Chipotle Mexican Grill: Recovery Still Questionable Before Earnings

| About: Chipotle Mexican (CMG)


Chipotle followers wait anxiously. Sales were bad in Q3 - the question is: how bad?

Consensus expectations have been edging downward. Is a positive surprise likely?

Bill Ackman's notorious Pershing Square takes a position. Does it matter?

Consensus Expectations: Upcoming Earnings Release

Chipotle Mexican Grill, Inc. (NYSE:CMG) is scheduled to report its 16Q3 earnings on October 25th after the market closes, with a conference call at 4:30 PM Eastern Daylight Savings Time. Per Bloomberg LP, of the 34 sell-side analysts covering CMG, the mean estimates of revenue, comps and EPS of $1,100 million, -17.2% and $1.65, respectively, are unchanged or very modestly lower than the estimates in the table above prepared on 9/21. Q4 estimates have lately also been revised downwards modestly, though no analysts have changed their rating. According to Bloomberg, the current median target price is $425, with the price targets ranging from $215 to $564. Earlier this month, management announced the nationwide rollout of chorizo, citing a strong customer response since its introduction in 5 markets in June. The spicy sausage blend of pork and white chicken meat is available in tacos, burritos, burrito bowls and salads.

Current Conclusion

We believe the evidence is increasingly clear that the recovery at the Company will be slower than management or CMG stockholders have been hoping for. Sales will look better over time, but margins may not recover to previous levels for a very long time, if ever. While investors may produce the Battle of the Bulls and the Bears over CMG, customers of Chipotle (who built their business on Food With Integrity) continue to wage the "Battle of The Loyalists vs. The Betrayed".

CMG: Company Overview

Chipotle, bought with 14 units in 1998 by McDonald's (NYSE:MCD), then sold to the public with 500 locations in 2006, has grown stores and profits steadily to the point of operating 2,010 locations as of 12/31/15 (including 11 in Canada, 7 in the U.K., 3 in France and 1 in Germany). Per the Company's 2015 10-K filed with the SEC, average volume per store was $2,424 million. Because of its health crisis - discussed below - this metric is down from the $2.5 million AUV achieved earlier in the year and virtually the same as the $2.474 million in 2014. Obviously, AUVs will be materially lower in 2016 as CMG works through its well-known issues. Store size is a modest 2,550 square feet (seating about 58), on average, costing $843,000 for leasehold improvements and equipment. As a result (with sales at $970/ft.), its store level profitability has historically been among the very best in the restaurant industry. Again, the current objective is to regain traffic, sales, and historical return on investment. There were also 11 fast casual ShopHouse Southeast Asian Kitchen restaurants and 3 fast casual Pizzeria Locale locations.

The Company's mantra since inception has been "Food With Integrity", with the objective of serving meats raised without non-therapeutic antibiotics or added hormones, also promoting animal welfare. Additionally, a portion of the produce is organically grown and/or sourced locally when in season. Additional methods of raising and sourcing raw materials also work toward the FWI objective. These standards are also used in the ShopHouse and Pizzeria Locale restaurants. As the Company has become larger, problems in terms of its sourcing objectives have surfaced. In early 2015, a pork supplier had to be eliminated, so pork products were not available in the stores for nine months. In late 2015 and early 2016, food-borne illnesses, apparently contracted at CMG restaurants, triggered criminal and SEC investigations and an investigation by the Centers for Disease Control and Prevention (CDC). While the CDC investigation ended in June, remnants of the other legal issues, including class action lawsuits, seem to remain. Per its Q2 SEC 10-Q filing, the Company's balance sheet was still "bullet-proof", with no debt and $270 million of cash at its 16Q2. The ratio of its capitalized leases (8X rent) to T12M EBITDAR is a comfortable 2.6X and T12M cash flow from operations was $462 million, which, net of $270 million cap ex, left free cash flow of $192 million. In the same period, Chipotle spent $1,046 million on repurchasing its stock, a nearly tenfold increase over the year ago pace, before the stock price plunged in response to illnesses at its stores. Over the last 5 years, it has purchased 3.7 million shares for $1.6 billion, or an average price of $445/share. The Company may spend an additional $140 million on share repurchases under its current authorization.

