Chipotle: Can It Be Fixed?
- Barron's 7/02/2017, 10:46 AM
WSJ WSJ LIVE MARKETWATCH BARRON'S DJX MORE
News, Quotes, Companies, Videos SEARCH
ASIA EDITION
U.S. EDITION
Log In Subscribe
HOME MAGAZINE DAILY INVESTING IDEAS ADVISOR CENTER MARKET DATA PENTA BARRON'S NEXT
BARRON'S COVER
Chipotle: Can It Be Fixed?
The fast-casual chain is getting past its food-safety issues. CEO Steve Ells can improve service, but rising costs could cut into an earnings
rebound.
Email Print 13 Comments Order Reprints Most Popular
By JACK HOUGH 1. This Time, AMD’s Revival Is for Real
February 4, 2017
2. Chipotle: Can It Be Fixed?
3. Snap’s Coming IPO Looks Like One to
Avoid
4. How to Answer “Tell Me About
Yourself” in a Job Interview
5. The Real Cost of Health Care in
Retirement
SEE FULL LIST
Latest Market Videos
1 Raj Sharma:
Investments Are
Just One Puzzle
Piece
Chipotle CEO Steve Ells Victor J. Blue/Bloomberg
Shares of Chipotle Mexican Grill might look cheap at a recent $404 apiece, down from
a peak of over $750 a year and a half ago. Don’t dig in yet, though. The Denver-based
2 Why AMD Shares
Are Soaring
burrito chain is moving beyond a punishing sales decline caused by widespread 2015
outbreaks of E. coli, salmonella, and norovirus, but keeping a clean record from here
while luring back lost customers could involve a long-term shift higher in sourcing and
marketing costs.
3 Why Tinder is
Sales at longstanding stores have begun rebounding from their level a year ago, but Sexier than
they are still down from two years ago, and comparisons are about to become more Match.com
difficult. At the same time, competition is heating up and labor costs are rising.
Our biggest beef with Chipotle (ticker: CMG), however, is its price. We don’t mean the
$8-or-so burritos, which can weigh as much as yoga dumbbells. Those are a square
enough deal. But the shares, up 8% in the past three months amid an activist-led board
shuffling, trade at 49 times the consensus earnings estimate for 2017—a consensus
that has been steadily falling. A healthy return for investors from here would require
either that Chipotle blast past growth estimates in coming years or that shareholders
maintain their enthusiasm as growth slows.
It’s possible, but as Under Armour (UAA) reminded us by tumbling 29% this past week,
sometimes fallen growth stocks find another leg down. Chipotle could drop a further
10% or more over the coming year. One bear we spoke with sees downside this year of
35%.
CHIPOTLE CEO AND FOUNDER Steve Ells studied at the Culinary Institute of
America and worked as a sous-chef under celebrity chef Jeremiah Tower at Stars in
http://www.barrons.com/articles/chipotle-can-it-be-fixed-1486187844?shareToken=st4189235d1da04d68a3701888832ec408 Page 1 of 7
Chipotle: Can It Be Fixed? - Barron's 7/02/2017, 10:46 AM
San Francisco, a restaurant that helped define California cuisine in the 1980s with a
focus on fresh, locally available ingredients. But it served up steep losses in the 1990s
and closed by the end of the decade. In 1993, Ells took what he learned at Stars, and
from visits to Mission District taquerias, and opened the first Chipotle near the
University of Denver, using $85,000 borrowed from his father.
The idea was to use the cash flow from selling tacos and burritos to launch a fine-dining
restaurant. But Chipotle took off, and Ells decided to focus his culinary passions on
redefining the fast-food chain. McDonald’s (MCD) was an investor from 1998 to 2006,
but in some ways Chipotle is the anti-McDonald’s.
The menu is simple: mostly burritos, burrito bowls, soft and hard tacos, chips with
guacamole, and drinks. A single line snakes up to a row of servers. Steak, chicken,
carnitas, chorizo, barbacoa, or sofritas? White rice or brown? Black beans or pinto?
Salsa? Behind these workers are sights that aren’t common in 2,000-store quick-
service chains, like fajita veggies sizzling in actual pans on actual stoves.
