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How Hubris Messed With Chipotle

A Chipotle Restaurant Ahead Of Earnings DataA 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

Anyone tempted to buy shares of Chipotle, following the stock’s 45% decline from its 2015 all-time high, should take a deep breath.

Given all the uncertainty, investors shouldn’t be desperately calling a bottom but rather asking, ‘How low can the stock go?’ I’m firmly planted in the bearish camp and see significant downside. Here’s why.

Last week, Chipotle (CMG) pre-released fourth quarter earnings numbers to reflect the slew of E. coli and foodborne illness outbreaks that affected its restaurants nationwide. The results? Not good. Comparable restaurant sales declined 14.6% in the fourth quarter for the month of December alone; comparable restaurant sales were down a whopping 30%.

To make matters worse, management also disclosed that a criminal investigation of the restaurant chain would be conducted by the U.S. Attorney’s Office for the Central District of California, in conjunction with the U.S. Food and Drug Administration’s Office of Criminal Investigations.

A key takeaway from the release:

“It is not possible at this time to determine whether we will incur, or to reasonably estimate the amount of, any fines, penalties or further liabilities in connection with the investigation pursuant to which the subpoena was issued.”

The long-term damage to the brand could prove very costly. Toward the end of December, we conducted a national survey of 200 Chipotle consumers to get a read on how much this outbreak will affect future business performance. Specifically, we screened participants by asking them: Have you stopped going to Chipotle because of the E. coli outbreak? The results were resoundingly clear: 31.3% of respondents said “yes” they have stopped going. That is an alarmingly high number, and implies a very rough road ahead for Chipotle.

Still need convincing about the bearish case against Chipotle? Having covered the restaurant industry as an analyst for over two decades, I can firmly say that while Chipotle’s case is extraordinary, its woes are not dissimilar from past crises at other companies.

In all of these previous examples, overconfidence and irrational expectations erodes the initial concept of the brand, which then loses its operational integrity as unit growth exceeds the company’s capacity to manage that growth.

As we have said in the past (click here to read my open letter to Chipotle CEO Steve Ells), hubris has killed Chipotle and only humility will save them. I have been making this case since first suggesting investors steer clear of the stock on October 19, 2015. (Since then, Chipotle shares are down 43.5% versus 5.3% for the S&P 500). The hard road back to salvation follows five stages and, in my experience, things at Chipotle are likely to get far worse before they turn the corner.

Below are my five steps outlining what the company is up against and what investors should expect:

Stage 1: Setting the Ground Work for Destruction — At this stage, the best SHORT stories are created! In the case of Chipotle we now know that management was short sighted in its approach to serving safe food to its consumers. Given the concept “food with integrity” position with consumers, it presents a set of issues that is unique to Chipotle. In fact, this whole situation is unprecedented in the restaurant industry.

Stage 2: The Denial – Usually, denial takes the form of bad real estate site selection that becomes increasingly hard to explain away, or acquisitions of new brands to maintain the façade of growth.

In the case of Chipotle, new unit (restaurant) productivity was at three years lows prior to the food safety concerns. I believe that management is still in denial about the company’s ability to grow at the same pace it did prior to the food safety issues. I would also not be surprised if Chipotle is forced to close some stores, given the significant decline in average unit (restaurant) volumes.

Stage 3: The Panic – Chipotle is still in the denial phase, but the market is starting to panic. Fortunately for Chipotle, they have the ability to repurchase a significant amount of stock. The authorization allows for the repurchase of $416 million in common stock, including a previous authorization.

To date, Chipotle has not demonstrated any of the classic moves of the panic phase, because the share repurchase has put a fake floor under the stock for the time being. This has also lulled management into a false sense of security. The true panic happens when more bad news causes management to scramble to fix its core business that continues its decline. In this period, senior management begins to be replaced by the operating team.

Stage 4: Depression – We don’t know what this stage will look like for Chipotle, but it’s coming! This is where things get ugly. Typically, management can reduce labor at underperforming units to improve profitability, or management sacrifices margins to increase customer counts by implementing a deep discounting strategy.

Stage 5: The Upward Turn and Hope – Management decides to close stores, stop growth and/or stops discounting to improve profitability. The next move is to attack the middle of the P&L to improve profitability. At this stage, the stock becomes washed out and the sell-side has abandoned the company. It also becomes very hard for the buy-side to pull the trigger and buy the stock. At this stage I like to go LONG!

To be clear, Chipotle’s woes are far from over. With a price target of $275, I see additional 33% 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.