Description

Chipotle has been extensively written on VIC, both as short and long, and reading the full history and comments is very interesting and full of lessons. The board spotted well the long opportunity in 2016-2017 and returns since have been outstanding due to a successful recovery from their sanitary scandal and a management reshuffle which allowed to address the underlying problems (food safety processes, digital measures). 

Today I believe Chipotle is a very timely short as both the short term situation and the store economics are rapidly deteriorating, yet the stock is trading at nosebleed valuations on extremely optimistic communication by management and a perceived “COVID winner” status. The stock outperformed the S&P by roughly 35% this year (!).

While I recognize the strong brand value of Chipotle (I’m a client) and the impressive changes brought on by the new CEO, I see a very high probability of making great returns shorting Chipotle now. I bought < 6 months dated puts close to the money paying a premium worth ~12% of strike. Alternatively the board may prefer a put spread with lower strike or shorting the stock outright.

Since the stock is well known, I’ll focus on the main points.

a.            Some very high-level update

In 2016-2017, the stock is heavily shorted until bottoming at 250$ a share. Bill Ackman is hitting a rough patch as they are significant shareholders. At the time traffic is decreasing and repeated food scandals cast doubt over whether the brand will survive. Chipotle tries lots of giveaways to maintain traffic. The dual CEO structure is stopped.

A new CEO comes on board from Taco Bell to revive the brand. The work he does is terrific and resolves the former pain points (my understanding is the founder was holding back on these):

• implementing better hygiene practices to avoid further scandals
• launching digital mobile apps & digital solutions
• working on menu improvements
• working on multi channel (deliveries, drive-in)

2. The hype about digital sales, menu innovation

Chipotle is pleasing investors recently as sales are only down -5% in Q2 (comparable sales -10%). This was done as the firm did not close almost any restaurants during the COVID crisis, except a few in malls. This was also done because digital sales were very successful. Starting at 18% of sales last year, they increased at 26% of sales in Q1 and 61% of sales in Q2. In absolute terms, this means they went from doing 372M$ in digital sales in Q2 and 828M$ in Q2. This also implies 1,039M$ of in-restaurant sales in Q1 and 536M$ of in-restaurant sales in Q2.

I disagree with the current narrative that this demand is purely incremental and that demand from dine-in will increase while demand from digital will remain stable. Current on-site Chipotle customers shifted to online and demand from new customers was rather small. As all sites reopen and/or other chains catch up with digital offering, Chipotle will again suffer from the low barriers to entry in the sector and from competition, and will have to compete on discounts etc - which they have been doing during the crisis. As pointed in other write-ups, price increases are doable but not a formality and end up hurting traffic.

Economically there are a few problem with digital sales:

• based on check with competitors, I believe they have lower average tickets as people order drinks less often and can’t be upsold by the employee preparing the command (no guacamole…)
• the cut of delivery apps significantly lowers restaurant level margins. While not disclosed outright, delivery costs are included in “Other operating costs” and I believe they are the main reason behind the increase from 13.5% of sales last year to 19.2% in Q2. (incremental 456M$ in digital sales vs incremental 52M$ in other operating costs)

If you believe the delivery apps will be a viable long-term delivery channel, then the story has changed and restaurant-level margins and average sales could well remain below historical levels.

Regarding menu innovation, they’ve been working on adding several items to the menu, such as cauliflower rice. Chipotle has long been criticized for not expanding menu items and most products have been in demand by clients for a long time. However I don’t think this will improve much the big pciture. Complexity of menu is usually inversely correlated with profitability in QSRs and I doubt that it will drive a meaningful number of new clients, rather, it will help loyal customers to come back.

3. The COVID risk

I’d argue that the current price doesn’t incorporate any kind of downside scenario due to a prolonged impact of COVID on the stock & the economy.  You’ve certainly seen the numbers of new cases which have been rising. Below are a few from 2 weeks ago. Situation has been deteriorating rapidly especially in the states where Chipotle is the most present. Last Monday California announced a closure of dine-in for restaurants, which represent 17% of outstanding Chipotle units and I estimate slightly more in terms of sales (those are 2018 numbers as management stopped disclosing the split per state in 2019). Were these to generate no dine-in revenues for 3 months, I estimate that would be a 100M$ hit to revenus alone.  As an answer to this, communication by management has been rather upbeat: “Chipotle Continues Accelerated Growth With 100th Chipotlane and 10,000 New Jobs”. That is 12% of current total workers to handle orders on the digital make line, most of which have already been hired.

4. What can go better vs what can go worse ?

Sell-side optimism is at the highest level since the 2015 peak, before the food scandal. It’s shocking that despite all the potential problems, analysts decided to put their rose-colored glasses on. I struggle to get excited.

What can go worse ? Everything which eventually always go worse in this sector:

• food & wage inflation
• higher costs & complexity due to expansion of menu items
• declining sss due to new entrants & competing concepts, as Chipotle is not alone anymore in the bowl QSR (Moe’s, Dos Toros for mexicans, Sweetgreen for a digital first salad bar)
• multiple compression
• as discussed, structurally lower margins due to a greater value being captured by the delivery apps

5. Wait, what about the growth story overseas and the other concepts ?

It remains to be seen whether Chipotle manages to reach any scale abroad. Currently, they have 39 restaurants abroad which is immaterial and they have shown limited success. In Canada, the growth has stagnated for the last 2 years. In Europe, notably in France, number of stores at remained at 6 and the French entity, Chipotle Mexican Grill SAS, remains loss-making at the OP level to the tune of 2+M€ per year, although this may be due in part to transfer pricing. In Paris, a few copy cats concept have been very successful (BocaMexa), successfully targeting the same customer demographics. In the UK, it’s roughly the same story as there has been no net store openings for roughlt 5 years. At this stage, assigning any value to overseas growth seems speculative.

Other concepts, Pizzeria Locale and ShopHouse, have been closed.

6. Valuation

I think the case is pretty self explanatory and we can all run dozens of DCFs from the simple one to the complex one going down to unit economics. At the current price I’d argue it doesn’t make much difference. Chipotle is trading at a valuation that allows no room for mistakes. 

Making the assumptions (very optimistic in my view), that Chipotle manages to grow at the same speed as McDonald’s when it was the same size, I forecast an 8% CAGR for 14 years from unit growth. I then assume that OCF margin will get back an reasonable level of 14% and that they can maintain the attractiveness of their future park of 7,600 restaurants with 450M$. I get to a terminal cash flow of roughly 2B$. Doing the full DCF, a 3pc discount rate is necessary to get to current market cap (5pc discount rate & 2pc terminal growth rate)

Another way to see it in the short term: a ~610M$ OCF, excluding NWC and stock options effect, deducting 100M$ in current maintenance capex, yields 510M$ in owners’ earnings. This assumes store economics won’t improve back to their former levels. Current market cap is 31.5B$. 62x owners’ earnings.

Catalyst

• food & wage inflation
• higher costs & complexity due to expansion of menu items
• declining sss due to new entrants & competing concepts, as Chipotle is not alone anymore in the bowl QSR (Moe’s, Dos Toros for mexicans, Sweetgreen for a digital first salad bar)
• multiple compression
• as discussed, structurally lower margins due to the shift in channel