Chipotle Short Thesis

I decided to share with you guys and anyone else interested what exactly my short thesis in Chipotle (CMG) is. I am doing this because I often get people asking how I develop my thesis and such. This particular position has gotten a lot of questions about the thesis so I decided to do a blog post on it. I wold like everyone to know that this is a personal position as well as a position for the Lehigh Dreyfus Portfolio which I am on. I presented the idea and the other members voted that we should commit capital.

My thesis can be summed up in these three points from my pitch to the Dreyfus Portfolio in Early December 2016:

Chipotle still has not fundamentally recovered from the food safety issue last year despite a stock that has pretty much been cut in half. Along the way many customers have not come back and recent consumer surveys by BellWether food group, 38% of people 18-34 worry about getting sick due to chipotle’s food while 29% from ages 35+ feel the same. This lack of confidence fueled most recently by the misguided calorie counts for the new chorizo burrito, have led to Chipotle to do whatever it takes to get people back in stores. This has led to mass discounts and couponing at the expense of margins. My thesis is that this discount ting will continue as chipotle will try to regain positive same-store sales on both a quarter over quarter and year over year basis.

 

Another part of this story is the activist investor Bill Ackman investing over one billion dollars into the company, Ackman hasn’t had the best track record recently, but has a very good track record with resultants. Ackman plans on getting board seats and eliminating board members and splitting up the current Co-CEO structure. There has even been talk that the CEO and founder Steve Ellis may be asked to take a more passive role, this would be like asking Starbuck’s Howard Schultz to take a lap. I think this management shake-up and the potential for Ackman’s clashes with management will have a negative impact on the stock in the near future.

 

Chipotle also faces several operations headwinds. They have guided that Labor cost will on average rise by 5-6% in the next three years due to a combination of state and federal minimum wage increases and company wage increases. Chipotle has also forecasted that Q4 2016 will have COGs of 35% with this coming down in early 2016 with the change in avocado prices, this is, of course, all weather based and in the past Chipotle has suffered do to swings in commodity prices such as avocado and pork.

I made this pitch the evening before the investor conference where Chipotle declined 7% in trading. At that conference, management did say that they will be facing higher labor cost and that they should probably raise prices, but they are not going to in order to regain sales. This to me was the same as management was essentially saying that they don’t really care about margins anymore.  This lack f concern is at the core of my short thesis because a company can have all the sales in the word, but if they cant convert that into free cash flow then you have a big problem. This comes at a time when Chipotle is trying to increase the customer usage of their mobile order system that they have had in their app since 2009 and trying to possibly have stores with drive-thrus which will need to have changes in kitchen layout and potentially more staff. All of those things will require a good deal of capital, which if they cant get through cash flow will have to come through the issuance of either stock or debt. To chipotle’s credit, they have no debt outstanding.

The last big part thesis that was reinforced by management’s appearance at a recent conference was that management is really going to suffer from the loss of the Co-CEO Monty Moran. The company has been run with the dual CEO structure of founder Steve Ellis and Moran. This partnership was what built the company up to the powerhouse it once was. Moran was the operations guy and Ellis was the brand man and visionary, a similar structure to Apple in the 2000s if Jobs and Cook. With Moran’s execution a problem arises, you have a visionary leading the company alone. Going back to the Apple comparison, remember when Jobs was the sole leader? He was kicked off by the board and had to go Microsoft for a bailout. Ellis, unlike Howard Schultz of Starbucks Ellis, hasn’t really had to manage the company. Which makes him being the sole leader of the company scary for the longs. Now Ackman has brought operations people who were at McDonalds on the board, but I think this will have limited success in the near future as it is still Ellis who is running the ship.

Overall I think Chipotle will eventually stabilize, but I think it will take a couple of years and more management changes to do so. Currently, though the company has too many operations headwinds and rising cost of both labor and food. For thus reasons I think it is a good short opportunity for the next year or so. I have a price target of $272 or about 15x my modeled 2018 earnings.

 

 

 

 

Reflection for 2016

 

 

 

The number everyone is probably waiting to hear is -11.48%. That’s my performance for this last year with all fees included and dividends received. I haven’t done a sharpe ratio or quarter by quarter performance because I didn’t track that this year. This year was my first down year against the S&P 500 since 2011 where I blew out my much smaller account with a lot of trading racking up commissions.

So why did I perform so poorly? I think a lot of it was massive holes in my process and learning big lessons from the world of options. When it comes to options, about ¾ of my loses this year was through options. I started to use options after trying them out for a while on the paper account that is provided through my broker. I thought I had learned it all, but this was of course a mistake. I mainly used options to be able to hedge fast like in the sharp decline last January. Or making lots of little bets. I never risked more than 3% of my account in anyone options play, but the small losses I took with my stops in place added up along the way. On the process side, I had so many holes that looking back are kind of crazy. A good deal of these holes were uncovered during my internship with Avory & Co this last July.

I was lucky to spend a month with their CIO Sean Emory (@_SeanDavid). He helped me reveal the holes in my process and help me realize how to close those holes. We went through everything like my faults as an investor, my major one is getting too emotional, and not having valuation targets. Looking back, it seems crazy that I never had defiant targets for when to get out of my investments, something that has hurt me in the past. This was mainly due to not ever modeling, but after a month with Sean I could whip out a model with my eyes closed. He also helped me develop a firm process with finding various Ideas as well such as using various screeners.

A lot of the plagues that affected me this year was not having a definitive process in place for a lot of things, like those mentioned above, I struggles this year with a lot of my equity positions not preforming and I just didn’t know when to reduce to keep those gains that I had. A great example this year was Under Armor. I held it all the way until the election and watched a great deal of my money disappear. I have since then introduced ways to stop this from happening.

Another big thing that I have also introduced is economics into my process. Throughout my investing career I have always said I was a equities guy and I could only pay attention to some economic factors, I always thought that was the realm of the global macro guys. This year taught me that Where we are in terms of the economic data greatly effects what equities perform well and when. Over this holiday period I have created a couple of economic models that tell me when the data is accelerating and where we are in terms of a sine curve. If you want to learn more about this feel free to email me or DM me on twitter.

This year has become a great, but hurtful learning period. Like every year, I look back at where I was and am amazed at how far I have come as a investor. I had some of my best trades of the year whether it be short Volatility ETFs into the election or being long Deutsche Bank puts into Brexit, but this also came with me having one of my worst returns for my core portfolio that I have ever had. I have also come to realize just how long it takes to get a firm process that works for a investor can take. I for one am glad I am learning this with my own money and not having to figure this out while I am investing the money of others. For right now I am happy with having higher knowledge gains than monetary gains. I don’t think a hedge fund is going to come calling me because of my track record over these past eight years. I would rather take the knowledge I gave gained or these years then what I have earned and with this I hope to continue this journey and hopefully some of you can take something away from my journey and apply to your own.