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CMG: A CLASSIC PATTERN DEVELOPS!


Chipotle, like every restaurant company is currently "over earning" which is not a bad thing, just a function of the times. By "over earning" I mean the rate of pricing running through the P&L is far out stripping the rate of inflation the company is seeing, so margins are exploding. For CMG this will continue for at least one to two more quarters, depending on traffic trends and how the new menu initiatives perform.

 

Given how young the Chipotle concept is, there is not a lot of history to understand how consumers will view the concept in a recession. Fortunately, senior management has bought themselves some time and margin to adjust to the new reality; consumers are not flocking to the concept as they once did on the past.

 

In 2007, Chipotle was enjoying rapid growth with little or no advertising expense. Much of the growth was driven by word of mouth and CEO Steven Ells justified the scant spending on advertising in March 2007, saying, "Advertising is not believable." Fast forward to today and Chipotle's traffic was down 4.5% in 1Q09 and the company is launching its first advertising campaign.

 

Ells and his team have come up with mychipotle.com as a centerpiece for an advertising campaign seeking to bring the credibility of word of mouth promotion to a wider range of people. The aim is to get more people into Chipotle. I'm sure we will hear how successful mychipotle.com site is, but I'm skeptical that it will translate into increased traffic.

 

While I have no doubt that social media advertising is powerful and could possibly benefit CMG in the future, value is a key theme today. Clearly, the concepts declining traffic trends are down partly in response to the 8.5% price increase implemented last year. In the short run, the menu price increase certainly helped margins, but may create some difficulties should traffic not pick up significantly in 2010.

 

By the time we reach 2010, the Chipotle concept will have little or no pricing flexibility and at some point variable costs and lower price points on the menu will impact margin. At the same time, the company will have opened over 250 stores at lower margins or 25% of the store base. There will continue to be a "portfolio" impact on the overall margin structure of the company.

 

The following are some of the key issues the company faces. CMG clearly has a number of significant issues to overcome, but nothing is terminal. The comparisons in 2Q09 are difficult, but the "over earning" status suggests that it might not be that difficult to compare against. In this scenario, the 19% short interest is a bullish signal.

 


MENU CHANGES

 

By design the Chipotle menu is simple and easy to execute as it displays the individual ingredients, and leaves it up to the customer to mix and match. The company research suggests that this design leads to a perception of limited variety and discourages experimentation. More to the point, the concepts price points are not flexible enough to provide choices for families with kids. In order to broaden the appeal of the concept, the company is testing a new menu that includes new entree options, several featured items, new, smaller, lower priced options, and a complete kid's menu. Without a broad based communication strategy to communicate the menu changes and drive incremental customer traffic, the risk that the concept sees a lower average check from current customers is high.

 

Can they introduce value and maintain margins; that thought is inconsistent in the restaurant industry!

 

CMG:  A CLASSIC PATTERN DEVELOPS! - cmgpod1

 

MARKETING

 

Chipotle new marketing campaign is called My Chipotle and is designed to engage directly with Chipotle's current customer base. The idea is build on the traditional word-of-mouth strategy. The new campaign will be using radio, print, outdoor and a website called mychipotle.com. The intent is for the concepts customer to become part of the ongoing My Chipotle advertising campaign. The new strategy appears to be directed at the concepts existing heavy users and not drawing in new customers.

 

As a percentage of sales, Chipotle spent 2.2% in 1Q08, 2.5% in 2Q08, 1% in 3Q08 and 0.7% in 4Q08. In. Overall for 2008, CMG spent 1.75% of sales on marketing. In 2009, advertising should remain at 1.75%, with 1Q09 spending 2009 at 1%, advertising is expected to accelerate for the balance of 2009 putting pressure on margins in 2H09.

 

SAME STORE SALES

 

Chipotle took a very aggressive approach to pricing in 2H08 and given the decline in overall restaurant traffic, it's hard to quantify how much of the decline in traffic is in response to higher prices. In 2009, the price increases taken last year will result in an effective increase of about 6% for the full year with effective pricing of around 6% for 2Q09 and 3Q09 and less than 3% in 4Q09. Currently, guidance is for same-store sales to be in the low single digits for 2009. In 2Q09, CMG will lose a day as a result of being closed on Easter and it will lap a 2% menu price increased from last year.

