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.