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A Valuation So Big, You Can Ride It…Down

“So Big You Can Ride It” is the slogan on a Chipotle Mexican Grill parade float featuring a cowboy riding an oversized burrito.   What is really so big, however, is the big lie perpetuated on an increasing base of retail investors that sales growth at Chipotle is resurgent and worthy of an eye-popping 56x multiple on trailing 2013 Earnings, a 46x multiple on 2014 estimated EPS, and only a 37x multiple of 2015 estimates EPS (all numbers ex the cash balance).  This despite earnings per share growth of only 20% in 2013 and an even weaker net income growth of 18.5%.

Putting Chipotle’s valuation into perspective: Assuming 3000-3500 restaurants are possible in the U.S. at $2MM to $2.4MM in revenues per restaurant (compared to $2.17MM today and likely declining productivity in a large rollout), with 27-29% restaurant operating margins (versus 26.5% today), 5-5-6% center costs (versus 6.5% today), and 150 bps in maintenance cap ex, would imply per share values for a mature Chipotle brand of $337 to $493.  The market thus is applying a value for ShopHouse, Pizzeria Locale, and Europe of between $3.7 billion and $8.5 billion.

Chipotle even failed to beat some bullish analyst earnings estimates for 2013.  Sanford Bernstein’s Sara Senatore started last year with 2013 and 2014 EPS estimates of $10.50 and 12.98, respectively.  Comp store sales estimates were 3.3% and 7.0%.  Her price target was $450.  Chipotle missed her original 2013 earnings estimates by 3 cents while beating her comp store sales estimates by 2.3%.  Now, her 2014 EPS estimates are for $13.48 on 8% comps and her price target has risen to $640.  For reference, Chipotle’s share count is a little more than 31 million shares.  A $15 million increase in her expectations for profitability in 2014 has resulted in a $5.9 billion increase in her estimate of the value of the business.  Most analyst’s estimates and price targets show similar patterns.  Either they were crazy wrong then; or they are crazy wrong now.  Even if the truth lies in the middle, the stock, at $610 per share today should be significantly lower.

The excitement, stoked by the general enthusiasm for growth without regard to profits, stemmed from accelerating same store sales comps.  Based on these accelerating comps alone analysts confirmed management’s growth credentials, expanded their views of the potential opportunity for the Chipotle brand (in terms of units and day parts), and assumed success for Chipotle’s international expansion plans, and new Asian and Pizza concepts.

Granted, profitless growth was the mantra of 2013.  However we believe that might make sense in a zero sum, potential winner take all market such as enterprise software, electric vehicles, or on-line retail.  However, we are skeptical it applies to fast casual restaurants.

In reality, Chipotle’s existing store base is mature and Chipotle has been aggressively promoting and discounting to drive the apparent improvement in traffic and comp store sales growth.   In actuality, the apparent acceleration in same store sales is not one when looking at multi-year comps; the recent sequential rise has been against an easier and easier comparison and only achieved through the aggressive promotions, advertising and couponing mentioned above.  

Analysts and traders are ignoring Chipotle’s mediocre earnings growth in 2013.  Meanwhile, they have been bidding up the stock anticipating 24% earnings growth in 2014 and 2015.  This decidedly “not spicy” earnings growth relies on management’s promised price increase, one that has been twice delayed as management in practice discounts to drive traffic.  In early November, Chipotle CFO Jack Hartung (in the third Chipotle management appearance this year on CNBC’s Mad Money) seemingly downplayed the necessity of a price increase in 2014 after management basically promised one on the Q3 earnings conference call three weeks prior.  Management similarly backed off confirming a price increase in 2014 on their Q4 2013 earnings call after only weeks prior at the ICR exchange conference talked about it with confidence.  When will investors realize that Chipotle is not raising prices because they cannot without impacting traffic?

It is a brilliant conceit that a same store sales improvement trend on easier comps and underpinned by discounting that has failed to deliver expected profit growth is rationale for a super premium earnings multiple.  That Chipotle’s food cost increases are so significant and not expected to reverse reveal the material role giveaways (coupons for a free burritos or free chips and guacamole with a burrito purchase…) are having on transactions and margins.  The company’s recent rise in marketing costs, on top of the rising food costs of promotions, underscores how fast they are pedaling to keep the bicycle moving uphill.

