In case you aren't aware, Chipotle Mexican Grill (CMG) - Get Report operates Chipotle Mexican Grill restaurants, which serve a focused menu of burritos, tacos, burrito bowls (a burrito without the tortilla) and salads, made using fresh ingredients.
Chipotle was founded by Steve Ells who graduated from The Culinary Institute of America in 1990. After working as a sous chef at Stars restaurant in San Francisco, Mr. Ells moved to Denver with the goal of opening a restaurant. With a loan from his father, he opened the first Chipotle Mexican Grill in 1993. After opening another 15 locations, the company accepted an investment from McDonald's, which was diversifying by buying other restaurant chains at the time. McDonald's helped accelerate Chipotle's growth in a mostly hands-off manner, and ultimately sold its stake during and shortly after Chipotle had its IPO in 2006.
As of September 30, 2016, the Company operated 2,129 Chipotle restaurants throughout the United States. The Company also had 15 Chipotle restaurants in Canada, six in England, five in France, and one in Germany. Further, the Company operated 15 ShopHouse Southeast Asian Kitchen restaurants serving fast-casual, Asian inspired cuisine, and is an investor in a consolidated entity that owned and operated seven Pizzeria Locale restaurants, a fast-casual pizza concept.
The Chipotle brand was developed by founder Ells with the philosophy that food served fast does not have to be a traditional "fast-food" experience. This vision later evolved into an ambition to change the way the world thinks about and eats fast food. Chipotle's authentic brand developed a loyal following, which allowed the company to grow from one restaurant to more than 2,100 relying primarily on customer word of mouth, supplemented by non-traditional marketing techniques including digital and social media, owned content, and local events.
The company has been fabulously successful. In 1998 the company had 14 locations, when it came public in 2015 it had 480 locations and a share price of $17.50. As I mentioned twice already the number of locations is now over 2,000 and the share price is near $400.
The growth in locations has been running at a rate of roughly 200 new locations per year over the past few years.
That may sound like a lot, but compared to the 35,000 plus McDonald's restaurants that operate in 119 countries it isn't. There is a lot of growth left in this story both in the United States and internationally.
Chipotle shares climbed to over $700 each at one point in 2015. Then (as you are quite likely aware given the press it received) came a major bump in the road
Very well-publicized E. coli and norovirus outbreaks at Chipotle in October and November of 2015 decimated customer traffic, such that fourth-quarter 2015 same-store sales were down 14.6%.
Those struggles have continued through the third quarter of 2016.
In the third quarter 2016 same store sales were down 22% from 2015 levels as the impact of the bad press lingers.
Bill Ackman's Investment In Chipotle
On September 6th, hedge fund investor Bill Ackman announced a 9.9% stake in Chipotle Mexican Grill which was purchased at an average price of $405 per share.
Here is some of his reasoning for the purchase:
Chipotle has built a superb brand pioneering the "fast casual" restaurant industry with the success of its outstanding product offering, unique culture and powerful economic model. We have followed the business for years, noting how it has disrupted the fast food industry with its high quality, delicious and customizable hot meals that are prepared quickly and sold at affordable prices.
The company has been significantly negatively impacted by food safety issues beginning in the fourth quarter of 2015 which caused a peak decline in average unit sales of 36%. In response, the company has implemented best-in-class food safety protocols over the past year, and worked to win back lost customers. While traffic and sales have begun to recover, average unit volumes are still 19% below peak levels.
What Ackman believes that he has right now with Chipotle is a great business that is in temporary trouble. While Chipotle's reputation has been bruised, Ackman believes that with the passage of time and improved marketing, technology and governance initiatives, the business will not only recover but become much stronger.
I agree with him. We can go back to the classic Buffett investment in American Express during the salad oil scandal during 1963 where Warren used a market overreaction to a short-term issue to generate big gains.
When detailing his investment Ackman notes that Chipotle's sales recovery will be neither smooth nor predictable over the next few quarters; yet, more importantly he believes that all of the key drivers of Chipotle's powerful economic moat and long-term success remain intact.