Chipotle’s flavors might be Tex-Mex, but its category, which it played a large part in
creating, is ethos-as-brand fast food. Its motto is “Food With Integrity.” The chain’s
Website discusses its close relationships with farmers, wandering room for pigs,
respect for soil, and making the world a better place. It’s even trying its hand at satire
with an original comedy series that streams on Hulu called Farmed and Dangerous.
The poster features “Buck Marshall” of the Industrial Food Image Bureau wearing a suit
and holding a pitchfork—the devilish kind with spear tips.
Millennials are said to want a story with every purchase. Chipotle gives it to them,
sometimes literally. Its bags and cups have featured original writing from Jonathan
Safran Foer, Malcolm Gladwell, and Judd Apatow. The message is that Chipotle
customers are caring and smart, not like those slop jockeys that settle for Wendy’s
(WEN), Taco Bell, and McDonald’s. But most big food companies are getting better on
social and environmental matters. For example, animal treatment is broadly improving,
judging by metrics like the Business Benchmark on Farm Animal Welfare score, which
was developed by animal-rights groups. And there are some surprising comparisons.
On a scale of 1 to 6, with 1 being best, Wendy’s rose to a 3 from a 4 last year, beating
Chipotle, which stayed a 4. Taco Bell owner Yum! Brands (YUM) remained a 5.
McDonald’s has them all beat, holding on to its industry-leading 2.
That trend speaks to rising competition for Chipotle, not just in Tex-Mex or even ethics-
forward fast food, although supply there is growing quickly— Panera Bread (PNRA) and
privately owned Jimmy John’s each have roughly as many stores as Chipotle.
Competition could also come in the form of industry giants gradually moving toward
what their customers clearly want: simpler menus, natural ingredients, and all-around
decency. Wendy’s says it will use only cage-free eggs by 2020. By next month,
McDonald’s says, it will no longer use chickens raised with antibiotics that are important
to humans.
The menu at McDonald’s is now a jumble of upscale efforts, like the popular Buttermilk
Crispy Chicken Sandwich on an “artisan” roll, and aging standards, like the Big Mac.
Change is glacial, but ongoing.
E. coli is a bad fit for any restaurant, but it’s especially damaging for one like Chipotle
built on word-of-mouth advertising and a reputation for wholesomeness. The germ lives
in the intestines of people and animals, which means infection typically occurs when
food has been tainted somewhere along the supply chain by feces. Some strains of E.
coli can cause severe diarrhea, kidney damage, and even death.
In the summer of 2015, Chipotle was linked to five E. coli cases near Seattle, and then,
in California, hundreds of customers came down with norovirus, a stomach bug that can
spread through contaminated food. Later that year, there was a salmonella outbreak in
Minnesota. Unlike the other cases, that one was linked to a particular food at Chipotle:
tomatoes. In autumn, there were dozens of new E. coli cases in nine states. Before
year’s end, more than 100 more Chipotle customers tested for norovirus around
Boston.
RESTAURANT CHAINS can come back from food-safety failings. Wendy’s stock is
http://www.barrons.com/articles/chipotle-can-it-be-fixed-1486187844?shareToken=st4189235d1da04d68a3701888832ec408 Page 2 of 7
Chipotle: Can It Be Fixed? - Barron's 7/02/2017, 10:46 AM
almost back to where it traded in August 2006, when Utah health officials linked four E.
coli cases to contaminated lettuce at a Wendy’s in North Ogden. Its investors weren’t
hurt so much by dirty lettuce as by the combination of a sky-high valuation and
suddenly slowing growth, made worse by a global financial crisis.
Chipotle can grow from here, too. But its shares remain priced for perfection. Its
outbreaks were much more widespread and varied than the Wendy’s case, which raises
the question of whether some of Chipotle’s commendable practices, like small-farm
sourcing and on-site cooking, make food safety more difficult, especially when they
push up against the mandate of any publicly traded company to boost profit margins.
Chipotle management didn’t respond to numerous requests for comment by Barron’s.
