When David Einhorn speaks, Wall Street listens. The reason is simple: Einhorn is right much more often than he is wrong. That is why shares of Chipotle (CMG) dropped over 4% on October 2, as Einhorn laid out his short thesis against the restaurant chain. For many investors, the thought of being on the other side of David Einhorn is enough to cause them to hit the sell "button." However, we believe that this time, the outcome may be different. Chipotle shares several differences with Einhorn's most successful shorts, and the thesis itself is, in our view, lacking in concrete detail. In this article, we will explore Einhorn's thesis against Chipotle, his track record, and why we believe that this time, the outcome may be different. For purposes of disclosure, we hold shares of Chipotle.
Shorting Chipotle: Have Burritos Gone out of Style?
Einhorn's thesis against Chipotle was presented at this year's Value Investing Congress, an annual gathering of Wall Street's top investors. Einhorn's short thesis touched on several points, but the core of his thesis was that Taco Bell's (YUM) new Cantina Bell menu will spell trouble for Chipotle as it steals customers and market share. Einhorn stated that he conducted a survey of Chipotle's customers, and found that 75% of them frequent Taco Bell, which he argues is a material issue for Chipotle. While the issue of Taco Bell's attempt to enter this market forms the core of Einhorn's short thesis, he also discusses the company's valuation, rising input costs, and regulatory issues (which we will touch upon later on).
With the stock off over 4% on the back of Einhorn's criticisms, it is clear that the market is paying attention due to Einhorn's track record. And that is the first point that we believe needs to be addressed. We freely admit that more often than not, David Einhorn is, in the end, correct in his short bets. But, his best-known, and most profitable (at least for him and Greenlight Capital) are ones that fall into a specific category, and we address this below.
Arcane Accounting: Einhorn's Niche
Einhorn's best and most famous shorts all share one common trait: arcane and often inaccurate accounting. This trait goes all the way back to Einhorn's first major short, and is present throughout his most successful shorts.
- Allied Capital. In 2002, Einhorn argued that Allied Capital was defrauding the Small Business Administration, and that the valuations assigned to its loan portfolio were inflated. Naturally, Allied Capital disputed this notion, and the SEC began an investigation. But rather than investigate Allied Capital for claims that, in hindsight, turned out to be true, the SEC chose to investigate Einhorn for market manipulation. It took until June 2007 for the SEC to conclude that Allied Capital broke numerous securities laws relating to its loan portfolio.
- Lehman Brothers: Einhorn called out Lehman Brothers for being undercapitalized, and for improper accounting related to its CDO portfolio. This was simply the first stage of Einhorn's involvement in Lehman Brothers, and occurred in July 2007. In March 2008, Einhorn gave an even more detailed presentation at that year's Ira Sohn conference, highlighting numerous accounting issues he discovered regarding Lehamn's deteriorating CDO portfolio, its synthetic CDOs, as well as its Level 3 assets. Lehman and its CFO at the time, Erin Callan, vigorously disputed Einhorn's findings. Lehman Brothers filed for bankruptcy in September 2008, and helped set off the deepest part of the financial crisis.
- Green Mountain Coffee Roasters: Einhorn's short thesis regarding Green Mountain Coffee Roasters (GMCR) dates back to October 2011, when he argued that the company has "a litany" of accounting issues, as well as disclosure and transparency issues. While Einhorn did discuss other issues such as patent expirations and the size of the total market, the core of his short thesis was (and remains) the company's accounting practices. As of this writing, shares of Green Mountain are down over 74% over the past year, due in large part to the issues that Einhorn raised.
David Einhorn is, by all accounts, a great investor. But, like all investors, he has a specialty in which he does best. For him, it is accounting issues. For someone like Warren Buffet, it is simple, easy to understand, but hard to replicate businesses, like that of Coca-Cola (KO) or American Express (AXP). Every investor has a specialty, and it is important not to let Einhorn's track record cloud investor judgment. This issue can be seen in 2 stocks that have recently attracted Einhorn's attention: Herbalife (HLF) and Martin Marietta Materials (MLM).
Herbalife plunged in May when Einhorn appeared on the company's quarterly conference call. He asked several questions about to the company's disclosure policies relating to its customer base and distribution network, and then left the call. The stock immediately lost a fifth of its value as investors fled the stock of what they assumed to be Einhorn's next target. Since May, however, Herbalife has put out another quarter of solid earnings, and Einhorn has said nothing about the company since then, including at the Value Investing Congress. Despite Einhorn's silence, shares of Herbalife are still down over 26% since the company's May earnings call, as investors cannot shake the feeling that Einhorn knows something about the company's accounting and disclosure policies that they do not.
(click to enlarge)Martin Marietta Materials presents the other side of this. Einhorn laid out his short thesis against the company in May, arguing that the company's earnings over the past few years have been propped up by federal stimulus money. Einhorn stated that Martin Marietta's earnings will fall as those dollars run out. Naturally, shares of Martin Marietta plunged on the back of Einhorn's comments, falling almost 10% as investors assumed (naturally) that Einhorn was right about the company's prospects. However, Einhorn made no mention of accounting issues, or disclosure problems at the company. It is notable that shares of Martin Marietta have outperformed the S&P 500 since the day before Einhorn laid out his short thesis. Of Einhorn's several recent short candidates, the one that has managed to outperform the market is the one that does not seem to have accounting or disclosure issues (the exception is Herbalife, which has underperformed due to worries that Einhorn will announce a detailed case against the company).