 

A critical issue going forward will be management expectations for its new marketing initiatives and the impact on traffic. I would not be surprised to see management be overly optimistic about the potential impact for the increase in customer counts. It's unlikely to see a significant improvement in same-store sales from current levels.

 

CMG:  A CLASSIC PATTERN DEVELOPS! - cmgpod2

 


NEW STORES/LOWER RETURNS - A RESTAURANT INDUSTRY CLASSIC!

 

This is where one of my biggest concerns lies when looking at CMG. I don't know one restaurant company that has been able to overcome the "portfolio impact" on margins and returns from opening stores with lower average unit volumes.

 

Total capital expenditures in 2008 were $152 million; declining to $140 million in 2009, of which $120 million relates to the construction of new stores. In 2008, CMG spent, on average, $916,000 to build a new store - up from $880,000 in 2007. This is due to opening a larger portion of the restaurants in urban locations being partially offset by a decline in the percentage of free-standing restaurant openings and smaller square foot per store. In 2009, development costs are expected to remain the same as 2008.

 

Here is the problem; CMG new growth is coming from building new stores with lower average unit volumes that cost more to build! This trend will not reverse as they have built out all the best return sites. Also weighing on future performance is the company ability to pick only A/B sites; right now there is room for error in site selection.

 

Going forward, incremental growth provides a diminishing return. Over time while the company may be able to grow total EPS, but the multiple on the EPS will contract providing very little upside to the stock price.

 

Another classic pattern will be for the investment community singularly focused on the performance of the existing store base relative to the new stores being opened. The company reported its first decline in system-wide AUVs in 1Q09 as more new stores are annualizing at $1.35 million to $1.4 million are brought into the comp base. Currently the system average is about $1.7 million. In 1Q09 I calculate new store average unit volumes at $1.26 million versus $1.40 million in 1Q08, down 10%. This compares to management stated number of $1.350 million to $1.4 million. I know that the new store performance is not a new issue, but it's one that should not be over looked.

 

Over the past year CMG has been opening lower volume stores; as a result, the company's return on incremental invested capital has declined from 26% in March 2008 to 17% in 1Q09. While this metric has improved from the low of 12% in 4Q09 the trend will decline given the company current strategy.

 

Toward the end of 2009, I would not be surprised to see the company accelerate unit development in an effort to maintain a growth multiple!


CMG:  A CLASSIC PATTERN DEVELOPS! - cmg3

 


Are You Down With O-P-E-C? “Yah You Know Me”

 

The Energy Information Administration ("EIA") prints a weekly piece which is entitled, "This Week In Petroleum", which offers a broad view of what has happened in the last 7-days in the petroleum markets, with a particular focus on the United States.  In the most recent version, which was publicized last Wednesday at 1pm, as it is every week, it had an interesting note relating to surplus capacity in OPEC, which was as follows:

 

"The members of the Organization of Petroleum Exporting Countries (OPEC) generally hold almost all of the world's available surplus crude oil production capacity, providing them with the ability to alter production levels to influence global oil prices and manage market conditions. Saudi Arabia and other Persian Gulf countries usually hold the bulk of available surplus production capacity, with Saudi Arabia stating it wants to maintain 1.5 to 2 million barrels per day of surplus capacity. In contrast, non-OPEC countries generally produce at capacity and tend to have surplus capacity only when oil prices are so low that marginal production is unprofitable and is shut-in."

 

While there is a great deal of speculation as to what was driving the rampant rise in oil prices into the summer of 2008 (Was it the financial speculators? Was it the evil-doer short sellers?), the fact of the matter remains that based on the measurable data, "oil producers were operating at 98 to 99 percent of capacity".  As the global oil market began operating closer and closer to capacity, it became even more susceptible to marginal changes in supply, such as those related to geo-political risk.  Currently, OPEC is operating at about 4 million barrels per day of surplus capacity versus the 30-year low of 1 million barrels of surplus capacity in Q3 2008.  The current level of surplus capacity is comparable to the level that was maintained for much late 1990s and early 2000s, when oil was at a much lower level even on an inflation adjusted basis.

