Chipotle: Widespread 'Queso Is A Disaster' Consensus Could Be Flawed

| About: Chipotle Mexican (CMG)

Summary

The reaction on Twitter suggests Chipotle's queso is a disaster. Sell-side analysts have been negative on CMG, citing bad "Twitter buzz" about queso.

A Chipotle spokesperson has repeatedly suggested queso is not a disaster and cautioned people from making conclusions from social media comments.

Queso received a similar social media reaction during the test market phase, yet its performance was strong enough to be rolled out nationally.

For Chipotle to have its spokesperson publicly refute the "negative queso" narrative repeatedly, between quarters, is remarkable and suggests the consensus view could be flawed.

Chipotle reports earnings next Tuesday after the close.

Chipotle's Queso History

For years, Chipotle told customers that it did not serve queso, a Mexican cheese sauce, because it could not make it without using artificial ingredients and stabilizers. Chipotle's well-known "Food with Integrity" approach prevents it from using anything but ingredients you'd find in your grocery store or farmers market.

However, the food safety debacle that began in late 2015 has justifiably changed its approach to new products. Now, management is willing to do pretty much anything it takes to try to recover its formerly off-the-charts unit economics.

Queso is interesting because it is the single most-requested menu item from Chipotle. Mexican competitors like Moe's and Qdoba have it, and there really are people out there who like Chipotle but prefer one of the other chains solely because they have queso. Chipotle even had to make a marketing video a few years ago explaining that it doesn't have queso because of the artificial ingredients required to make it.

At some point over the last year or two, Chipotle stepped up its queso R&D.

In July, Chipotle rolled out queso at its Chipotle NEXT test kitchen in New York and expanded the test to test markets in Southern California and Colorado shortly after.

On September 12th, Chipotle added queso to its menu nationwide. The reaction on social media, particularly on Twitter, was harsh. Many claimed it was awful because it has an odd texture or they didn't like the flavor. An example of one of the more hyperbolic comments was that Chipotle's queso is "a crime against cheese."

I've tried the queso a couple times, and I can tell you the reaction on Twitter is a massive overreaction. The queso is fine. It's good. Is it something I'll order every time I go to Chipotle? No. But there is no cheese sauce on the planet I'd order every time I eat at a Mexican restaurant.

I think the Twitter reaction is mostly from Moe's or Qdoba loyalists who are just used to the smooth, artificial kind of queso. I would not be surprised if some of the comments are from Moe's and Qdoba employees and franchisees or their families who really don't want to see Chipotle's queso do well. Chipotle already crushes Moe's and Qdoba on average unit volume, and having queso on their menus was really the only solid differentiator for them against Chipotle. If Chipotle's queso is popular, it would certainly harm Moe's and Qdoba's sales to some extent.

Whether that is going on is beside the point, though. The social media reaction has driven the news cycle and has influenced Wall Street analysts.

The Goldman analyst cited bad Twitter "buzz" about queso as the reason to be negative on the stock. Several other analysts have lowered estimates or price targets or expressed caution towards the stock in recent weeks due primarily to Twitter comments about queso.

Notwithstanding the myopic short-termism of these analysts, I find it amazing they are citing Twitter comments as the key part of their investment thesis.

Four Signs Queso Might Not Be The Disaster Twitter Says It Is

I have noticed five clues that suggest queso is performing just fine for Chipotle despite the bad Twitter "buzz."

