Chipotle Mexican Grill’s “A Series of Unfortunate Events”

  Price Target $275.00

Link to Newswire Release
  
Rating:                             Sell
Price Target:                   $275.00
Price 11/15/2016:          $400.00
52-Week Price Range:    $352.96 - $614.70
Market Cap (USD):         $11.6B   
Shares Outstanding:        28.95M
  

November 16, 2016

For those of you who have little persons in the home, you may be aware of the children’s book “Lemony Snicket’s A Series of Unfortunate Events,” in which the villainous Count Olaf attempts to steal the inheritance of three wealth orphans in his charge.  When the children discover his true intentions and try to escape, Olaf orchestrates numerous disasters in an attempt to get his hands back on the children and their fortune. 
  
In much the same way, a series of unfortunate events has befallen Chipotle Mexican Grill (NYSE:CMG) that has served to shave over 45% off the company’s value (and consequently its investors’ fortunes) since last August when the stock was flying high trading in the mid $750s.  Today, it trades at levels not seen since mid-2013, and we see significant further downside risk.  These risks include (1) wage inflation; (2) rising input & advertising costs; (3) consumers’ realization that burritos are not health foods, (4) a tarnished brand image; (5) mediocre reviews for its new foray into burgers (its long-term plan to steal market share from Shake Shack (NYSE:SHAK) and McDonald’s (NYSE:MCD) not doing too well right now; (6) a possible Mexican standoff between activist investors and entrenched management; (7) unwise use of cash; (8) still trading at a premium to competitors such as Panera (NASDAQ:PNRA); (9) overhang from pending criminal and civil investigations; and (10) insiders doing much more selling than buying.
Any one of these factors by themselves would be cause for concern, but taken together, we have serious doubts about Chipotle’s ability to steer this behemoth out of murky waters.  As such, we have set a Strong Sell rating with an accompanying $275 price target.


  
1. Wage Inflation

Rising wages have been a major cause for concern for Chipotle over the past few quarters.  While it and other restaurant stocks such as Panera and Shake Shak got a bump in share price last week from perceived benefits of a Trump presidency, those benefits must be considered in context.  Yes, chances are Mr. Trump will loosen regulations in a way that’s beneficial for restaurant chains such as removing the mandate that employers provide health insurance to employees or keeping the federal minimum wage at $7.25 per hour.  However, while he built his campaign in great part on repealing the Affordable Care Act, Trump has already stated he’s open to keeping certain provisions of Obamacare after a meeting with President Obama last week.  On top of that, the federal minimum wage requirement is not applicable in most states because those states already have a higher minimum state wage. 

As of last month, there were 29 states with a state minimum wage greater than the federal minimum, and 14 states began 2016 with higher minimum wages than the prior year.  This is particularly troubling for Chipotle, especially since state wages are rising in many areas where Chipotle is highly concentrated.  Below are a few examples:

California:  Of the 2,129 Chipotle restaurants throughout the United States, California is home to more than 350.  The California legislature recently increased the state’s minimum wage to $15 over six years.  The minimum will rise to $10.50 an hour in 2017 and $11 an hour in 2018, and it will increase by another $1 an hour in each subsequent year until it reaches $15 in 2022. Businesses with fewer than 25 workers will have until 2023 to reach $15. 

New York:  New York is home to over 115 Chipotle locations.  Earlier this year, Governor Andrew Cuomo signed legislation enacting a phased-in statewide $15 per hour minimum wage plan and a 12-week paid family leave policy, the longest and most comprehensive in the country.

Arizona, Colorado, & Maine will incrementally increase their minimum wage to $12 per hour by 2020.  Those three states are home to over 80 Chipotle restaurants.

The company also will not be able to get away with as much “wage theft” as before.  In August, a group of approximately 10,000 employees sued Chipotle for allegedly cheating them on their pay.  According to the lawsuit, “Chipotle routinely requires hourly-paid employees to clock out then continue working until they are given permission to leave.”  The participants in the lawsuit come from about every state in which the company operates, indicating a system-wide problem.  This is somewhat unexpected from a company that claims to serve “food with integrity.”


