Fast Casual's First Activist Investing Casualty

| About: Chipotle Mexican (CMG)
This article is now exclusive for PRO subscribers.


What will be the next restaurant stock to get an activist?

The fast casual industry could be ripe as growth slows.

We’ve already seen Panera forced into more buybacks and re-franchising.

I recently talked about what activist investor Marcato Capital is up to at Buffalo Wild Wings (BWLD), which includes potentially re-franchising and a boost in buybacks. The benefits of such a re-franchising includes using its underleveraged balance sheet to buy up franchised stores.

But could other restaurant stocks get the same activist treatment? Including the likes of fellow underperforming restaurant stock Chipotle (NYSE:CMG). Shares of CMG have fallen more than 40% in the last year and well off the $750 a share all-time high thanks to salmonella and E. coli outbreaks.

CMG shareholders are getting a bit frustrated with the weak recovery, where previous restaurant health scares - e.g. Taco Bell (NYSE:YUM) a decade ago and Jack In The Box (NASDAQ:JACK) in the early 1990s) saw quick rebounds. Short sellers are now swarming, with CMG short interest going from near 0% to 16% in just a matter of months - short interest is now at half-decade highs. With that in mind, we could see a more aggressive investor get involved - in particular an activist investor.

The biggest catalyst of all

The biggest catalyst for CMG and an activist investor is selling stores to franchisees, where it currently owns all its stores. While Marcato Capital will likely push BWLD to use debt to buy back franchised stores and then cut general and administrative expenses to juice margins, an activist at CMG would likely push the company to grow its store count and the top line even faster by franchising locations. Or, CMG could look to expand overseas, possibly using international franchisees.

Plus, with shares nearly cut in half in just a year, the other catalyst will likely be buybacks - where CMG has no debt. So it can not only raise debt but use the proceeds from selling stores to willing franchisers.

One of the greatest stories of increased franchising has been McDonald's (NYSE:MCD), where Glenview Capital pushed for more franchising as well as a potential split of the real estate. Shares of MCD have managed to outperform most of the fast food companies over the last couple of years. But what's interesting is that MCD previously owned CMG and tried franchising those restaurants with no success.

Another opportunity exists

The big opportunity for CMG might go beyond the typical activist investor playbook. CMG has gotten the honor of being known for its excessive executive pay packages, where shareholders have spoken out in the past by voting against its management pay. To the extent that it got more against votes for executive pay than any other company in 2014 - only a quarter of shareholders voted for the compensation plan that year. This year, it got just around three-quarters of shareholder support. So we could see a push to cut management compensation and ultimately better focus the board and executives.

Then there's the opportunity for CMG to juice its marketing spend to try and get customers back into its stores after the health crisis. The beauty of CMG is that it has an advantage - being an organic and on-trend restaurant. Other key changes include revamping the way it preps its food, making it cleaner and safer. CMG has already rolled out a rewards program for the summer in hopes of getting customers back in the stores, thinking they just need a second chance to re-prove how great the food is.

But again, I go back to the activist tactic of refocusing CMG management. The company has decided to make a foray into burger joints, announcing plans to roll out its first fast casual burger joint later this year. They'll join a host of other companies already trying their hand in the burger game, MCD included. The rise of high-end burger shops could be hitting saturation, however.

Lest we forget, CMG management is also trying to launch two other brands, one a pizza shop called Pizzeria Locale and the other an Asian concept dubbed ShopHouse Kitchen. The problem is that it's just not that cheap, at least not cheap enough to attract an activist. BWLD trades at 25 times next year earnings, while CMG still trades at 40 times.

But ousting management is not the answer, as they've created an experience and atmosphere that has managed to outpace and outgrow other fast casual players, including the similar concept Qdoba - owned by JACK.

Other Headwinds

However, there are headwinds at CMG. This includes figuring out how to get customers back into stores. A Morgan Stanley survey from last month found that a quarter of CMG customers have stopped visiting or cut back their visits to the restaurants - all due to health safety concerns. And switching costs are nil in the space, and the trend toward discounting is troublesome. New menu items, such as chorizo, adds some excitement, but heading further down that path could lead to increased menu complexity and kitchen inefficiencies.

The beauty of CMG

People love the feel-good organic and natural food movement; however, everyone hits a growth wall sooner or later. Whole Foods (WFM) is one such example, exploding on initial growth, but it's slowed of late. Shares of WFM went from under $10 a share to $70 in less than half a decade. It's now back closer to $30. Still, customers are paying the high prices for WFM products.

Chipotle still has a moat of sorts, which includes its first-mover advantage in the space and brand recognition. It generates over $4 billion in sales a year, which makes it a giant in the $40 billion fast casual industry.

Unlike BWLD, CMG still operates in a growing part of the restaurant market, where there's still money to be made in fast casual. CMG is one of the pioneers of the space and organic goods. While ShopHouse and Pizzeria Locale are taking away from management focus, they could turn out to be positives and the next hit in fast casual.

Chipotle needs to remain disciplined and not get over excited with rewards and promotions, as well as keeping the menu in check. There is food safety issues to be expected when dealing with fresher food, but having more sound protocols is the answer, instead of squeezing margins with rewards and complicated menus. For now, I'm on the sidelines waiting to see which path CMG takes to rekindle growth.

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.