The opportunity to short Chipotle stock has been created by Wall Street enthusiasm and confidence that a mature retail concept currently driving traffic primarily through discounting and increased advertising can raise prices later this year without impacting traffic.  Truly, Chipotle’s current 47x earnings valuation is not based on the value created by this last year’s trend in margins which declined 52 basis points.  Rather, investors seem confident that the rapidly growing store base will be more profitable at higher menu prices promised for next year.  Management seems less confident in the future as they sell tens of millions of dollars of stock, in many cases liquidating stock appreciation rights multiple years before they expire.

Chipotle is priced for a place in its growth curve that it no longer occupies. Chipotle faces numerous challenges over the near and intermediate term that management implicitly recognizes by their aggressive stock sales.  We reiterate our concerns highlighted above and discuss other issues we have with Chipotle’s business model and valuation.

1)   Accelerating Comp Store Sales are not what they appear.  Chipotle is buying traffic through aggressive coupon mailings, promotional contest giveaways, and increased advertising.  Chipotle drove traffic in 2013 by way of BOGO (Buy 1 Burrito Get 1 Free) coupon mailings in Q1 and Q2, contest giveaways such as Adventurito and the Scarecrow game in Q3, and catering promotions in Q4.  Chipotle management blames higher food costs on inflation and shortages when it is likely that food giveaways while driving traffic and revenue are also driving significant cost of goods.  BOGO offers (which were at least mailed in Q1 and Q2 2013) are effectively 50% discounts to certain customers.  The Adventurito Treasure Hunt gave away free burritos for a year to approximately 380 winners and free burritos for life to another 20 grand prize winners.  But thousands of wannabe winners could get clues to the game from Chipotle receipts thereby driving traffic in Q3[1].  Traffic was further driven by the Scarecrow iOS App that gave away an unknown number of BOGO offers.  Finally, Chipotle drove part of its 9% Q4 comp by offering two free burritos in January 2014 to catering orders in December 2013.   Chipotle’s active couponing has even inspired fake coupon offers (http://www.ibtimes.com/chipotle-free-burrito-coupon-hoax-voucher-march-20-tricks-hungry-fans-photos-1559820).  Chipotle’s active discounting, promotions, and revenue and cost shifting and associated declining margins reveal Chipotle is buying top line growth and signal that the existing stores are mature.  We believe that Chipotle will have difficulty lapping 2013’s heavy promotions. 

2)   Accelerating Comp Stores Sales are not what they appear, One time lift from Qdoba closures.  In the second calendar quarter of 2013 (just as Chipotle’s sales began to improve), Chipotle largest competitor Qdoba closed 62 restaurants, with over $35 million in sales.  Assuming Chipotle captured 50% of the sales from the Qdoba closures, Chipotle’s same store sales comps would have been only 4.8% and 5.6% in Q2 and Q3.  Qdoba plans to resume unit growth in FY2014 with 60-70 store openings.

3)   “Accelerating Comp Store Sales” are not what they appear; 2013 Comps benefitted from a temporary bump up in the rate of store openings in 2012.  CMG’s comparable store sales benefit by 2-3 percentage points per year because the company has a large number of new stores entering the comp base each year, which naturally increase sales as they mature.  The larger the the number of store openings the prior year, the larger the impact to comp store sales.  While Chipotle increased stores by 13.4% in 2010 and 13.5% in 2011; store openings increased the store base by 14.6% in 2012.  Thus the comp store sales statistics reported in 2013 has a larger benefit from the newly entering stores than the two previous periods.  The Store base should increase by 12.8% in 2013 and 12.5% in 2014 if the top of the range of store opening guidance is met.  This temporary benefit in 2013 should dissipate going forward.

4)   Accelerating Comp Store Sales are not what they appear.  “Accelerating Comp Store Sales” are not what they appear as recent numbers are on easier comparisons.  Looking at two and three year comp store sales, sales growth at existing Chipotle units is still declining.  Looking at four year stacked comps, sales growth at existing stores is appreciating, but not accelerating at the hyperbolic rate implied by 1 year statistics.

5)   Accelerating Comp Store Sales are not what they appear.  Average restaurant sales growth (the trailing 12 month sales for restaurants in operation for at least 12 months) is slowing rapidly.  Average Restaurants sales, which grew 6.5% in 2010, 9.4% in 2011, and 5.0% in 2012 came in at 2.7% 2013.  The overwhelming majority of comp store sales growth is coming from new, immature stores recently added to the comp store base.