CMG: Developments Disclosed in Q2 Report and Conference Call

When Chipotle reported its 2015 annual and Q4 results on 2/2/16, the results were in line with its earlier pre-release. Most stunning, however, was that comps were down 34% in the last 4 weeks of December (following the last of the illness outbreaks in Boston) and down 36% in January. The poor sales results drove the disappointing results in every other metric, from restaurant margins to EPS. Since then, the focus of the Company and investors alike is how long, if ever, it will take to recover its former momentum. Chipotle's guidance for 2016 has been very limited: while continuing to expand the store base with 220-235 new stores, G&A will increase both from recurring expenses such as food testing and marketing as well as shorter-term expenses such as higher legal costs. There has been no comp or top line guidance, and certainly not EPS guidance. Instead, the Company is periodically describing the recovery in sales as it is taking place, and reiterating its objective of being the world leader in food safety. The plan continues to include extensive upgrading and testing of food sourcing, preparation and serving and handling procedures, and more intensive marketing than ever before.

More recently, as reported, comp sales in Q2'16 were down 23.6%, an improvement from the negative 29.7% in Q1. Traffic in Q2 was a bit better than sales, down about 20%, due to price promotion efforts. Management indicated on the Q2 conference call, on 7/21, that comp sales had improved early in Q3, down about 20%, and traffic had improved to the mid-teen level. The aggressive couponing and discounts had brought some customers back in April, May and June, and "Chiptopia", an aggressive loyalty program, was instituted for three months starting July. In its simplest form, Chiptopia offered a free burrito after the customer visits four times in a month, then again next month with the free item counted as a visit. So the first free item came at a 20% discount, and subsequently at a 25% discount. There were additional benefits, such as free guacamole and chips when you sign up, and a "banquet" for 20 people for a very heavy user. Our "channel checks" indicated that Chiptopia generated a substantial increase in traffic at the outset in July, but that traffic and sales did not build materially from that level.

In mid-September, the Goldman Sachs analyst lowered the comp estimate for Q3 to a negative 21.4%, and, more dramatically, a negative 5% in Q4, which many analysts have hoped would comp positively against the beginning of the dismal numbers in 2015 (-14.6%). The Street consensus, per Bloomberg LP, as shown in our table above, was a negative 17.2% in Q3, plus 1.6% in Q4, then continuing recovery to plus 7.7% for full-year 2017. As far as earnings are concerned, Goldman Sachs was estimating $2.26 in 2016, $7.65 in 2017 and $12.08 in '18. These numbers were materially lower than the Street consensus as at 9/21 of $3.71 in '16, $10.24 in '17 and $14.09 in '18. Obviously, the further out we go, the less certain everyone's numbers are.

It is worth mentioning that Bill Ackman's Pershing Capital has taken a 9.9% position in CMG, obviously his vote of confidence that the Company will regain its previous investment standing. We don't believe he has a material "edge" here in terms of the timing or likelihood of CMG's recovery. Ackman is very smart, and especially persistent (e.g., his battle with Herbalife (NYSE:HLF), stumbles at J.C. Penney (NYSE:JCP) and Target (NYSE:TGT), his long-term vindication with MBIA, and his amazing success with General Growth Properties (NYSE:GGP)), but there is no underlying real estate play here, balance sheet or cash flow characteristics that are not transparent to everyone, and CMG still trades at 3 times trailing sales and a very high multiple of expected (uncertain) earnings. We view Ackman's involvement less as an indication of the value in CMG and more as a commentary on the state of the current equity environment that this (uncertain, in our view) is one of the best situations he can find.

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.

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