  
2. Rising Input & Advertising Costs

The Mexican avocado crop which normally surges in June and July hasn’t done so this year.  Lower supplies have translated to higher avocado prices to the tune of $1.25 each in July, a 46% increase over last year.  In May, the average price of a Haas avocado was only $0.93.  This is a significant challenge to margins for Chipotle which uses upwards of 97,000 pounds of it every day.  Fresh Del Monte Produce (NYSE:FDP) reported profits that were 125% higher than consensus estimates two weeks ago in part due to avocado sales.   Additionally, rising food costs associated with the new food safety procedures initiated in the wake of last year’s E. coli, salmonella, and norovirus disasters is taking its tolls on margins.  The company says it plans to achieve “efficiencies” and increase prices at some of its locations to offset the higher prices.  We are not seeing much increased efficiencies achieved with labor costs…the drop in unemployment and ensuing tightening of the labor market is compelling restaurants to either raise wages or provide benefits, which is further pressuring margins. 

The following excerpt from the company’s 2015 annual report shows the low levels of advertising from 2012 to 2015.  Company-wide advertising in all of 2015 was less than $70,000!  That’s amazing!
  Unfortunately, the company is finding out that it can no longer rely on its reputation to drive sales, and is now having to spend millions for expensive giveaways and additional advertising to stem losses from reduced customer traffic.


  
3. Burritos Are NOT Health Foods

According to Morningstar, “Responsibly raised and locally sourced food is one thing; food that’s good for you – from a nutritional standpoint – is another.  Chipotle’s burritos have both a high calorie count and a high sodium count.  For instance, a Chipotle burrito stuffed with pork, rice, veggies, cheese, guacamole, and salsa can actually be worse from a nutritional standpoint than a McDonald’s Big Mac.  The burrito has more sodium than the Big Mac (2,600 mg versus 1,010) and more carbohydrates (102 grams versus 47).  One Chipotle burrito can be twice the calories of a Big Mac and have nearly a full day’s worth of calories. A burrito with chicken, white rice, black beans, fajita vegetables, tomatillo-green chili salsa, guacamole and cheese with a side order of chips is 1,695 calories — and has 690 milligrams of sodium. (Chipotle states 2,300 milligrams of sodium are the recommended limits for a 2,000 calorie daily diet.)  A Big Mac — with two beef patties, cheese, onions, lettuce, pickles, “special” sauce, and buns made with high fructose corn syrup — has 530 calories, and 960 milligrams of sodium. A large order of French Fries adds another 510 calories.


  
4. A Tarnished Brand Image

Why has Chipotle’s brand image taken such a major hit?  Because the instances of food poisoning were not limited to just one or two incidences, but to five incidences over a roughly six-month period.  Here is a rough timeline of those incidences:

July 2015:  Five people sickened with E. coli in Seattle, WA.  The source of the outbreak was never uncovered.

August 2015:  At least 234 people sickened with Norovirus in Simi Valley, CA.  The source of the outbreak was never uncovered.

August – September 2015:  About 64 people sickened with Salmonella in Minnesota.  The source of the outbreak was tomatoes.

October 2015:  About 52 people sickened with E. coli in CA, IL, MD, MN, NY, OH, OR, PA, and WA.  The source of the outbreak was never uncovered.

December 2015:  At least 140 people sickened with Norovirus in Boston, MA.  , most of whom were students at Boston College.  The source of the outbreak was never uncovered.

What is particularly alarming, of the five incidences of food poisoning, the source of the poisoning was only uncovered in one incident.  It will take a slew of advertising to overcome this public relations nightmare.  The diagram below shows how other chains have recovered from food poisoning incidents.  Chipotle may never recover because the incidences were so numerous over such a long period of time and so many people became ill, including many students.
  
