The following interview was featured on Business Insider
Once among the most touted stocks of the decade, Chipotle Mexican Grill (CMG:US) has been under intense scrutiny after a series of food-borne illness outbreaks in its restaurants in late 2015. When stocks take a steep plunge, the value investor in all of us begins to ask “is now the time to buy?” SumZero sat down with portfolio managers at two of its member hedge funds, one bullish and one bearish, to find out.
Nick Mazing specializes in restaurant stock investing after spending years in the food industry with Aramark and later consumer banking at Lehman Brothers. He launched Ampera Capital in 2013 and has been short CMG since December 2015.
Andrew Tseng worked at Prudential and Jefferies, and co-managed money with a partner for almost five years before launching Bramble Hill in early 2015. He has formal experience covering the paper & forest products and consumer products sectors. He’s been buying CMG throughout 2016.
SumZero: Why is now the right or wrong time to buy CMG?
Nick Mazing, Ampera Capital: In my original short thesis (posted early Dec 21, 2015 when CMG was at $522) I suggested that it was too early to “buy the dip”. I still think this is the case with the stock at $430. The situation is a lot more nuanced and a lot less of a slam-dunk. If you look at the progression of the food safety crisis at CMG last year and their string the inadequate responses -- from blaming the media, to panic buybacks at much higher prices, to ignoring the 200+ person California norovirus outbreak now subject to a DOJ investigation, to making an appearance on Mad Money, and so on-- it really has become a “show me” story rather than a “trust us” situation. The parallels to prior outbreaks are misleading: none of the examples have happened to a company so intertwined with CMG’s “holier than thou” food image, nor did they happen in an age where every customer has access to a megaphone via social media.
Andrew Tseng, Bramble Hill Capital Management: One of Warren Buffett’s many great quotes is, “The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.” Chipotle fits that description perfectly.
Chipotle has incredible unit economics, a long growth runway, and as a stock is trading at a big discount to its intrinsic value. It is rare to find an investment opportunity with all these attributes. Chipotle invests about $880,000 in cash costs to open a new restaurant and earns about $650,000 in pre-tax restaurant profit per year within about two years. That’s a cash-on-cash return of over 70%, which is phenomenal and best-in-class among restaurants.
After accounting for incremental corporate costs, depreciation, maintenance capex, a very small working capital benefit, and taxes, I estimate real after-tax cash flow is well over $300,000 per year by year three and growing. By my math, the net present value of that cash flow stream is around $5 million. Clearly, new restaurant openings create a tremendous amount of value.
Management thinks they can open over 2,000 more Chipotles in the U.S. alone over time. That growth has a present value of more than $8 billion. As for the 2,066 existing restaurants, I assume the unit economics recover within a few years, and I value that at about $11 billion. That makes the business worth about $19 billion.
After certain balance sheet adjustments, I reach an equity value of around $640 per share. With the stock trading around $430 per share. Of course, I don’t have a crystal ball and the future is certain to differ from my expectations, but I think I’d have to be wrong to an unrealistic degree to lose money permanently. For the stock to be fairly valued around $430 per share, Chipotle’s future would have to be disastrous. To get to that value, I have to assume a recovery by 2020, and Chipotle only opens another 100 restaurants before permanently halting its expansion. I’m willing to bet Chipotle’s future will turn out a lot better than that.
SumZero: CMG has always been an expensive-looking stock and some argue it still is. What are your thoughts on that?
Nick Mazing, Ampera Capital: I think it is a big negative. A very good example of this is Whole Foods Market (WFM). In the last 10 years, from FY2006 to FY2015, Whole Foods grew sales 174%, net income 163% and EPS by 111%. Their stock price, adjusted for dividends, is flat since then. This is because a lot of the growth that came was already priced in through a high multiple. CMG will probably experience a similar multiple deflation as the chain matures. The food safety crisis might just be the catalyst for that.
Andrew Tseng, Bramble Hill Capital Management: I think this is misunderstood. A high multiple is not necessarily an indication of an overvalued stock and a low multiple is not necessarily an indication of an undervalued stock. Value is the present value of future cash flows; nothing more, nothing less. Valuing stocks by applying multiples that “seem appropriate” can lead to inaccurate conclusions, particularly for companies that are growing or shrinking in any meaningful way. CMG’s average trailing P/E multiple is 43x since its 2006 IPO, yet the stock managed to appreciate from $22 to $758 per share in less than ten years—a 34-bagger. It turns out the “high” multiple severely undervalued the business. What trailing P/E multiple could you have paid for CMG at the end of 2007 and still managed to compound your money at a double-digit annual rate? The answer is 183x. I don’t recommend running around paying huge multiples, but I try not to assume anything about a stock’s valuation based on its multiple. When I discount the cash flows, I get an intrinsic value meaningfully higher than the stock price.
SumZero: What are your thoughts on the brand and the extent to which the recent food safety issues have damaged the brand?