6)   Competition is increasing.  Skeptics have asserted that a revamped menu at Taco Bell would steal share from Chipotle.  We actually doubt this; we believe the Taco Bell and Chipotle customer are different.  We believe KFC will not materially dent the marketplace with KFC select chicken burritos.  That said real competition is growing quickly.  Qdoba, despite closures of 62 restaurants in 2013 opened 68 units in 2013 and plans to open 60-70 units in 2014.  Freebirds World Burrito has approximately 100 locations throughout Texas, California, Oklahoma, Kansas, Missouri and Louisiana; doubling units in 2012 from 2010.  Most significantly, Moe’s Southwest is targeting 800 locations by the end of 2015, up from approximately 500 today, which is hard on the heels of the unit-opening pace targeted by Chipotle.

7)   Chipotle will suffer from traffic declines if they raise prices in 2014.  Analyst predictions of earnings accretion from a price increase in 2014 assume no loss in traffic from higher prices; However, given that a significant portion of Chipotle traffic growth has been on the back of coupons which are actually price cuts, we expect that traffic growth to turn negative as prices are raised unless couponing activity is actually increased.  We expect current levels of demand to to prove significantly more elastic than analysts predict.  Chipotle has suffered from brutal traffic declines following price increases in the past.  Management has repeatedly delayed a price increase because they have to show growth.

8)   The Chipotle Unit Growth Opportunity is Limited.  Management has traditionally cited 3,000 stores as their expected opportunity.  As Chipotle has opened over half that amount, not surprisingly, analysts are starting to increase their estimates of the eventual total number of Chipotle’s possible in the United States from 3,000 to 3,500 and even 4,000.  We doubt the 3,000-unit number and point out that at the current rate of 13% unit growth per year, Chipotle would, in any rate, hit 3,000 in five years.  To justify Chipotle penetrations above 3,000 analysts extrapolate from the penetration of Chipotles in Colorado and Ohio to guess at potential penetration across the entire United States.  What is naïve about this approach is that Colorado and Ohio both have populations concentrated in urban and suburban centers.  Dense populations support Chipotle’s high volume model while more dispersed populations will lead to either smaller units, underperforming units, or no units at all.  Furthermore, Chipotle had a first mover advantage in Colorado and Ohio to a greater extent than they do in other regions.

9)   The quality of new store locations is rapidly declining.  The next 1,500 stores (if there are so many) cannot be as productive as the last 1,595.  The company may from time to time get lucky, but opening stores in Plattsburgh, New York (a new location) will not prove as attractive as Manhattan, New York.  Average store sales will continue to slow and may even become negative as the company opens more and more units in lower productivity locations.  We invite readers to visit the streetlevel views on Google Maps for the following new and planned Chipotle unit locations:  3219 Watkins Road, North Carolina, 3425 Jefferson Davis Hwy, Alexandria, Virginia, and 3819 Airport Boulevard, Mobile, Alabama

10)         Food Costs must increase as Chipotle catches up to its promise to its customers. Chipotle continues to over-represent the amount of “integrity” in its ingredients.  Catching up to its promise, a condition precedent to raising prices according to management, will drive foods costs even higher than those pressuring margins today.

11)         Food Inflation is Skyrocketing.  The drought in California as well as disease in the pig population has conspired to dramatically ingredient costs for Chipotle in the short term.  Hogs, beef, chicken, avocados, and cheese prices are all making significant advances that are not fully reflected in analyst estimates.

12)         Marketing costs will continue to rise.  Chipotle will start lapping the 2013 coupon campaigns in the first quarter of 2014.  How will Chipotle increasingly drive traffic without additional couponing, promotions, and advertising?  The recent burrito giveaway for ordering catering is emblematic of the increasing frequency in promotions and their permeation into all aspects of the business.

13)         Chipotle significant savings in new unit capital costs during the financial crisis are starting to wane.  In 2008, Chipotle’s average cost per new unit was $916,000 but had declined to only $800,000 in 2013.  While it is reasonable to believe that process efficiencies contributed to some of the savings; we believe a significant portion of the savings came from the depressed construction and real estate industries.  Chipotle estimates capital costs per new unit to increase 5% in 2014.  We believe these capital cost increases will continue and accelerate. 

