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A Chipotle Restaurant Ahead Of Earnings Data
The company said there were no confirmed cases of e. coli in Massachusetts yet. Photograph by Bloomberg via Getty Images
Commentary

The Better Burger Won’t Save Chipotle’s Investors

Apr 25, 2016

Fast-food chain Chipotle Mexican Grill on Tuesday is expected to report its first quarterly loss as a public company following last year’s E. coli outbreaks that exposed the chain’s health safety issues. Wall Street analysts are estimating a GAAP earnings loss of $1.04 versus $3.88 last year. I suspect the media will focus on Chipotle’s loss and its decline in same-store sales of roughly 30% during the first three months this year. Meanwhile, anyone who is still bullish on Chipotle’s stock will likely focus on the pace of its recovery in same-store sales and the improving profitability over the next two years.

I’m bearish and think massive shareholder value will be destroyed over the next few years. Up until the E. coli outbreak, Chipotle’s management team has never managed a company crisis. They continue to believe consumer attitudes toward the brand have not changed and that customer traffic will return to pre-crisis levels within the next 12 to 24 months.

That outlook is flawed. The fatal mistake the company is making is all about capital deployment. Chipotle ended 2014 with 1,783 stores and $445 million in net income. By the end of 2018, the company’s estimates suggests that they will spend $1.3 billion to add 1,117 new stores, a 62% increase in its store base. The problem is that during the same period between 2014 to 2018, even the most bullish investors of Chipotle estimate that the chain could earn net income of $506 million or incremental net income of $61 million. So if Chipotle invests $1.3 billion in new stores and generate $61 million in incremental new income, that’s a 4.7% return on investment. That is what I call the definition of destruction of shareholder value.

On top of this, the company has applied for the trademark “Better Burger” in a move to expand into the burger business. While the restaurant industry is abuzz, the hype is merely a distraction from the real issues of the 2015 E. coli outbreak and other health safety concerns plaguing Chipotle. These problems run much deeper than many investors realize.

What’s more, the flurry of media coverage around Better Burger last month missed the fact that Chipotle has already tried to diversify into pizza (via Pizzeria Locale first launched in 2015) and Southeast Asian food (ShopHouse in 2013). Shareholders have yet to be rewarded for these initiatives and the future looks decidedly dim. There’s little reason to believe Chipotle will have better luck in the burger space, arguably the most competitive in the ‘quick serve’ space.

When Chipotle was first spun out of McDonalds in 2006 it was definitely a novel concept with a goal of changing the industry forever. While they were successful in accomplishing this goal of selling burritos, other companies in the restaurant industry are doing just fine selling cheeseburgers.

A closer look at Chipotle reveals that there is nothing proprietary about the company’s process that would make it successful in the burger category:

  1. It does not have a trademark on its “food with integrity” slogan.
  2. It does not have any intellectual property for running great restaurants.
  3. There is nothing proprietary about the food the company serves.
  4. What it does have is the Chipotle name.

That last point is important. Following the 2015 food illness disaster, customers are already beginning to realize that Chipotle is just like every other restaurant company. Its food is just as unhealthy as the other companies it routinely criticizes. More importantly, management neglected to remember the first rule of running restaurants: Don’t get your customers sick.

It’s unclear if Chipotle management can manage this crisis. In fact, in the first 60 days of the recovery process, management has clearly not improved consumer attitudes toward the brand. For the better part of the last two months the management of CMG has been spending millions of dollars on free food trying to get the consumer to come back into the stores. Looking at the CivicScience constantly running brand survey, it would appear those consumers are not responding very favorably. Some of the changes to note over the last few quarters:

  1. The “I don’t like it” crowd is up from 18% during the last three months of 2015 to 26% during the second quarter of 2016.
  2. Those replying “I like it” is down, but to a lesser extent. From the second quarter of 2015, it is down 400 basis points from 21% to 17% during the same period. And more recently, from the first quarter of 2016 to the second quarter of 2016, it has recovered 100 basis points.
  3. The “I don’t have a strong opinion” is down 90 basis points from the last three months of 2015 to to current levels, as consumers have become more opinionated on the brand.

As we noted in our Fortune piece “How Hubris Messed With Chipotle,” management is in denial of the extent of its own problems.

My takeaway is that simply giving away millions of free burritos is not having the desired outcome. If management is having trouble fixing its core business, how could they possibly start yet another concept? Also, why would Chipotle management enter the most competitive category in the restaurant space which is better burgers? The simple answer is they are not; it’s just a distraction.

As we’ve said before, Chipotle’s woes are far from over. With a price target of $275, I see additional 40% downside from here. Look out below.

Howard Penney is a managing director and restaurants analyst for Hedgeye, an independent investment research and financial media firm based in Stamford, Connecticut. Neither Penney nor Hedgeye are investors of Chipotle.

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