Will Hassell
February 23, 2017
Lehigh University Dreyfus Portfolio

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.

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