14)         Scrutiny of Chipotle’s Labor practices could lead to a step function increase in labor costs.  Chipotle’s strikingly low labor costs will jump meaningfully if a lawsuit recently granted class action status in June (U.S. District Court, Southern District of New York) is successful in exposing and reversing Chipotle’s payroll scheme that avoids paying any overtime and any overtime premium to “Apprentice” employees.  Apprentices are basically assistant managers who, classified as “executives” earn a salary (of around $35,000 to $40,000 per year or about $12 per hour at 40 hours per week) regardless of hours worked.  As part of Chipotle’s high achieving cultural expectations, Apprentices routinely work significantly more than 40 hours per week performing duties identical to hourly employees.  These duties include: providing customer service, working the line, prepping food items for the line, operating the cash register and other forms of manual labor, rather than supervising employees.  Should Chipotle have to change its pay practices for assistant managers (at the roughly three quarters of its restaurants with an Apprentice), earnings per share should be approximately 2-3% lower.  More information about the lawsuit can be found at U.S. District Court Southern District of New York (1:12-cv-08333-ALC-SN Scott v. Chipotle Mexican Grill, Inc.), or at the website of the plaintiff lawyers: http://www.chipotleclassactionlawsuit.com/.

15)         An Increase to the Federal Minimum Wage would pressure Chipotle’s profitability.  In Early November, Barak Obama backed a Democratic proposal to raise the federal minimum wage 39% from $7.25 today to $10.10 in 2015 in three increments of 95 cents.  Proponents contend that the minimum wage has not increased since 2009, trailing inflation.  While Chipotle employees earn more than minimum wage ($9 on average according to management on the Q4 2013 call), the premium is not significant and will have to rise as the minimum wage rises to remain competitive.  With restaurant level labor costs 23% of revenues and most of that made up of hourly workers, a significant increase in the minimum wage would cut Chipotle’s profits by 10 to 20%.

16)         A movement to organize the Fast Food Industry, Fight for 15, also threatens Fast Food and Fast Casual Labor costs.  Pressure on how much Chipotle pays its employees is not only coming from the left side of aisle in Congress.  The “Fight for 15”, is a growing labor movement pushing for a “living wage” in the fast food and fast casual industry where front line employees average a paltry $8.94 per hour.   Fight for 15 staged multiple 1-day nationwide strikes in 2013 targeting Chipotle among other chains.  Similar to a minimum wage increase; if Chipotle’s hourly workers successfully unionize, Chipotle’s labor costs would increase significantly.  For our part, we were surprised to learn that Chipotle’s crewmembers earn only $18,235 per year in salary and bonus.  Apparently, Chipotle’s slogan, “Food with Integrity”, only applies to the source of the ingredients and not the low level employee pay practices of one of the most profitable restaurant companies in history.

17)         Various local and federal agency investigations into Chipotle’s employment of undocumented workers appear to be expanding. In early 2010 an inspection by the U.S. Department of Homeland Security into Chipotle’s hiring practices in Minnesota resulted in a Notice of Suspect Documents and the termination by Chipotle of 450 employees who could not substantiate their work eligibility status.  The disruption caused increased labor costs, inexperienced workers resulted in decreased throughput, and sales suffered.  In December 2010, the investigation expanded to a similar audit of employee records in the District of Columbia and Virginia.  In April 2011, The U.S. Attorney for the District of Columbia opened a criminal investigation into these matters.  In May 2012, the U.S. Securities and Exchange Commission notified Chipotle that it is conducting a civil investigation of the Company’s compliance with employee work authorization verification requirements and its related disclosures and statements.  In April 2013 the civil division of the U.S. Attorney’s Office for the District of Columbia requested work authorization documents for all of the Company’s employees since 2007.  Also, the office of the U.S. Attorney for the District of Columbia has broadened its investigation to include a parallel criminal and civil investigation of the Company’s compliance with federal securities laws.  As we mentioned before, In Q2, Q3, and Q4 Chipotle cited increased legal costs as one factor impacting General & Administrative costs. There is no room in Chipotle’s valuation for any disruption to their business.  The implications of the outcomes of these investigations on Chipotle’s reputation, labor costs, and operating efficiency remain unknown.  The disclosures related to these investigations reveal that they continue, and are broadening.