5. Mediocre Reviews For Its Foray Into Burgers

We don’t believe it was an overly bright idea for Chipotle to venture into the crowded burger space amidst a major health scare.  The company is nixing its 15 ShopHouse Southeast Asian Kitchen restaurants in favor of its new burger concept, Tasty Made.  Just to show the arrogance of the “food with integrity” people, Chipotle is using a very similar name and logo to a small chain in New England, Tasty Burger.  The similarities are so apparent (see picture), Tasty Burger’s owner David DuBois has issued a cease-and-desist order to Chipotle to which he has received no response from Chipotle.  Mr. DuBois may not have too much to worry about though, as reviews for Chipotle’s Tasty Made burgers have been “meh,” according to the websites 
eater.com and yelp.com.  Diners taking to social media to share their experience are sticking to the same theme, that Tasty Made is mediocre and underwhelming.  Diners share a common theme, a desire to eat elsewhere because the burger was good but not filling and the milkshake was good but very small.  According to one diner in Lancaster, OH, “I would rather pay the couple extra dollars for burgers and fries at Five Guys, cause you get so much more food for your money there.”  One commenter on the Denver Post’s website put it best, “Chipotle has driven another nail in their coffin by launching into the burger market.  Red Robin recently tried a standalone burger concept and shut it down, due to the fierce competition and overstatuated burger market.  Tell me how Tasty Made is better than Shake Shack, In-N-Out, Smashburger and Five Guys?”  
Chipotle’s long-term plan to steal market share from Shake Shack and McDonalds is definitely off to a rocky start.  On Friday, a company spokesman said sales have been “strong” at the Lancaster, OH location since it opened three weeks ago, however many patrons have indicated an unwillingness to return after an initial visit.  In addition to the complaints about the food, diners are unimpressed with the 1960s décor with no curb appeal.  We believe sales at this first location may be off to a “strong start” as the company stated only due to it newness, but we seriously wonder how this burger concept will help improve the company’s margins once the newness has worn off.

  

6. Mexican Standoff With Activist Shareholders

Chipotle’s last two annual shareholder meetings have been contentious at best, and the annual meeting in May of 2017 promises to be even more interesting.  Two investors, Amalgamated Bank and CtW Investments have filed a shareholder resolution to strip board leadership from founder Steve Ells and replace him with an independent director.  The investors are displeased with the company’s stock performance, quarterly sales, earnings performance, corporate governance, and executive compensation; and they want a change.  At this year’s shareholder meeting earlier in May, shareholder activists failed to oust two long-tenured directors despite arguing they have served way too long, one for 18 years and the other for 21 years, and are no longer capable of adequately performing their jobs. 

The problem lies in the fact that kicking off a board member this way is rarely successful.  According to Bloomberg, “Of the nine board members, two of them are co-CEOs Steve Ells and Montgomery Moran, who have served on the board for 11 and 9 years, respectively. Four others have served between 17 and 21 years, with the remainder joining over the past few years. Meanwhile, 4 of the 7 outside directors were elected to the company's board before the company went public, back when it brought in half a billion dollars in annual revenue from fewer than 500 stores.”  These directors are dug in and have no exit plans anytime soon.

Activist investor Bill Ackman recently disclosed a 9.9% stake in Chipotle, but has so far has made no demands of management or the Board.  Upon the disclosure of the stake, Chipotle’s insular board immediately hired Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), as well as law firm Wachtell, Lipton, Rosen & Katz LLP to defend against Mr. Ackman.  They also dug in even further and hired a crisis public relations firm.  While Mr. Ackman has said his relationship with Chipotle is “extremely constructive,” we wonder how constructive it will be when Chipotle fails to deliver in future quarters. 

Recently billionaire investor Carl Icahn has hinted that there is a concerted effort to take Ackman down a peg or two in the Herbalife (NYSE:HLF) battle.  Some have argued that Mr. Icahn could take Ackman down another peg or two by taking a short position in Chipotle.  That scenario not outside of the realm of possibilities as “Uncle Carl” has increased his bearish bets six-fold since March of this year according to Zerohedge.  Regardless of Icahn’s plans, we definitely see a Mexican standoff brewing between Chipotle’s Board and its activist investors.

 
7. Unwise Use of Cash

Chipotle has spent about $1 billion buying back its stock at elevated prices this past year in an effort to shore up its flagging stock price, all to no avail.  That was okay with investors when the company was minting money, but not now.  The company is in a much worse cash position as of the end of this most recent quarter than it was as of the end of FY 2015 as the excerpt from the company’s 2016 Q3 report shows.  
  
