Chipotle Mexican Grill (CMG, Financial) has been among the most successful fast food chains in recent years by providing differentiated high quality food served quickly in a good environment.
The company claims that it uses naturally grown ingredients and serves more naturally raised meat than any other restaurant chain. Customers liked it. The number of stores grew from over 500 locations in 2006 to about 2,200 locations. But the company suffered significantly starting in November 2015 when E. coli outbreaks were linked directly to its restaurants. Comparable sales were in the negative 20%-plus range in 2016. Earnings dropped to close to zero.
Chipotle was founded in July 1993 by Steve Ells, who was a young chef. Chipotle had 16 restaurants when McDonald's Corp. (MCD, Financial) became a major investor in 1998. It had more than 500 locations when McDonald's fully divested Chipotle in 2006.
Activist investor Bill Ackman (Trades, Portfolio) bought a bit less than 10% of the shares of Chipotle in fourth-quarter 2016. Since then, the company has removed a co-CEO, making Ells the only CEO. The board has selected four new members and given a seat to Ackman’s Pershing Square.
Financial profile before E. coli outbreak
Chipotle had been one of those amazing success stories in the restaurant industry until the E. coli outbreak in fourth-quarter 2015. Its food tasted good and felt good because of the high-quality ingredients. According to the company’s annual 10-K filing, Chipotle restaurants “serve only meats that were raised without the use of nontherapeutic antibiotics or added hormones.” Its service was fast. Some Chipotle restaurants “have been able to serve more than 300 customers an hour.” Its restaurants were nice, clean and modern-looking.
From 2006 until the end of 2015, the number of locations grew about 15% a year. The sales grew over 21% per year. Operating income grew over 32% a year. Chipotle has been growing not only its number of locations but also sales and operating leverage.
Sales growth was from both an increase in the number of stores and improvement in same-store sales.
Margin has improved significantly over time.
Chipotle maintained impressive return on invested capital until the E. coli outbreak.
Heart attack after E. coli outbreak
In November 2015, Chipotle experienced a major setback as its restaurants were linked to a major E. coli outbreak and a minor one following the first. The total number of people sickened was about 60. Chipotle's revenue was down 18% year over year for the first three quarters of 2016 compared to 2015. Comparable sales were down over 20%. Operating income went to barely break-even. There was a lot of finger pointing. It is quite possible the company did not handle the incident with care.
Why is Chipotle worth buying at $400?
Food safety issues are not rare incidents. Chipotle’s E. coli outbreak is not on a grander scale compared to what happened at other restaurants. People always forget. As a result of people forgetting, other restaurant chains have recovered from their fair share of E. coli outbreaks. Chipotle’s strength lies in its operating efficiencies. When the customer returns, the chain would still be one of the best-run and most profitable restaurant businesses.
And as a result of the E. coli outbreak, the stock price finally came down to earth.
Now let us explain in detail.
- Food safety issues are not rare incidents. The CDC database for foodborne outbreaks shows that just from 2011 to 2015, there were 326 foodborne illness outbreaks linked to fast food restaurants which caused 4,500 people to become ill, 412 people to be hospitalized and two deaths. The number of outbreaks by year is shown in the following chart. In fact, same statistics for sit-down restaurants are more than four times larger. This certainly does not mean that Chipotle has a reason to be forgiven, but it does show that foodborne illness is almost a fact of life.
- Chipotle’s E. coli outbreak is significant enough to be one of the largest but was not off-the-charts large. The following table shows some of the biggest E. coli outbreaks traced to restaurants. Chipotle’s outbreak is by no means on a grander scale compared to others.
- Other restaurants that had outbreaks have recovered. This includes Jack in the Box (JACK, Financial), whose outbreak in 1993 made four people die and 500 people sick. Jack in the Box paid $15.6 million to settle the lawsuits that followed but ultimately recovered and has more than doubled its restaurant count since, from 1,224 to 2,910. The 10-Ks of Jack in the Box showed a significant decline in sales and profitability, but revenue appeared to recover from the third year.
Note: The above table is a picture from the 10-K. In the first column the date looks like a typo with the correct date Sept. 26, 1996.
4. Chipotle has shown that it has great economics coming from operating efficiencies. The company had one of the highest ROICs and the highest revenue per restaurant and profitability per restaurant among fast-food peers. If you believe revenue will ultimately recover, then it is reasonable to believe that profitability will largely return.
5. If point No. 4 is sensible, then you now have a stock priced at 20x normalized earnings and that could grow 15% to 20% a year. The stock is cheap relative to restaurant peers. See valuation session for details.
Risks
There could be another outbreak that damages its reputation again. In fact, this E. coli outbreak was actually two, a bigger one in October in Washington and Oregon and a smaller one in Washington afterward. Prior to E. coli in 2015, there was a salmonella and norovirus outbreak linked to Chipotle in August. Then there was another E. coli outbreak in 2009 that sickened 29 people when Chipotle had 800 locations rather than more than 2,000 locations today.
Remember, unlike the majority of its fast food restaurant peers, Chipotle restaurants prepare food on site so the food is fresh and tasty. This makes Chipotle more prone to cross-contamination than fast food restaurant peers that heat frozen food on site. In fact, sit-down restaurants, which also prepare food on site, are much more prone to foodborne illness outbreaks. According to the CDC website, from 2011 to 2015, the number of outbreaks and people who were sickened from those outbreaks linked to sit-down restaurants were more than five times those linked to fast food restaurants.
The reputation and revenue will take time to recover. It has been 14 month since the outbreak. Jim Cramer commented on CNBC that it has usually taken restaurants 18 months to recover from foodborne outbreaks. Jack in the Box seemed to have taken 24 months to recover from the very serious event. Given that the customers of Chipotle are more health conscious than typical fast food restaurant patrons and the company’s handling of the outbreak seemed unsatisfactory, it could take it longer than 18 months to recover.
Valuation
The stock is currently trading at 21x normalized earnings of $19 (i.e.,Ă‚ earnings as if E. coli had not happened) based on 2016 store counts and 2015 profitability prior to the E. coli outbreak. The chain currently has 2,200 restaurants and plans to open about 200 in 2017. With restaurant ROI at 50%, if revenue and profitability recover in a reasonable time frame, the company should be able to easily self-fund 10% store expansion.
The management has commented that the market can support 5,000 Chipotle restaurants. Then the company could enjoy 10% store growth for the next 10 years until 2025. Why do we think it is possible? Because there are 14,000 McDonald’s and 7,000 Starbucks (SBUX, Financial) in the U.S. alone. If same-store sales could keep above inflation at say 2%, a 13% to 15% top-line growth after earnings fully recover and a 15% to 20% bottom-line growth are achievable for 10 years. If this happens, and apply a 15x earnings at the end of 15 years, we could have a three- to four-bagger within 10 years. This calculation is captured in the following table.
It may still be a bit expensive than value investors would like. But just remember, if the Trump administration lowered corporation taxes, Chipotle would be the biggest beneficiary with 100% of operations in the U.S. and the majority of its goods and services costs occurring in U.S. In that case, the net earnings would be instantly higher.
Chipotle stock appears cheaper than restaurant peers on normalized earnings with higher growth and a zero-debt balance sheet. Starting from this quarter, Chipotle will need to have very easy comps to beat. This could be the time to start accumulating Chipotle shares. But we would caution that the valuation for the whole restaurant industry is high, so shorting a peer with less growth to hedge may be smart.
Disclosure: We have no positions in any stocks mentioned. But we could initiate a long position in the next 72 hours.
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