 

This spike in OPEC capacity correlates with an increase in U.S. Crude Oil Days of Supply, which has been solidly above 25 days of supply since mid-March, which is a level not last seen since 1995 / 1996.  This chart is outlined below.  Clearly the major spike up in days supply has been a drop off in demand due to the recession and increasing unemployment, though there has been a sizable increase in domestic production on a y-o-y basis as well.  In fact, from February to the week ending May 8th, 2008 domestic oil production in the U.S. has been up on average 5.7%. In aggregate for the year-to-date, the U.S. has produced ~4.163MM more barrels than the year before, which while not insignificant is still less than 10% of the 44.8MM build-up in oil stock we have seen y-o-y.  Thus even if domestic production dropped back to levels from a year ago, we would still have had a surplus of oil domestically.

 

Are You Down With O-P-E-C? “Yah You Know Me” - crude

 

Despite these negative fundamentals, Oil is up ~33% in US$ year-to-date and we see a positive quantitative set up going forward.  In fact, we see the TREND upside line at $77.09 versus the TREND support line at $47.94.  Based on the current price of oil at ~$59 / barrel, we see a compelling risk / reward of $11 downside and $18 upside, with our TRADE support at $53.84.

 

The price of oil appears to be signaling one of two things:  either demand will at some point in the near future accelerate or that there is a geo-political event on the horizon that will reduce supply.  

 

In 2007, many corporate management teams responded the following way when we asked them about their macro view: "We have no crystal ball."  In this case,  we really do not have a crystal ball, but one thing we have learned in our careers is that price is a leading indicator and historically reported fundamentals are, by their very nature, a lagging indicator.  As always, price rules.

 

Daryl G. Jones
Managing Director


SKS Quick Read

SKS reported -$0.04 for the quarter vs. the Street at -$0.26.  On the surface it looks like a huge beat driven by much better gross margins and huge expense cuts.  However, a huge clearance event was pushed out into 2Q, which positively benefited the quarter by about $0.05.  Net, net still a better number but 2Q will be hit on the gross margin line by the clearance shift.

 

Inventory not well controlled relative to sales, which has been a consistent issue here.  Total inventory down only 7.3% vs. sales down 27%.  They talk about getting inventories more in line by 3Q, but they are not suggesting huge cuts here but rather more gradual pruning.  

 

As for trends in the quarter, all regions, categories, geographies, and channels were weak.  Notably the NYC flagship was worse than the overall average of down 27.6%.  This confirms other anecdotal commentary that the NYC market is still very soft.

 

Eric Levine


Early Look

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NJ ATTEMPTS TO RISE FROM NV’S SHADOW

The New Jersey Division of Gaming Enforcement determined that Pansy Ho, MGM's Joint Venture Partner in Macau, was unsuitable.  The Division can only make recommendations and the final determination will come from the New Jersey Gaming Commission.  While Nevada has already signed off on the deal, New Jersey is flexing its muscles.  This was always a risk for MGM but it seemed to matter more when expectations for MGM Macau were much higher. 

 

If the Commission follows the Division's recommendations, MGM will be forced to exit its JV in Macau or its JV in Atlantic City (The Borgata with BYD).  Exiting the former is more likely.  The good news for MGM is that MGM Macau generated less than $100 million in EBITDA over the past 12 months, well below initial expectations of $200-300 million.  The property is clearly worth much more than the current EBITDA run rate would suggest.  Due to the forced nature of the sale, MGM will likely receive less than the property is worth.  However, due to the depressed nature of the EBITDA, net proceeds will still be a large multiple of current EBITDA, meaning the transaction will likely be deleveraging. 

 

The negative for MGM is that they may have to give up future growth opportunities in Macau, same store revenue and new store growth.  However, it is doubtful that there is much Macau value residing in MGM's stock.


