Chipotle (CMG, Financial) jumped on the news Bill Ackman (Trades, Portfolio)’s Pershing Square acquired a 9.9% stake. Given the star fund manager has had 1 ¾ of terrible years in the rearview mirror, that may have come as a bit of a surprise. Ackman’s struggles with Valeant (VRX, Financial) and Herbalife (HLF, Financial) notwithstanding, his track record in the restaurant business is to be envied. He racked up wins with Macy’s, McDonald’s, Burger King, Yum Brands and others. Pershing stated in its 13-D filing Chipotle has a strong brand, differentiated offering, enormous growth opportunity and visionary leadership. In addition, the 13-D called Chipotle an undervalued and attractive investment.
But what’s Ackman’s plan with Chipotle? Why’s he engaging with this chain? His successes came through operational improvements, lots of cost cutting and financial engineering.
The 13-D states Pershing:
intends to engage in discussions with the Issuer and Issuer’s management and board of directors, other stockholders of the Issuer and other interested parties that may relate to the governance and board composition, business, operations, cost structure, management, assets, capitalization, financial condition, strategic plans, and the future of the Issuer.
The two most obvious things I believe Ackman will be pushing for are:
- A franchise model
- A reduction in executive compensation
Franchise Model
The franchise model is an incredibly attractive feature of the restaurant business. If you have a terrific fast growing brand like Chipotle does, it allows you to capture a slice of the enormous fast food market with much reduced capital expenditures. Currently, almost all of Chipotle’s 2000+ restaurants are company owned. The company did franchise earlier in the rollout, but later chose to scrap the franchise model and retain full control. Reinstalling this program has the potential to reignite growth and it is also valuable because it puts entrepreneurship back into the veins of the restaurant managers. Retaining control sounds good, but it is difficult to find and retain motivated employees who work day and night to pad the Chipotle coffers. If you can find entrepreneurs to run your restaurants, putting up their capital while you take a cut, you are free riding on their talent. I would definitely support Ackman pushing for increased franchising if I were a shareholder. It also seems like it would be a natural fit with Chipotle:
Source: slideplayer
Reduction in Executive Compensation
Long before Ackman entered the fray, another hedge fund called CtW Investment Group exerted pressure on Chipotle to shake up its board, which it considers one of the least diverse and least independent in the S&P 500. CtW called attention to the average director’s tenure being 17 years with six directors having been on the board over ten years. The firm didn’t leave it at that, but pushed for compensation reform at the top. The co-CEO’s are taking home a lot of dough:
Source: Morningstar
Key executives are missing out on some bonuses due to the food scandals, so executive pay is already declining, but the question is whether Ackman will be satisfied with a temporary reduction or that he will seek a more structural amendment to executive pay.
Usually pay reductions do not add up to much. Although the amounts involved are often astronomical compared to the pay cheques many of us find in the mail on a monthly basis, compared to the cost savings that can be achieved on operations, it is not much and the activists often need CEOs on their side or just out. Therefore, pay reduction is not usually a priority.
In this case it could be interesting. Chipotle is a growing company and commands a high multiple even post food scare. Not only would a severe reduction in executive pay actually substantially increase earnings on a percentage basis; TTM earnings are $212 million but the increase also benefits from a high multiple. If you can save $20 million on executive comp on a structural basis, in Chipotle's case that would turn into $1.2 billion of value creation (10% increase in stock price) as it trades at a 60x multiple. Okay, this is very rough math and that is not how it will exactly play out in practice, but it does serve to show how powerful a sizeable cost reduction can be for a high multiple fast growing restaurant chain.
Disclosure: No position.
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