Chipotle – Nearly Impossible To Value

chipotle

On January 8th, I posted an article about Chipotle (NYSE:CMG). Since then, the stock is up 8.1%. The S&P 500 is up 6.5% over the same period. In this post I outlined the struggles of the company and why it could be an opportunity for investors. I explained why I think the business is terrific and discussed the valuation of the stock. If you would like to read the post, you can find it here.

Since this post, a large amount of additional information has become available:

  • On February 1st the CDC closed their investigation of the multistate E. Coli outbreak. However, they were not able to identify the cause of the outbreak.
  • On February 2nd, Chipotle released their Q4 and full 2015 year results. Additionally, they disclosed that the company was served with a subpoena broadening the scope of the previously-announced criminal investigation by the U.S. Attorney’s office for the Central District of California. This will be a company wide investigation on food safety matters dating back to January 1, 2013.
  • On March 15th, Chipotle announced February sales comps of (26.1%). This was an improvement from (36.4%) in January.

In addition to these pieces of information there have been some large trends that have emerged. Some of these trends have already impacted the company, but all of them will have an impact going forward.

Macro Trends


Minimum Wage Increases

In the last two weeks we have seen both New York and California change their minimum wage legislation to $15 per hour. Chipotle has 338 locations in California and 122 in New York. Together these account for 24% of existing stores. Current minimum wages in these states are $10 in CA and $9 in NY. In addition to these two states, we have seen numerous localities around the country raise their minimum wage to $15. It is worth noting that Chipotle usually pays their employees above minimum wage but this will now change and potentially affect the their talent pool. Chipotle will pay the same wages as fast food and many other types of businesses. To offset these cost increases, they will have to raise menu prices. In 2015, Chipotle increased prices by 10% in San Francisco after the minimum wage was hiked 14%. They will need to continue to raise prices gradually as the minimum wage rises over the coming years. It is unclear how much pricing power Chipotle has. At some point customers will not allow the company to push the minimum wage hikes on them. Customers might also not have much tolerance for pricing increases after the foodborne illness outbreaks.

In 2015, labor costs were 23% of total restaurant sales. If labor costs rise by 30% over the next five years, Chipotle will need to raise menu prices by 7% just to keep their margins constant. A 7% increase doesn’t sound like much but this will be on top of any food inflation or other costs. It is difficult to forecast how this trend will affect CMG’s margins over the next five years.

Social Media

In my post on January 8th, I mentioned I thought comp sales would be bad through Q1. However, the comps have been worse than I had anticipated. I have been amazed by how many people became aware of the outbreak. It is my belief that social media put a magnifying glass on the company during the outbreaks. This increased the population that became aware of the incidents. Chipotle’s foodborne illness issues are the first to happen since social media became widely used. I haven’t been able to find any research discussing the increased reach of bad news from social media. The good news is, even though more people were made aware of this outbreak, Chipotle could still use the increased reach of social media to help them come back. We will see if this materializes.

Millennials Eating Healthy

Healthy diets for Millennials are considered very normal today. I would attribute a lot of this to technology that has allowed for better education. For instance, it was once believed that three meals a day was optimum. But now some health experts say six meals is better. The Millennial generation grew up during the fast food era, even celebrating birthdays with Ronald McDonald. Today, Millennials understand fast food and that is why we choose the healthier alternative like Chipotle. This is not a fad, it is a massive trend that will continue with Generation Z. I eat Chipotle probably three times a week and have for several years now. Chipotle uses 68 quality ingredients across the entire menu compared to typical fast food where a single item have can as many as 100 ingredients, many of which are chemicals. Chipotle is an easy choice for Millennials and Generation Z because it is fast, healthy, consistent, and affordable.

Foodborne Illness Outbreak


E.Coli

In late October an E.Coli outbreak at Chipotle restaurants in the northwestern United States resulted in a shutdown of 43 restaurants. Then in late November, another E.Coli incident occurred. On December 18th it was confirmed that between the two incidents 53 people fell sick in the nine state outbreak.

