Has Chipotle Overcome Its Problems?

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  • Source: Chipotle.com

    Sometimes, success is an accident. Not a pure accident as in “I was walking down the street and found a gold coin on the sidewalk.” But, sometimes a business owner finds that sales and profits exceed expectations.

    That’s the case for Chipotle Mexican Grill (NYSE: CMG). The company’s founder has explained, according to CNBC, that he never expected the burrito maker to become a restaurant chain. He was simply trying to use cheap burritos to fund his plans for a fine dining restaurant.

    Steve Ells was working as a chef in San Francisco when “he decided to open up a small burrito shop in Colorado, a low-risk investment, that could provide the capital for the restaurant he really wanted to run.

    “This was going to be one restaurant,” Ells said. “And this was going to be a cash cow that could fund and help support a full-scale restaurant. You know, I knew that full-scale restaurants were a dicey proposition. I mean, they go out of business often. It’s hard to make margins, very difficult to operate. And so I wanted Chipotle to be a backup.”

    “There was no business plan,” he said. “I was just making this up as I went along.”

    Well, the initial results were impressive. Chipotle began trading as a public company in 2006 and by 2015 has gained more than 1,100%, making its founder a billionaire.

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  • CMG chart

    Growth Brings Gains, and Problems

    In 2015, health officials linked the company’s restaurants to an E. coli outbreak that sickened 52 people in multiple states. Later that year, Boston College said health officials confirmed a food-borne illness outbreak linked to a Boston-area Chipotle. More than 120 students reported to the college’s health services with symptoms consistent with norovirus.

    The company acted swiftly to address the problems. Many changes were small but designed to prevent the risk of illness. For example, in the restaurants, workers add cilantro to higher-temperature rice than before to kill any bacteria on the cilantro.

    They blanch avocados, onions, jalapeños, lemons, and limes for 5 to 10 seconds in boiling water. That will destroy any microbes on the surface. Lemon and lime juice are added earlier to the salsa and guacamole to reduce the microbe count.

    These are all minor changes, but cumulatively are intended to reassure customers that the food is safe. The changes were required as both traders and companies avoided Chipotle in the aftermath of the 2015 incidents. The small steps did help as the next chart shows.

    Chipotle

    Source: Bloomberg

    The chart shows that Chipotle still has a long ways to go to reclaim the customers that were lost when the problems developed. Investors understand this and the stock’s halting recovery can be seen in the first chart in this article.

    The stock fell for more than two years and is just now turning up. Before considering the future of the stock, let’s consider whether there were signs in the company’s financials that could have alerted investors to potential problems.

    Growth Brought the Problems

    Growth is difficult for companies to engineer. That’s why investors reward growth with high trading multiples. But growth must be tightly managed. The next chart shows that CMG was growing rapidly, with the store count steadily increasing.

    CMG growth

    In the year before the health problems, the company opened 227 new locations, upping its store count by about 12%.

    Growth was a risk factor for Chipotle given its business model. The company uses high quality, fresh ingredients. Fresh ingredients are a risk and one mistake could cause illness. With more than 2,000 stores, the risk of an error by a single employee is high, especially in low wage paying jobs.

    This was a risk factor that investors could have spotted with some research.

    Detailed Analysis Can Pay

    In 2014, the full year before the incidents at the stores, CMG reported sales growth of 27.8% to more than $4.1 billion. Strong sales growth is good for a company, but it needs to be studied at a large company. This is the most important lesson from CMG’s crash.

    Sharp changes in metrics like sales and earnings for large cap companies should be understood. In some cases, the jump could be due to a new contract or to accounting changes. If the reason cannot be understood, the stock should be avoided.

    In this case, the pace of growth in sales jumped 50%. New locations were one factor but much of the growth came from existing stores. That’s where the risks, and losses, developed.

    Rapid gains in same store sales could be a problem. It could mean customers are waiting longer and that’s not likely to last long. Sales will suffer as wait times drive customers away.

    Or, it could mean staff at the stores is getting stressed and vulnerable to mistakes. This would be a larger risk at someplace like Chipotle with fixed floor space and relatively labor intensive products.

    The 16.7% increase in same store sales CMG reported before its food safety problems was the red flag for investors to research. Qualitative analysis would have revealed this vulnerability.

    The Future Looks Better

    CMG seems to have learned from its past. In a recent conference call with analysts, the new CEO noted that his plans for growth are focused on new advertising campaigns and improved access to the existing stores. This was welcome news to investors.

    That means instead of looking for ways to expand the menu, for example by adding breakfast burritos, management will work on maximizing the menu it has. This is a good decision since breakfast would carry new risks associated with eggs and breakfast burritos.

    By simply staying later on weekend, a tactic used by many fast food restaurants, sales could grow. This minimizes risk since sales would be added with existing ingredients and procedures.

    The CEO also wants to make it more convenient for people to eat Chipotle with offerings such as delivery, catering, online order pickup, and even drive-thru windows. Digital orders accounted for 8.8% of its sales in the most recent quarter and could grow.

    However, the stock is still expensive at about 30 times next year’s estimated earnings. CMG is speculative and should be avoided by value investors.

    Qualitative research, like understanding how growth and operations could collide at CMG, could be profitable. But research is time consuming. If you are uncomfortable doing your own research, there is a TradingTips.com trading service, Triple-Digit Returnswhich uses a very specific system for choosing the right stocks to trade.

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