Nick Mazing, Ampera Capital: Brand perceptions have already recovered, more or less, at least according to the surveys that the company has shared with the investing public. Obviously, what customers say versus what they actually do, especially without a coupon, is a different story. CMG had chosen to link its image to the whole “food with integrity” concept, and they are seeing the downside.
Andrew Tseng, Bramble Hill Capital Management: Chipotle has a great brand, but it is clearly facing headwinds. Same-store sales fell 29.7% during the first quarter, so damage has clearly occurred. Recent surveys continue to indicate higher than usual reluctance to eat at Chipotle, although that appears to be improving and should continue to improve over time. People have short memories. The longer Chipotle stays out of the news, the more quickly the brand will recover. I looked at the historical incidents of food-borne illness at major restaurant chains; the customers always come back. It does not happen overnight, but it does happen. If we wake up tomorrow and it is 2018, I don’t think anyone would be talking about food safety at Chipotle. I think they would be talking about the ~2,600 restaurants, how high restaurant sales can go, whether restaurant margins will be 25% or 26% the following year, whether it is too soon for Chipotle to be taking a price increase, and how they are still kicking themselves for not buying CMG in early 2016 in the low $400’s.
SumZero: How has the economic model changed since the food safety issues occurred and to what extent are those changes permanent?
Nick Mazing, Ampera Capital: Some changes are permanent: the company has established extensive changes as to how it handles food and the testing frequency. Some changes were tried but ultimately not implemented (i.e. lettuce washing and cutting on-site). In my view, there is little pricing power to recover the costs associated with these: the softness across commodities has brought back a lot of value offerings in the space. The big “known unknowns” are labor deleverage as the state and local minimum wages creep up, and the on-going marketing spend.
Andrew Tseng, Bramble Hill Capital Management: Restaurant economics have taken a big hit. Same-store sales have fallen significantly and restaurant margins were a paltry 6.8% in the first quarter. When sales fall and expenses are largely fixed, margins get crushed. The company is spending a lot of money on marketing and promotional offers, higher food safety-related expenses, higher food waste, and inefficiently staffed restaurants. In the long run, restaurant sales will recover and margins will follow. Management does cite about 2% higher food safety-related expenses on an ongoing basis, but I believe the company will eventually be able to recover that through operating leverage, optimizing procedures, and perhaps implementing a small price increase down the road. So I expect the company’s economics to make a full recovery, although it will certainly take time.
SumZero: What do you make of the recent significant share repurchases? Has that been a good use of shareholder capital?
Nick Mazing, Ampera Capital: The share buybacks have been a disaster. In Q4, they spent $166mm to buy back shares at an average price of $556; the low in January was $399. You can do the math. In Q1, they spent almost $140mm on buybacks at an average price $464, still above where it trades now. These repurchases are done at pretty high multiples even of the 2017 estimates, and I think the new incentive plan, where management comp is based only on stock price, might be leading to sub-optimal capital allocation decisions. Ultimately, the market determines the price: management teams should be focused on what they control: sales, margins, earnings and so on, not on market perceptions (and, by extension, multiples).
Andrew Tseng, Bramble Hill Capital Management: Definitely. Share repurchases are not always wise, but they make sense when a company’s stock is trading at a big discount to intrinsic value and the company has excess cash. Both are true in Chipotle’s case. To the extent they repurchase shares at a big discount, intrinsic value per share will increase.
SumZero: What do you make of Chipotle's recent marketing and promotional blitz? To what extent has it been effective?
Nick Mazing, Ampera Capital: There are two answers to that: “yes” and “TBD”. Short-term, it has been very effective in bringing people back to the stores. The free burrito SMS coupon had really high redemption rates, 67% on 5 million offers sent, according to the company. I personally took my wife to CMG for Valentine’s Day as we both had the free entrée coupon (so my sincere gratitude to the management team for that). The longer term effects are TBD: the traffic did not look good in April after they pulled back the offers but that is not a long enough period for me to draw conclusions.
Andrew Tseng, Bramble Hill Capital Management: It seems to be effective at bringing the customers back. Once customers eat at Chipotle and enjoy their meal without incident, they will return as paying customers. The company started with free entrée offers and a free chips and guacamole offer, and has more recently introduced BOGO (“buy one, get one free”) offers. I also recently received an offer to get a free burrito if I buy a $25 gift card. Interestingly, each subsequent offer has had a higher margin for Chipotle, so the company seems to be getting less promotional as the year unfolds. Management recently discussed the potential to add chorizo as a new menu item and roll out a temporary customer loyalty program, both of which would probably help customer traffic.
SumZero: What are the risks to your investment recommendation? If you end up wrong, how would it happen?
Nick Mazing, Ampera Capital: The bet is that the “glory days” of high growth, high margins, and high multiples do not return. Obviously, it is an educated guess: all the bull theses that I have seen are for 2+ year time horizon, and this is not a time frame that I can handicap in this case. There are other things CMG could do that change the game, like franchising some units. All the usual disclaimers regarding shorts also apply.