Norovirus

The week of August 18th, 204 people were infected with norovirus at a southern california Chipotle. Then the week of December 7th, 141 boston college students fell sick with norovirus. Between these two separate outbreaks 345 people became ill.

On February 1st, the Centers for Disease Control and Prevention (CDC) closed their investigation of the multistate E.Coli outbreak. However, they were not able to identify the source of the outbreak. Privately, Chipotle blamed an Australian beef supplier for the multistate E.Coli outbreak but this was never confirmed. If this is what the company believed to be the cause, then why did they implement additional procedures for boiling onions and thoroughly washing vegetables? My guess is the company still has no idea how the outbreaks happen. In my view, the outbreak remains unresolved and it could happen again.

The media coverage around the incidents would make you think this was a large outbreak. But in reality, neither the E.Coli or norovirus were anything different than other outbreaks going on at the same time. Chipotle’s were probably smaller than some happening at the same time. According to the CDC, there are more than 250,000 cases of E.Coli annually. Additionally, there are 19 to 21 million cases of norovirus annually. The average person will have norovirus five different times throughout their life. This means that on average each day, there are 685 people that become sick with E.Coli and over 54,000 with norovirus. Between the two E.Coli outbreaks, 53 people became sick. Between the two norovirus incidents, 345 people became sick. Why didn’t the media talk about the other 3,000,000+ people that fell sick with norovirus from other places during that same timeframe? Probably because headlines like “E.Coli Outbreak at Chipotle” get good ratings. Even though I believe people have completely overreacted, if CMG has another incident, the stock will probably get crushed again. People don’t take the time to understand the big picture. They just eat somewhere else. If Chipotle were able to identify the cause of the outbreak as a certain supplier and cut ties with them, I would have a different opinion. But at this point, the outbreak is unresolved and another could happen because we really don’t know if the cause has been remediated.

Operating Margins


Chipotle has quite a bit of operating leverage which is currently working against them. When same store sales are growing, you have fixed costs spread out over more meals. Currently, same store sales are down sharply so the opposite is happening. Chipotle has increased operating margins over the last ten years from 7.53% in 2006 to 16.96% in 2015. The company has recently announced they would be implementing a new food safety program that will shave 200 basis points off of operating margins. In addition, they have the headwinds from the rising minimum wages working against them. In my valuation, I forecast a long term operating margin at 11%. This is still a phenomenal margin for a fast casual restaurant but I think the days of 16% margins have come and gone.

Valuation


CMG’s stock is incredibly difficult to value. I attempted to value the stock in my last post using a relative valuation. That is now worthless due to the amount of change in analyst estimates in the last three months. On January 8th, analysts expected Chipotle to earn about $15.50 in 2017. Today they only expect $13.44. This makes the stock quite a bit more expensive today than it was on January 8th even though it has only moved 8%. Due to the fluctuation of analyst estimates, I have decided to perform an intrinsic valuation. Please refer to the chart below.

CMG Valuation

The stock is currently trading at 39x forward earnings which is in line with the historical average. However, I think the pressure on operating margins will slow the growth rate down from what we have seen the last few years. I have factored in the pressure on operating margins in my normal valuation where I calculated a share value of about $400. This assumes an average annual growth rate of 17% over the five years. If Chipotle bounces back and grows closer to 21% a year, investors buying the stock today around $440 most likely have limited upside.

Conclusion


I continue to believe that Chipotle is a great business and want to own it. However, with the current information available, the stock is too expensive to buy right here. The company will report Q1 earnings on April 26th and they are expected to be horrible. After these earnings, we will have more information about how fast customers are returning to the stores. The stock currently has a lot of tail risk between the open criminal investigation and risk of another foodborne illness incident. If the company were to have another incident in the next year, no matter how small, the stock would get crushed. I plan on staying patient and hoping the valuation will become more reasonable over the next few months.

Disclosure


No Position 

 

 

 

 

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