(click to enlarge)Are we saying that David Einhorn is not a successful investor? Of course not. His track record is enviable, and he truly does believe in the importance of removing fraud from the marketplace. That being said, no investor can be right 100% of the time, not even David Einhorn. His talents lie in the realm of accounting and disclosure policies. But there is more to a public company than its financial statements and its SEC filings. Things like brand, industry positioning, and customer loyalty all matter just as much as financials. And they are things outside of Einhorn's comfort zone.
Einhorn's Thesis on Chipotle: The Issues That Matter are Priced In
In arguing that Chipotle is a short, Einhorn laid out several points: the threat of commodity costs, labor issues, Cantina Bell, and the company's valuation. We address these issues below.
- Commodity costs: While this may be an issue in the quarters to come, it is not a new issue for Chipotle. CFO John Hartung laid out the issue on the company's Q2 2012 earnings call, stating that, "In terms of full year inflation, while costs have been relatively stable overall so far this year, the recent extreme weather will likely put pressure on our food costs later in the year and into 2013. Overall, we expect inflation for the rest of the year will stay within the range of low to mid-single digits on top of the 32.1% food costs in Q2. In addition to the higher expected cost of avocados and beef we discussed in our last call, there will likely be additional pressure on dairy and chicken." The best short theses are those that lay out new ideas and issues that the market has not had an opportunity to price in. When it comes to commodity costs, however, we feel that the issue has been priced in. Chipotle's management team was fairly transparent on its conference call that there will be upward pressure on input costs in the second half of 2012 and 2013. Furthermore, CFO John Hartung said on the call that Chipotle is not seeing price increases for its "sustainable" ingredients rise faster than more traditional versions of the same commodities. In that sense, Chipotle is not suffering more than any other restaurant chain in terms of rising input costs. In fact, the company's food costs as a percentage of revenue dropped in Q2 2012 from the previous year, coming in at 32.1% of revenue, as opposed to 32.9% in Q2 2011. As Chipotle investors, we are cognizant of this issue, but believe that the company has the ability to weather it. The company's Q3 2012 results will be released after the markets close on October 18, giving investors a chance to see just how much of an issue commodity costs have become.
- Labor issues: Einhorn's thesis touched on the labor issues at Chipotle. Chipotle's employment eligibility verification practices are being investigated by the SEC and Justice Department, and Chipotle is cooperating with the investigation. We admit that this is an unknown, but the company has been under investigation since 2010, and has paid no penalties nor been charged with any wrongdoing or illegality since coming under investigation. If there have been no charges filed in 2 years of investigation, how much more information is there left to go through? Chipotle has already overhauled its verification systems, and is now using the government's E-Verify system to screen new job applicants to see if they are eligible to work in the United States.
- Cantina Bell: The core of Einhorn's short thesis is that Cantina Bell will finally be what gives Chipotle true competition. We, however, do not think that this will be the case. Our last article on Chipotle, published in June around the time of Cantina Bell's nationwide rollout laid out in detail our arguments as to why the Cantina Bell threat is overblown. Chipotle has enormous brand equity with consumers, and it is important to remember that price is rarely the only factor that consumers consider when making a purchasing decision. Chipotle provides its customers with an experience; one that is difficult to replicate, especially for a company like Taco Bell (that is not to say that Taco Bell is not a successful brand; rather, it is successful because its core market is different than that of Chipotle). Even if Cantina Bell's menu is cheaper than Chipotle's, it may not matter, for reviews of the Cantina Bell menu have been subpar, and many still see Chipotle's as having a wide lead in terms of food quality. Furthermore, Einhorn's survey of Chipotle's customers is unlikely to be scientifically accurate. There is much more to accurate polling than finding some consumers and asking them what their opinions are about a given issue, which is what Einhorn appears to have done in this case. We can easily take a poll of readers of this article and ask who thinks that David Einhorn is a good investor. Most readers will respond "yes." And while we would be among those who say "yes" to that question, that does not automatically make the statement "David Einhorn is a good investor" true. We expect Chipotle's Q3 conference call to include a great deal of discussion about what sort of impact, if any, Cantina Bell has had on Chipotle since its launch. But based on what we see today, we do not think that Chipotle is losing ground.
- Valuation: The fourth pillar of Einhorn's short thesis is Chipotle's valuation. He argues that the company is overvalued, and that there is little room for error. The numbers, however, tell a different story. (click to enlarge) As of this writing, Chipotle trades at 33.625x estimated 2012 earnings. While that is a relatively high multiple on its own, it means nothing when growth rates are not included. Even when taking account estimate cuts that took place after the company's weak Q2 results, Chipotle is still projected to grow EPS by 32.305% in 2012. Chipotle trades for 27.769x estimated 2013 earnings, which are projected to grow by 21.088%. Chipotle's present valuation is, in our view, not outrageous considering its current projected growth rates.
We believe that this drop in Chipotle stock presents a buying opportunity. David Einhorn is, without a doubt, one of the most successful investors of this generation. But no investor can have a perfect track record. And we believe that when it comes to Chipotle, Einhorn has made a mistake. The company is in solid financial shape and is still growing despite some headwinds. We look forward to Chipotle's Q3 earnings to see how the company is dealing with commodity and labor issues, as well as what kind of impact Cantina Bell has had. But, based on the information available in the market today, we believe that Chipotle will overcome the issues that David Einhorn has raised, and think that Chipotle's best days are ahead of it.
Additional disclosure: We are long shares of KO via the Fidelity Growth Company Fund.