Andrew Tseng, Bramble Hill Capital Management: If traffic and sales never recover, it would reduce each restaurant’s value and would probably limit how many new restaurants the company can open. I would value the stock around $300 or $350 per share in that scenario. However, I find that far-fetched. History shows us that the customers always come back. This is not a perfect analogy, but air travel took a big hit after 9/11 and eventually recovered. It just took time without further incidents. Another risk is the long-term unit potential assumption, which is forward-looking and inherently uncertain. If the brand recovers but Chipotle only ends up with 3,000 restaurants, the stock is probably worth $500 or $550 per share today and will compound at a lower rate than I currently expect. Another risk is if future restaurants are much less productive than current restaurants, which could happen if new stores can only be opened in much smaller markets or if they seriously cannibalize sales at existing stores. I have not seen evidence of that to date, but it remains a risk. Finally, another food safety incident would be an unfortunate setback and would further delay the recovery.
SumZero: What competitive threats do you see Chipotle facing now and in the future?
Nick Mazing, Ampera Capital: Restaurants are a very competitive business (never, ever open one) and it is possible that CMG’s metrics revert to the industry mean over time. You are seeing a lot of menu innovation in the space (which is not a core CMG competency), and you are also seeing increased competition in the Mexican space, both quick-service and casual (e.g. Moe’s offered me a coupon on the day all CMG’s were closed for their big meeting in February). Near-term, the worst possible thing for CMG is another outbreak.
Andrew Tseng, Bramble Hill Capital Management: Competition among fast casual and quick-service restaurants is intense, but it has always been intense and Chipotle has prospered. Some people worry that the food safety issues have driven some customers into the arms of other restaurants on a permanent basis. I don’t see that happening. For example, Qdoba, another large quick-service Mexican chain, has seen no benefit from Chipotle’s recent woes. Even without any further recovery, Chipotle will still do almost $2 million of average restaurant sales, which is higher than all but a handful of other fast-casual or quick-service restaurant chains. The brand remains extremely popular even today.
SumZero: What are Chipotle's biggest growth opportunities?
Nick Mazing, Ampera Capital: It is hard for me to judge: obviously every company brings in outside consultants who lend their name to some estimates regarding its “white space.” Given the incentives, these estimates are likely on the high side individually, and almost certainly on the high side in aggregate. I doubt there is a 5,000+ unit concept in the US that is already not within that magnitude. CMG, like several other mature chains, has investments in smaller concepts, and even applied to register “Better Burger” as a trademark (I do not see how it gets approved but who knows). At this stage, these are probably distractions rather than “free options.” Internationally, they have neither the brand recognition nor the supply chain at this stage.
Andrew Tseng, Bramble Hill Capital Management: Opening more Chipotle restaurants in the U.S. and Canada is the biggest opportunity. The very high returns make this a no-brainer. Another opportunity is to continue to grow average restaurant sales beyond last year’s peak. We still don’t know how good Chipotle’s “mature” economics can be. They were improving virtually every year until 2015. Only a few years ago, people thought average restaurant sales of $1.8 million was the peak. Then it was $2.0 or $2.1 million. Then it jumped to $2.4 million in 2014 and $2.5 million in 2015. New units used to open at $1.6 million; that jumped to $2.0 million in 2014. No one knows where the upper limit is. The company’s online/mobile ordering initiative and its integration with PostMates, a third-party delivery partner, have the potential to improve sales because these orders can be made on a second line without disrupting the main line during peak throughput hours. To the extent online/mobile/delivery orders grow, it could alleviate congestion at the restaurants and allow additional customers who might have previously balked at the long line to join the shorter line. Growth in Europe and from ShopHouse and Pizzeria Locale are also potential growth drivers. Both those concepts were designed to replicate Chipotle’s unit economics, but sales levels will ultimately dictate if that’s possible. Chipotle also recently applied for the “Better Burger” trademark, so we’ll see if anything comes of that.
SumZero: Which key metrics should investors be focusing on to determine whether the company is tracking to your expectations?
Nick Mazing, Ampera Capital: It’s pretty clear that the top line metrics bottomed in Q1, barring any additional incidents. For the second half of the year, I am watching margins as there will be additional labor deleverage and there is considerable uncertainty regarding the increased marketing spend, which the company extended during the Q1 call versus prior guidance. And fundamentally, uncertainty begets a lower multiple.
Andrew Tseng, Bramble Hill Capital Management: Same-store sales growth is important. When it improves, margins will follow. I expect same-store sales growth to become less negative during the rest of this year before turning positive late this year or early next year when the year-over-year comparisons get easier. However, I would not put undue emphasis on very short-term data points. I’m confident average restaurant sales will improve over the coming years, which would be just fine with me.