We wrote negatively about the stock just before the E. coli mess (“Chipotle Losing Its
Spice,” July 3, 2015). It’s down 30% since then.
IN PUBLIC STATEMENTS, Chipotle has said it’s investing in technology, training, and
inspections to improve its supply chain and restaurants. It has begun preparing some of
its food off-site. Ells has spoken frankly about the company’s stumbles. In December,
co-CEO Monty Moran stepped down, putting Ells back in full control of his creation.
Also in December, activist investor William Ackman reached a settlement with Chipotle
that gives him control of two board seats.
We see no reason to doubt that food safety at Chipotle is improving and that fans can
eat there with confidence. We have reservations, however, about the safety of earnings
forecasts and the share price.
Veteran restaurant analyst Howard Penney at Hedgeye calls Chipotle’s E. coli troubles
the worst he’s ever seen. “There’s an expense involved in serving safe food,” he says.
“They need to invest in that. And now they need to invest in advertising.”
Those two efforts alone could raise costs by six percentage points of revenue for the
foreseeable future, according to Penney, and that stands in the way of management’s
stated goal to get back to peak volumes and margins. Increased advertising is
important because Chipotle’s word-of-mouth advertising has turned negative. “It used to
be ‘GMO-free organic,’ ” says Penney. “Now, it’s ‘Don’t go there or you’ll get sick.’ ”
Click to enlarge
Expect a stretch of healthy same-store sales growth for Chipotle, but for reasons that
are less than ideal. In the fourth quarter of 2015, when E. coli headlines began taking
their toll, same-store sales fell nearly 15%. Over the first three quarters of 2016, same-
store sales plummeted by 30%, then 24%, then 22%. The gradual improvement was
aided by Chipotle resorting to aggressive couponing, even giving away burritos to lure
back customers.
Last quarter, same-store sales fell nearly 5%, Chipotle reported this past week. But
same-store sales jumped by double-digit percentages in December and January. That’s
partly because Chipotle has reached the anniversary of its initial downturn, making
comparisons easier. Soon it will come up to the couponing anniversary, too. Investors
should know by later this year whether the recovery is gathering pace or stalling.
While Chipotle works on its turnaround, the supply of fast-casual and casual restaurants
is expanding by 4% a year, versus 1% growth in employment, a good proxy for demand
growth, according to JPMorgan analyst John Ivankoe. He downgraded Chipotle stock to
Neutral from Overweight last month, citing rising competition, wage inflation from a tight
labor market and minimum-wage hikes, and flattening commodity prices after years of
declines. Worker retention could be especially important for Chipotle if it is to improve
http://www.barrons.com/articles/chipotle-can-it-be-fixed-1486187844?shareToken=st4189235d1da04d68a3701888832ec408 Page 3 of 7
Chipotle: Can It Be Fixed? - Barron's 7/02/2017, 10:46 AM
food handling at its restaurants.
Management wants to expand the restaurant base by around 9% this year. That’s an
unusual ambition for a company trying to work its way back from a decline in same-
store sales. The aggregate number of fast-casual restaurants has doubled over the past
decade, according to a Morgan Stanley report last week. “We think this will weigh on
Chipotle as it seeks to recapture customers that scattered,” the authors conclude.
Earnings for Chipotle peaked above $15 a share in 2015. Last year, the company took
a bath. This year, Wall Street is predicting a rebound to $8.25 in earnings. That’s down
from a consensus of over $10 back in September.
THE BULL CASE FOR CHIPOTLE, according to Hedgeye’s Penney, is that earnings
spring back above $16 a share by next year and that investors remain ravenous for the
stock, paying 35 times earnings, or more than $560. The bear case, he says, is that
earnings are stuck in the mid-$8 range next year and the stock’s multiple slides to 25
times earnings, bringing shares below $250.
Between those two extremes are two other possibilities that result in moderate declines
for the stock: Either earnings please shareholders, but the multiple contracts, or the
shares continue to trade at a high multiple of disappointing earnings.