According to Ackman these drivers include:
A strong and relevant brand built by visionary leadership A differentiated product offering with a highly attractive value proposition Substantial scale in the fast casual industry and first-mover advantage in real estate Strong unit economics and extremely high returns on capital, driven by a well-honed model that facilitates best-in-class throughput Enormous growth opportunities including new units and operating enhancements such as mobile ordering and catering
Chipotle Still Has An Enormous Growth Opportunity
Prior to the recent food safety issues, Chipotle's average unit volumes were approximately $2.5 million, nearly the highest in the industry, despite only serving two day-parts, and with limited store hours, i.e., 11 versus as much as 24 hours for other fast food competitors.
Chipotle prior to the food safety issues had one of the very best restaurant brands.
The investment thesis here is that initiatives such as mobile and digital ordering, loyalty program development, catering, and menu innovation including dessert will drive an accelerated rate of same-store sales growth for the foreseeable future, incremental to the impact of recovering lost customers.
In other words from today's temporarily depressed sales levels there should be both growth from a return to normal (the food safety concerns lessening) as well as from new initiatives.
Returns on capital for new units remain extremely compelling even at today's lower sales levels. Bill Ackman believes that the U.S. can support about 3,000 additional Chipotle restaurants, a total of 5,000 units representing 2.3 times the current store base.
Interestingly Chipotle operates all of these restaurants and hasn't franchised any of them. There has been speculation that moving to franchise the Chipotle brand is an avenue that Ackman as an activist may go down with management. Doing so would free up huge amounts of capital.
About That Bump In The Road
Ackman and his team researched the initiatives that Chipotle has taken to address food safety. While food safety risk can never be completely eliminated in any restaurant, Ackman believes that the company has done an excellent job of significantly reducing the risk of another incident while maintaining the freshness and taste of its food.
In addition, we should consider that Chipotle is not the first restaurant chain to have food safety incidents.
In 1993, Jack in the Box had its own outbreak that resulted in over 700 cases of E. coli. The outbreak originated from undercooked beef at 73 restaurants in Washington, Idaho, California, and Nevada. 171 people, including 45 children, were hospitalized. 41 victims developed hemolytic uremic syndrome (HUS), a disease that destroys red blood cells and can lead to kidney failure. Tragically, four children died.
Jack in the Box same-store sales declined 22% in its fiscal second quarter of 1993, including a 40% decline during the first week of February. After three quarters of 9% same-store sales declines, same-store sales rebounded 23% in its fiscal second quarter in 1994. The brand posted solid same-store sales gains in the next few years. Since 1993, Jack in the Box has expanded from about 1,200 total company-operated and franchise-owned restaurants to over 2,200 locations today.
In comparison, Chipotle's impact on human health in 2015 was far less severe. Chipotle sickened 60 people with E. coli in October and November. Two separate norovirus outbreaks linked not to food, but sick employees, sickened 386 people. Salmonella sickened another 60 people in two states. No one developed HUS and no one died. However, the widespread reach of today's media, including social media, significantly amplified the news. The negativity culminated with a Bloomberg BusinessWeek cover story highlighting Chipotle's food safety woes.
Chipotle's same-store sales fell 14.6% in the fourth quarter, including declines of 16% in November and 30% in December. January's same-store sales fell 36% as the media reporting continued for an extended period of time and the CDC's investigation into the cause of the outbreak continued. Chipotle management decided to wait until the CDC's investigation was concluded before trying to actively bring customers back in to the stores with a marketing campaign.
The CDC finally concluded its investigation on February 1, 2015. The long time period between the first negative headlines in October and the CDC's "all-clear" lengthened and likely deepened the same-store sale weakness.
I would be inclined to think that the cure to Chipotle's revenue weakness is going to be the passage of time and that this is an opportunity for patient investors.
I do not own shares in any company mentioned in this article.