  1. On September 19, CNBC aired this clip: Executive Edge: Chipotle's 'queso' bet. To save you the time, the CNBC host said: "A [Chipotle] spokesperson warned against drawing conclusions from Twitter about the new menu option. He said, 'The reaction online is similar to the initial response in the test markets. Chipotle was sufficiently encouraged by those tests to roll out queso nationwide.'"
  2. On September 20, Bill Ackman of Pershing Square, which owns 10% of Chipotle, made interesting comments in a CNBC interview. Here is the clip: Bill Ackman calls Chipotle stock 'extremely cheap' and says people in his office like the queso. The specific comment I found interesting was, "We're on the board [so] I can't tell you what the results are on a store-by-store basis but I'm hoping people are going to be pleasantly surprised."
  3. On September 21, the following Bloomberg story broke: Chipotle Executive Urges Chain's Staff to Ignore Queso Backlash. The company's Chief Marketing Officer sent an internal memo to employees that said to ignore the social media response. He said, "The formal research we conducted prior to rolling out queso nationally showed very different results than what you might assume if you only looked at comments on social media,” Crumpacker said. “The decision to move forward with the launch was based not on social media comments, but instead on in-depth research and the sales impact in the test markets.”
  4. On October 6, the analyst at Cowen published a negative report on CMG that reiterated their "Underperform" rating on the stock. The story is here: Cowen predicts Chipotle shares will drop nearly 20% on weaker-than-expected sales. In a move that I find almost unprecedented, a Chipotle spokesperson gave the following comment, in reaction to this one sell-side report, to CNBC: "We won't get into details on sales trends until we release our third quarter earnings later this month, but I will note that we moved queso from market-wide testing to a national rollout because we were encouraged by the results, both in terms of feedback in consumer research and sales ... What we have seen in terms of brand health and consumer sentiment is quite different than what the Cowen report suggests. We conduct ongoing research into consumer sentiment that looks at a number of brand health measures. Rather than providing a look at any single moment in time, that research provides an indication of where consumer sentiment stands on an ongoing basis. What we are seeing there is that we are closer to the levels we were seeing in early or mid-2015 (pre-crisis) than we are to the troughs, with many metrics at or near pre-crisis levels."
  5. I am friendly with a Chipotle employee who suggested to me that queso is not a disaster at her store. She called the actual customer reaction generally good or neutral. Certainly, not everyone is a fan, but she thinks the net effect of adding queso is positive.

Regarding 1, 3, and 4 above, a company spokesperson would not make these public comments to CNBC, or in a company-wide memo that would be publicly disseminated, if queso is the financial disaster for Chipotle that Twitter suggests it is. The company would simply keep its mouth shut and work to improve the recipe. The fact that the company put out this message on three different occasions only reinforces the point.

Further, the company was in a "self-imposed quiet period" during this time when it wasn't supposed to say anything to anyone. Apparently, it felt strongly enough about making these comments that it was worth violating its quiet period repeatedly.

Can you imagine the company making these comments on numerous occasions right before reporting that queso is unpopular and a bad business decision on its upcoming third quarter earnings call? I can't. I don't think it'd make these comments if queso were even a mild disappointment. I think the only way it'd make these comments is if queso is performing in line with its expectations and is performing reasonably well.

Regarding 2 above, the same logic applies. Pershing Square has its people on the Chipotle board. They are aware of the company's financial results probably on a week-to-week basis, if not more frequently during a new menu item rollout. "I'm hoping people are going to be pleasantly surprised" is not a comment one would say right before the company announces third-quarter earnings and says, "Everyone hates the queso! We screwed up on this one. Back to the drawing board."

A Side Thought on Queso Margins

I would also add that the margins on queso have got to be extremely high. If you order a ladle of queso on your burrito or burrito bowl, that's a two-ounce serving for $1.25. A four-ounce serving on the side is $2.05. With chips, and it's $3.45. Interestingly, management added the option to get a large queso and a large chips for $5.25. The ability to order a large chips did not even exist before the queso rollout.

But these prices are quite aggressive. I would imagine a two-ounce serving of queso probably costs Chipotle something like $0.10 or $0.15, including the plastic cup. That suggests a food margin of around 90%.

The margins on guacamole these days are almost certainly well below that, given the current astronomically high price of avocados.

Even if a limited number of customers (10-15%?) order queso with their meals, I think its margins make it a clear net benefit. The intense popularity of Chipotle's guac (many people call it the single best thing on the menu) suggests to me that those who order guac will generally continue to order it. Some of them may add queso in addition. I doubt very many routine guac orderers will stop ordering guac in favor of queso, so I don't think queso cannibalizing guac should be a big concern.

Conclusion

It is premature to make conclusions about the financial impact of Chipotle's queso on the business based on Twitter "buzz." If it were a disaster from a business perspective, a company spokesperson would not repeatedly and publicly refute those who suggest it is a disaster. Nor would the second largest shareholder with board representation suggest people will be pleasantly surprised.

I am a long-term investor and own a position in CMG. I don't make predictions about how stocks will react to quarterly earnings reports, and I have no view on how CMG will react to Chipotle's third quarter report (to be released after the close on Tuesday, October 24). However, I will say that there is a lot of negativity around queso that seems like it could be wildly misguided.

End Note

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Disclosure: I am/we are long CMG.

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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