More From Barron’s
There are some bright signs. RBC Capital
Markets analyst David Palmer
The Personal-Finance App That Saved Me
$1,448
recommends a purchase of Chipotle
shares and has a price target of $465,
Best Bets for Bonds in 2017
implying 15% upside. In a report this past
Next Stop, Dow 30,000 week, he lowered his earnings forecast,
but pointed to Chipotle’s digital ordering
initiative as a growth driver. Starbucks (SBUX) has had success with mobile ordering,
but recently said that pileups of those orders have slowed service in its stores. Chipotle
plans to add dedicated service lines for mobile orders.
Meanwhile, management is throwing in the apron on ShopHouse, its upstart chain
serving South Asian–style rice and noodle bowls. But it says it is still testing pizza and
burgers. Eventually, there also will be room for plenty more Chipotle stores. Even
Raymond James analyst Brian Vaccaro, who rates the stock Underperform, estimates
Chipotle can one day support 4,000 restaurants.
Before then, however, there could be more discomfort for shareholders. The risk is that
management will have to reset margin and growth expectations lower sometime this
year and scale back store openings, and that investors will then reprice the company at
a smaller premium to the market.
If that happens, we’ll eventually develop an appetite for the shares. And if the chain
indeed bounces back to peak form in short order, we’ll have to eat our words.
Eat This, Not That
Fast-casual restaurants are bingeing on expansion, but some companies are cutting
back. Chains are expected to add more than 2,500 restaurants over the next two years,
though a recent Morgan Stanley report found that more than 20% of chains the firm
covers have reduced their restaurant counts for two consecutive years. The competitive
outlook varies widely by company and sector. Here’s how some big players stack up.
Chipotle Mexican Grill (ticker: CMG). Among customers who have cut back, 33% say
it’s chiefly because of food-safety concerns, but another 23% say they have simply
found new places to eat.
Panera Bread (PNRA). There’s less competition for bakery-style sandwich shops than
Mexican eateries, especially after the bankruptcy of Cosi in 2016.
Olive Garden ( Darden Restaurants, DRI). Italian chain restaurants are disappearing,
with steep store-count declines at Romano’s Macaroni Grill, Buca di Beppo, and Johnny
Carino’s. That’s helping Olive Garden gain share.
Chili’s ( Brinker International, EAT), Applebee’s ( DineEquity, DIN). Bar-and-grill
http://www.barrons.com/articles/chipotle-can-it-be-fixed-1486187844?shareToken=st4189235d1da04d68a3701888832ec408 Page 4 of 7
Chipotle: Can It Be Fixed? - Barron's 7/02/2017, 10:46 AM
restaurants reached peak saturation in 2009 and have been shedding units ever since.
Industry same-store sales are still falling, though Chili’s in particular could hold value.
(For more on Brinker, see Sizing Up Small-Caps).
McDonald’s (MCD), Wendy’s (WEN), Burger King. Venerable chains like these three
are losing share to craft burger players like Shake Shack (SHAK) and Five Guys, and
now must choose whether to compete on price or quality.
Domino’s Pizza (DPZ). Mom-and-pop pizza places are closing down, providing room
for growth for national chains like Domino’s. Its U.S. market share has jumped five
percentage points in seven years, to 16%. Its worldwide share is 8%.
Texas Roadhouse (TXRH), LongHorn Steakhouse (Darden). Steak is tough, but a
bankruptcy and closings at Logan’s Roadhouse have helped remaining players. Texas
Roadhouse hopes its fledgling burger, pizza, and beer chain, Bubba’s 33, will be its
next growth driver.
-- J.H.
Email: editors@barrons.com
Follow @jackhough
Follow Barron’s on Twitter
Like Barron’s on Facebook
Email Print 13 Comments Order Reprints
13 comments
192 PEOPLE LISTENING
Want to participate in the discussion?
Already a subscriber? Log in for complete access.
+ Follow Share Post comment as...
NEWEST OLDEST
W Starkey 8 hours ago
One is left to wonder if the outbreaks were the work of Hedge funds. Yes the possibility is in the realm of
the bizarre but the "outbreaks" were not consistent with the Chipotle supply chain...