18)         Shophouse is likely to prove a limited opportunity.  A big part of the Chipotle Story is that management has a process and method for delivering high quality, desired, fast casual food, in a format that has high throughput and scalable costs.  Shophouse based on Southeast Asian Cuisine is Chipotle first foray into a new concept.  While the roll out has been slow and subject to significant menu changes over time, management insists that Shophouse’s development looks similar to Chipotle’s at a similar point in its lifecycle.  We are skeptical.  While Thai, and Vietnamese food are amazing, I do believe the tastes are less familiar and less accessible to the American palate.  The Asian population of the U.S. is significantly smaller than the Hispanic population and travel to Southeast Asia is far less common than travel to Mexico and Central America (Not that I think Chipotle is really Mexican food).  The addressable population of customers will be smaller and the frequency of visits will be lower.  We include a number of reviews of Shophouse’s new location in Santa Monica and encourage readers to visit Yelp for more reviews:

1. I liked the convenience and price point at Shophouse, and as much as I always appreciate more Asian food in Santa Monica, after a few visits I have to say it's just OK. The quality of the ingredients is good, but honestly you can only eat here so much because after a while the flavors get really monotonous. I've tried all different combinations but I can't help feeling like everything kind of tastes the same. 
2. I like chipotle so I would kinda assume coming from the same company that it would have similar quality. I guess I set the standard a little high. The food was a little too spicy, vegetables looked some what over grilled. The food came out a little cold as well.  It's ok if your hungry for something new and you so happened to be by 3rd st
3. It was my first time here and I loved it! The flavors were great the service was good, and if you like Chipotle and curry you will definitely like this place.  I can totally understand how some Yelpers feel it could get monotonous- not too many choices and I can't see myself eating here more than once every few months.

19)                  ShopHouse is likely to Prove a limited Opportunity.  We believe the announcement of Pizzeria Locale is potentially there to soften the blow from a faze out of ShopHouse or admission that opportunity is limited.

20)                  Pizzeria Locale will Face Significant Competition in Fast Casual Pizza.  Chipotle is not the only player trying to be the Chipotle of Pizza.  Blaze Pizza has a significant headstart with 12 locations and 150 planned soon.  An overview of the competitive dynamics can be found here:  http://www.qsrmagazine.com/competition/pizza-s-arms-race

21)                  Shophouse and Pizzeria Locale will take share from Chipotle.  We will only take the time to quote from an eater article about how Chipotle kept the Pizzeria Locale relation ship secret: 

1. a.      Jordan Roos used to eat lunch at the Chipotle in the plaza at Sixth and Broadway most weekdays. It's close to the architecture firm where he works, and it was quick enough so that he could cram both a workout and lunch into his one-hour break. After Pizzeria Locale opened, though, Roos started splitting his patronage between the two restaurants. He hadn't ever been to the original Boulder location before, but he liked that Pizzeria Locale Denver was just as quick and delicious as Chipotle. Over time, he began to learn the names of the Pizzeria Locale employees much the way he knows everyone on staff at Chipotle. Up until they announced the partnership, Roos says he had no idea the two restaurants were related. But, now that he knows, he feels less guilty about abandoning Chipotle for its hot new neighbor.  (http://eater.com/archives/2014/03/20/pizzeria-locale-chipotle.php)

22)         European expansion, by management’s own admission, is seeing limited traction.  This has been mentioned on numerous quarterly conference calls.  Maybe Germany will be more successful than the UK or France, but we’re still waiting. 

23)         Breakfast will be a small revenue opportunity and even smaller profit opportunity for Chipotle.  Breakfast is ofen touted as a large untapped revenue opportunity for Chipotle.  If it is its more than captured in the current share price.  That said, breakfast burritos are likely to have limited appeal are available from other vendors, and will require opening up units 4 to 5 hours earlier than they currently operate.  Maybe Chipotle can get the staffing model right for certain high volume locations, but we doubt it will be a significant system wide initiative. 

24)         Putting Chipotle’s valuation into perspective: Assuming 3000-3500 restaurants are possible in the U.S. at $2.0MM to $2.4MM in revenues per restaurant, with 26-29% restaurant operating margins (versus 26.5% today), 5-5-6% center costs (versus 6.5% today), and 150 bps in maintenance cap ex, would imply per share values for a mature Chipotle brand of $400 to $465.  The market thus is applying a value for ShopHouse, Pizzeria Locale, and Europe of between $4.5 billion and $6.7 billion.

25)         Short is not Crowded Anymore.  Short Interest in Chipotle has declined steadily in the past year as the stock has soared.  Short Interest, which amounted to 4 million shares or 13% of shares outstanding in February 2013, has declined to 1.3MM shares or 4.3% of shares outstanding in February 2014.

Key Risks

Sales Growth continues to beat expectations

Unit Expansion succeeds with cannibalization of existing locations or deteriorating performance in new locations 

Breakfast Initiative, ShopHouse, European expansion or Pizzeria Locale Prove to be significant successes.

Catalyst