Chipotle One Year Later: Reviewing My Bull Case

About: Chipotle Mexican Grill, Inc. (CMG)
by: Mike Berner


Here, I review my two-year long bull case for Chipotle, which I last recommended in October 2017.

The worst never came to pass; sales recovered fairly well, and the investment has been profitable.

However, the pace of recovery disappoints me, and earnings remain under pressure.

Ever the since the food safety scandal broke three years ago, the case for (or against) Chipotle (CMG) has always come down to two questions:

  1. Will Chipotle recover its brand and profitability?
  2. How much is that outcome worth?

Investors have attempted to answer both questions, with the answer to the first question usually driving the second. As far as the recovery is concerned, the most bearish observers have been proved decisively wrong, but the company's performance has also undershot my initial expectations. While I still stand behind my long-term thesis, the slow pace of recovery has me taking profits off the table and moving on to other opportunities.

The Forgotten Crisis

As I predicted would happen, memory of the 2015 food safety crisis has largely faded from the public consciousness. Although the foodborne disease woes of a company with the byline "Food with Integrity" initially proved irresistible to the media, the story naturally went stale in due course.

Indeed, a disease outbreak at an Ohio restaurant that sickened 700 people last August - Chipotle's worst outbreak yet - barely registered. The stock actually surged 20 percent that month to its highest level in over two years.

Where Did the Customers Go?

The latest quarterly earnings showed that Chipotle's comparable sales increased by 4.4 percent from the same quarter one year ago, marking the company's seventh consecutive quarter of improvement. However, much of the recent sales growth stems from price increases and mix, not customer count. Transactions, often seen as a proxy for foot traffic, slipped 1 percent from last year.

On paper, the company should be doing quite well in light of rising wages and a strong job market. While some analysts point to these weak sales numbers as evidence of Chipotle's brand decline, I think this misses the broader story.

In fact, foot traffic trouble is not isolated to Chipotle. The restaurant industry as a whole has posted three years of negative traffic trends but has offset the decline by raising prices and implementing menu changes and other innovations.

Moreover, Chipotle is certainly not unique in the restaurant industry for its fall from Wall Street's good graces. Most former 'fast-casual' high flyers, including Shake Shack (SHAK) and Zoe's Kitchen (ZOES), are down significantly from peaks set in 2015. The sudden about-face occurred around the same time as Chipotle's own precipitous decline.

Source: Morningstar

Chipotle's flaccid sales probably have less to do with a tarnished brand and more to do with a vastly overbuilt and highly competitive restaurant landscape. I missed this key headwind in my initial analysis, and it is likely the reason that the company has not bounced back as quickly as other scandalized consumer brands.

Increased Expenses

Another headwind for Chipotle's bottom line is increased marketing expenditure. Before the food safety scandal, Chipotle relied on word-of-mouth exposure and did not employ a national advertising campaign - an unusual marketing strategy for a restaurant company of its size.

Brian Niccol, who took over as CEO eight months ago, criticized the "invisible" nature of the brand.

I believe the brand has been invisible and I think as the brand becomes visible and we lead culture, that's going to be a huge opportunity going forward. This brand needs to be leading culture, not reacting to it.

The new management team wasted no time in launching a nationwide campaign emphasizing Chipotle's "real" ingredients and fresh preparation. However, the marketing strategy has come at the cost of a 32 percent increase in operating expenses from 2015.

New Restaurants

Despite the litany of issues facing the company, management is moving forward with an aggressive expansion plan. Chipotle is on track to open approximately 130 restaurants this year, and the company is targeting at least 140 new stores in 2019.

Even though total revenue is up 6 percent, average sales and profits per store have stayed constant over the last year. Management has been mum on the incremental impact of new stores, but the company maintains that cannibalization is not a concern.

2018 2017 2015 (peak)
Revenue $ 4,750,000,000 $ 4,476,000,000 $ 4,501,000,000
Earnings $ 188,000,000 $ 176,000,000 $ 476,000,000
# stores 2,460 2,300 1,900
Average Sales per store $ 1,930,894 $ 1,946,087 $ 2,368,947
Average Earnings per store $ 76,423 $ 76,522 $ 250,526

In one respect, no news here is good news; the company's expansion strategy clearly appears sustainable. The bad news is that these store-level results do yet not support the current valuation by themselves. As I demonstrate in last year's analysis, Chipotle needs to return to 2015 levels of average revenue per store levels in order to make a full recovery in terms of valuation. In a future (year 2027) where the company runs 4,000 locations and earns $200,000 in profit per store, a perpetual earnings model would value the company at $14 billion. Chipotle is still well below that threshold.

(4,000 stores * $200,000 per store)/(4 percent)/(1.04)^9) = $14 billion

Final Thoughts

On one hand, my Chipotle bull thesis has succeeded in terms of profitability. I personally made a satisfactory return on my investment, and readers would have made money at every point that I recommended the stock if they held until last summer.

Moreover, the public's collective shrug over the recent outbreak vindicates my prediction that the safety scare would soon fade into oblivion. In terms of restoring the previous store-level economics, Chipotle bounced back pretty well in terms of sales.

On the other hand, the recovery did not pan out as quickly as I anticipated, and earnings remain depressed. Part of that is due to increased marketing spend and other efforts to reignite growth, which seem like they will continue indefinitely.

Most of the continued sluggishness comes down to weak foot traffic, though. As I argue here and in other restaurant stock articles, this is an industry-wide issue rather than a problem confined to a single company. The passage of time will allow demand to catch up to supply, but in the meantime, I have taken most profits off the table.

I still expect Chipotle to play out well for investors as a long-term investment over many years, but other opportunities look more attractive at the moment.

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.