Behavioral investing case study: short Chipotle

Regular readers will be aware that I have something of a penchant for investing/trading not just with a view to the underlying fundamentals, but also occasionally in advance of behavioral changes that can affect those fundamentals and thus move a given stock. In this vein, I shorted Lumber Liquidators (LL) earlier this year, purely on the basis of a massive consumer shift away from LL product after the damning 60 Minutes allegations of carcinogens in some of their laminates. Guilty or not, I reasoned, the cost of remaining a LL customer was, for the ordinary consumer, simply not worth the risk of buying even at discounted prices. LL stock is now $15.

With regard to the power of ‘behavioral investing’ the current situation regarding Chipotle Mexican Grill (CMG), the ubiquitous and heretofore incredibly successful Mexican fast food restaurant chain, is another case in point. CMG has been a massive multi-year investment winner, is (or was, until very recently) a core holding of growth investment managers, and has a large and growing base of dedicated consumers across the United States. Operational excellence – CMG had mastered the art of serving customers faster than any other QSR chain – and secular growth potential (due to the increasing Hispanic population) had led to long-term above double-digit growth in sales and EPS, and the stock enjoyed a huge multi-year run. Ten years ago, the stock was $50; a month ago it was over $700.

Much of this thesis has changed in the last couple months, however. The first warning shot came with the 3Q report, where CMG reported comp store sales growth fell below 3% (+2.6%) vs +4.2% in 2Q. Positive comps in a difficult environment are nothing to sneeze at, to be sure, but it has become clear in recent quarters that CMG is running up against the natural limits of comp sales increases, having enjoyed heady comp store growth for so, so long. Sure, the company is still guiding to opening ~200 stores a year, providing for ~10%+ sales growth (current store count is ~1700) assuming flat comps. But with the stock trading in mid-October at ~40x earnings, low-single digit comp growth was taken negatively, and the stock fell below $700, to ~$675.

More recent newsflow has been much worse, and directly relates to the opportunity now. In early November, CMG announced they were shutting 43 stores in Portland and Washington state, due to the outbreak of the E.Coli virus amongst a number of people who had eaten at Chipotle restaurants in those states. CMG stock fell further – to $610 – though it initially appeared that the damage could be limited to a local supplier to restaurants in Washington and Oregon.

But despite subsequently re-opening these stores, by last week, it had become clear that E.Coli cases had spread to nine states, including the Mid-West and East Coast (casting doubt upon a whole new batch of regional suppliers, or indeed something specific to CMG’s supply chain processes). Worse, after the close Friday, CMG reported that consumers were abandoning the chain en masse: comp sales – predicted to be +3% just a month earlier – posted -20% in the days following the 43 restaurant closure, before moderating to -16% in the back end of November. As a result, the company pulled its 2016 comp view (for low-mid single digit comp increases) and, to my mind, it now appears highly likely comp sales will meaningfully decline in 2016. It was in the after-market on Friday – with the stock already down 30%+ from the highs – that I shorted CMG, at $525.

The behavioral calculus here is pretty simple: why would anyone in their right mind eat at Chipotle in the near-term? E.Coli is a very nasty virus, and can be deadly; and it is quite clear this is not an isolated outbreak anymore (nine states, over 50 hospitalizations). Consumers are clearly voting with their feet, and thinking logically, the cost to a consumer for not eating Chipotle (and say, going to Qdoba instead) is zero, while the penalty for not changing your behavior could be very severe. It is almost a given, then, that comps will turn meaningfully negative in the short/medium-term.

I would also be wary of banking on a quick rebound in comps, even if the situation appears to be brought under control. As mentioned above, there are very low to non-existent switching costs here and there are a plethora of other similar options in most US locations (Taco Bell, Qdoba, El Pollo Loco, Chuy’s, etc). Furthermore, food scandals in particular capture the public imagination and provide plenty of scary headlines for 24 hour news channels, which, combined with the low switching costs mentioned, could keep CMG demand quite low for the forseeable future. And finally, even if no other cases of E.Coli are reported, it seems quite likely some of the victims will have viable cases to press for damages from CMG, especially if ongoing investigations reveal meaningful fault on the part of CMG’s processes (not inconceivable given how widespread the problems have become).

None of this should be life-threatening to CMG as a company. But the beauty of this situation is CMG is still priced not just for growth but for high growth. Consider: at $560 (Friday close), CMG trades at 30x next years consensus EPS, and 15x EV/EBITDA, despite just 11% expected sales growth, and 9% EPS growth. I would argue that these numbers must continue to come down, especially in light of the recent disclosures that the company is seeing recent comp sales in the -16-20% range. But even before the E.Coli scandal. this was a rapidly maturing growth stock that somehow garnered the kind of lofty multiple deserved by a mid-life growth story with a long, long run-way still ahead of it. As anyone who has followed retail or restaurant chains from Michael Kors (KORS) to El Pollo Loco (LOCO) will tell you, generally speaking you do not want to be left holding a richly-priced growth stock when the growth disappears – and E.Coli scare aside, CMG could be confronting that exact point now. The E.Coli situation may just catalyze and clarify the downside in the nearer-term.

To my mind, current consensus models about a 10-11% sales hike from new stores and a flat to low single digit hike from comp sales next year, all with some margin compression (50bps or so at the GM level) to get you to ~9% EPS growth. To me, this is wildly optimistic and I would expect both much lower comps, as well as a slower pace of store openings, as the company struggles to get to grips with the E.Coli fallout. In a scenario where comps drop modestly (5%?), store openings slow to ~7% unit growth, there is some margin compression due to discounting (but not counting the announced ‘one-time’ costs to clean up the supply chain),  it is not hard to see CMG posting flat to +5% EPS growth next year, or say ~~$17-17.5 vs current consensus of $18.6.

This may not seem like a huge delta but in reality I would not be surprised to see consensus fall to year-on-year earnings declines. Putting even just a 25x multiple on say $17 of earnings – still a huge premium to the growth rate – suggests a $425 stock, or another ~20%+ downside from here, and frankly I don’t think 25x is the right multiple anyway (hint: it should be lower). The upside risk case is fairly moot given E.Coli newsflow should remain negative and even if it doesn’t, the behavioral thesis suggests consumers will really take their time coming back to the stores – which in any case were running at much slower comp rates than historically, despite the cheap stock.

Adding it all up, and CMG looks like another good ‘behaviorable’ risk/reward trade on the short side.

Disclosure: short CMG

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