Flag Share Like Reply
RALPH PETRILLO 2 hours ago
@W Starkey
I absolutely agree, and this should be investigated, for we are still waiting for a detailed
explanation of why there were so many health risks in such a short period of time that had not
existed before.
Flag Share Like Reply
John Reilly 1 day ago
Outbreaks weren't widespread; but, the media coverage was. Apparently millenials don't read the
tabloid press, because Chipolte here in Georgetown has been packed with students.
http://www.barrons.com/articles/chipotle-can-it-be-fixed-1486187844?shareToken=st4189235d1da04d68a3701888832ec408 Page 5 of 7
Chipotle: Can It Be Fixed? - Barron's 7/02/2017, 10:46 AM
1 Like Reply
Flag Share
Scott Madams 1 day ago
@John Reilly As a Canadian living in an igloo I don't have access to CMG. However, when
traveling to the US they're always packed and I enjoy the food every time. If CMG isn't making
money I can't see any restaurant ever making money.
Flag Share 1 Like Reply
RALPH PETRILLO 2 hours ago
@John Reilly CNBC talked about the outbreaks for three months straight five times a day.
Flag Share Like Reply
Bill Greenstein 2 days ago
The food safety issues may or may not be behind it but, simply put, CMG has become BORING and that
is the greatest sin of all. The menu (aside from price increases) hasn't changed in ages. Never thought I'd
say it but even MCD is more innovative than CMG. Unless and until they continually add new items and
give millennials (and the rest of us) some new reasons to go there, the comps will continue to decline and
tinkering around the edges won't make a difference.
Flag Share 1 Like Reply
Dan Breen 5 hours ago
@Bill Greenstein They have added Sofritas and Chroizo in the past two years.
Flag Share Like Reply
RALPH PETRILLO
2 hours ago
@Bill Greenstein Have to agree maybe e they should make a shrimp burrito.
Flag Share Like Reply
Matthew Luter 2 days ago
No offense, but it's a burrito shop making like it's a full on restaurant. No CMG needs to be larger than a
Subway sandwich shop. If you're searching for ideas, create a nationwide chain of food trucks. Think of
the cost savings- the same manner of food could be easily served with better margins.
Flag Share Like Reply
Dan Breen 5 hours ago
@Matthew Luter Before the E.Coli crisis, Chipotle had industry leading margins because their
restaurant is probably the most efficient fast casual concept known. They churn out more
customers than almost every fast casual restaurant. Their Average Unit Volume was only 20%
behind Panera Bread with only half of the average square footage per restaurant.
Flag Share Like Reply
Cathy Sagansky 2 days ago
very over valued stock on almost any metric: FCF, EV/Revs. One may be able to trade it on news, but
better investments out there
Flag Share Like Reply
http://www.barrons.com/articles/chipotle-can-it-be-fixed-1486187844?shareToken=st4189235d1da04d68a3701888832ec408 Page 6 of 7
Chipotle: Can It Be Fixed? - Barron's 7/02/2017, 10:46 AM
Show More Comments
Powered by Livefyre
Barron's
Facebook
Twitter Google+LinkedInYouTubeRSS Feed AppStore Google Play
Return to Top
Customer Service Create an Account About Barrons.com Also From Barron's Tools & Services
Customer Center Subscribe to Barron's Advertising Conferences Mobile Site
Contact Us Magazine Subscribers: Masthead Reprints Email Newsletters
Activate Your Digital Access
Live Help Privacy Policy Classifieds Barron's on iPad/iPhone
Cookie Policy College Program Barron's on Android
Data Policy Find a Broker Watchlist
Copyright Policy Barron's in Japanese Video
Subscriber Agreement Annual Reports
& Terms of Use
StockGrader
Your Ad Choices
Barron's 400
Community Guidelines
Economic Calendar
Stock & Mutual Fund Listings
Commodities, Options
& Annuities Listings
Fund Prospectuses
Copyright ©2017 Dow Jones & Company, Inc. All Rights Reserved.
http://www.barrons.com/articles/chipotle-can-it-be-fixed-1486187844?shareToken=st4189235d1da04d68a3701888832ec408 Page 7 of 7