The current ratio currently stands at 1.67 versus a more solid 2.91 at the end of 2015.  Cash and other current assets are being depleted, and all the while the stock price is falling.  The company continues to sink money into share buybacks, capital spending on building more Chipotle locations, and an unwise foray into the crowded burger space, even as it makes less money with each new restaurant.  
  


8. Still Trades At A Premium To Competitors
 
Declining customer traffic seems to be the new norm for Chipotle, and the era of lofty PE ratios is long gone.  The company will now have to prove it can maintain margins and grow profitably just like all of its competitors have to do.  The firm’s Co-Chief executive Officer, Montgomery Moran says the company is shifting to a model that will yield “solid” returns even if customers don’t return in their prior volumes.  According to Moran, “While it's critical to fully restore sales volumes and keep improving them from there, we also know that we need to improve our economic model now so that we can provide healthy returns even at lower volumes." 

Even though the stock has fallen so precipitously over the past year, it still trades at a premium to its competitors.  The company has the highest forward PE ratio among the 25 restaurant stocks included in the S&P 1500.  At yesterday’s closing price of $400.00, the company trades at 40 times the company’s forward earnings estimates for 2017 of $10.00 per share.  The next most expensive restaurant is Biglari Holdings (NYSE:BH) which trades at 35.5 times consensus 2017 EPS.  Panera trades at about 35 times forward earnings.

Given the challenges that Chipotle still faces and the amount of time it is taking for the company to recover from its public relations nightmare, we see a poor risk/reward scenario into 2017 and 2018.  In 2014, increased customer visits as well as new restaurant openings contributed to top line growth.  In 2015, top line growth consisted primarily of increased restaurant openings.  Going forward, we see top line growth primarily from increased restaurant openings with margins continuing to be pressured.  There will be no quick fix for Chipotle.

 
9. Overhang From Muliple Criminal & Civil Investigations

In addition to the “Wage Theft” lawsuit mentioned previously, Chipotle’s most recent quarterly report discusses several other lawsuits the company is facing, both civil and criminal.  The company is facing a criminal investigation by the U.S. Attorney’s Office relating to company-wide food safety matters.
The company is facing a lawsuit in the Southern District of New York from Susie Ong and a class of shareholders who allege the company failed to disclose material information regarding its quality controls, thereby causing its stock price to be artificially inflated during the claimed class period.
The company is facing lawsuits in Delaware and Colorado alleging the company breached its fiduciary duty in connection with excessive compensation, failure to institute proper food safety policies and procedures, and failure to disclose material information about the company’s food safety policies and procedures.
The company is under investigation by both the Immigration and Customs Enforcement arm of the Department of Homeland Security (ICE) and by the U.S. Attorney’s Office for workers who appeared not to be authorized to work in the United States. 
The SEC is conducting a civil investigation of the company’s compliance with employee work authorization verification requirements, and the U.S. Attorney’s office is conducting a civil and criminal investigation of the company’s compliance with federal securities laws. 
Recently, an ex-Chipotle employee won a $550,000 award in a pregnancy discrimination lawsuit against Chipotle.  A U.S. District Court in Washington D.C. determined that the employee was fired by her manager for being pregnant.


10. Insiders Are Selling, Not Buying

Within the last 12 months, insiders have sold 75,000 shares and have bought 1,590 according to Nasdaq.com. There is no need to expand upon that as the numbers speak for themselves.



Given all of the above, we continue to see pressured margins for Chipotle, and we see Tasty Made as a distraction rather than a strategic growth driver.  Chipotle has issues that cannot be fixed overnight, and it is certainly no longer a high-growth restaurant concept that is blowing away sales and earnings estimates.

The company is forecasting FY 2017 earnings per share of $10.00.  At a very generous forward PE of ratio of 35, that presupposes a fair value of $350.00 per share.  We are forecasting 2016 Q4 earnings per share of $0.80 and FY 2017 earnings of $7.85.  Using that same very generous forward PE of 35, we derive a fair valuation of $274.75.


Disclosure:  We are short CMG.  We do not have a financial relationship with the company.