to explore the company's strategy there more thoroughly. There is a dearth of good Mexican food in Europe and Asia, and those areas are ripe with opportunity. The average consumer on those continents likely has not heard about Chipotle's food safety woes, there is very little competition, and in Asia at least, labor costs may be more favorable. Organic growth will return to Chipotles in the US, but throwing millions at the problem clearly has not worked, and a different approach and possibly new geographies should be explored.

An afterthought that is not quite yet worth exploring as a primary point (though it may be given Bill Ackman's 9.9% stake) is franchising. There is a significant opportunity to franchise a relatively strong brand, which would vastly increase margins (at McDonald's (NYSE:MCD) franchised margins are around 82%), and hasten the company's expansion globally. A founder-run company will probably be extremely resistant to the idea, but this is, after all, what "activist" investors do...they "unlock" value.

At this point, Chipotle is simply too expensive. It is a classic case of investors looking at a peak share price, and reasoning that when Chipotle returns to those heights, they will have made a 90% return on their investment. CMG may one day return to those heights, but the road is fraught with risk, and it will not happen any time soon. At 50+ forward P/E, investors are paying a mighty steep price for a company still mired in crisis and mediocrity. I would not touch Chipotle before it hits $300.

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.