Buck Is Barking

"Here was neither peace, nor rest, nor a moment's safety. All was confusion and action, and every moment life and limb were in peril."
-Jack London, The Call of the Wild
 
One of America's finest novelists, Jack London, wrote this book in 1903. The story is basically about a dog named "Buck" who gets thrown into the wild. Gone were the days of his sheltered and pampered life. Ole Buck was thrown out into the cold of the northern Yukon, left to fight for himself amongst gold diggers and wild animals. What a metaphor for Wall Street in 2009...
 
As I was eating lunch yesterday, and saw CNBC flash "The Call Of the Wild" across the screen, I almost fell off my chair. I turned on the volume (I try to keep this channel perpetually on mute), and there was Larry Kudlow barking his political bias' under this banner... It's sad, but only fitting that this children's story is one of his networks new calling cards. Re-read the quote above - how perfectly that describes what someone who doesn't speak English must think when the volume is actually on listening to these people.
 
When all is "confusion and action" what is one to do? Pray? If one senselessly chases this tape without an investment process, that's actually not a bad idea. I'm thinking Buck's barking might have some value add here.
 
The real Buck that matters to this market is the US Dollar. Kudlow doesn't get this yet, but it will get harder and harder for him and his circus act to ignore as recognized economists like Ken Rogoff (former chief of the IMF) and Greg Mankiw (Washington advisor) get on board with my call to Break The Buck. Rogoff has written some fantastic economic history of crisis' as of late, and this morning Bloomberg has him in print saying he thinks the USA needs something on the order of 6% inflation "for at least a couple of years." Wow Kenny, if you weren't a Harvard man now, they might start saying this is The Call of the Wild!
 
The folks up in New Haven are quite accustomed to my barking about Breaking The Buck. As Washington/Wall Street groupthink is strangled by Keynesian thought, there is this Old Yeller of a Yale Economist by the name of Irving Fisher whose thoughts on ending deflation have been largely ignored. But as we macro men and women know all too well, because global economic facts (like say R-squares, inverse correlations, etc...) are ignored certainly doesn't mean that they cease to exist.
 
The New Reality is this: the price for compromising the American Financial System's credibility is expressed on a marked-to-market basis by her currency. As the US Dollar breaks down like it did intraday yesterday, asset prices from commodities to stocks that are priced in those fiat moneys REFLATE.
 
No, this doesn't end well. But for now, fiduciaries of other people's hard earned capital are tasked with trading the market that is in front of them. If you pressed the low volume lows from last Friday on the short side of the Financials (XLF) or Consumer Discretionary stocks (XLY), by yesterday's market close you rightly felt shame.
 
Managing risk in an interconnected global marketplace like we have here in 2009 is not to be done passively. Either proactively prepare for risk working both ways or suffer the Calls Of the Emotional Wild and react as markets melt-up/down.
 
Breaking The Buck will continue to pressure the shorts to cover. Yesterday's volume was up +26% on a day-over-day basis versus Friday's low volume selloff. The SP500 closed +3% yesterday, taking its rise from the ashes of the Depressionista March 9th consensus fear to +34.5%. If being long US Technology (XLK) or US Consumer Discretionary stocks (XLY) that are now +12% and +8%, respectively, for 2009 YTD, doesn't tickle your fancy, try Russia.
 
Russia? Yes, that big old freezing bear hunter of a country that was left for dead... just like Jack London's "Buck". It's not just Americans who are levered to the DOWN Boy! DOLLAR trade who get paid here. The Russians, Canadians, and Saudis all get paid in petrodollars don't forget. Russia's stock market is currently trading up another +4% so far in European trading this morning, taking it to +54.8% YTD!
 
Never forget that the US Dollar serving as the world's global currency reserve is not perpetual entitlement. In the FT this morning there's an article outlining how both China and Brazil are moving forward on settling their trade deals in their home currencies. In Hong Kong, both the Bank of East Asia and HSBC just won approval to issue Chinese Yuan based bonds. What does all this mean? Down boy! Down Buck, Down!
 
When you are measuring risk and the real stress that lies out on the tails of a legitimate global risk manager's sheets, don't get sucked into all that is born out of the manic media's "confusion and action." As the Buck breaks down, risk builds on the short side of your book and I, for one, will keep barking at you to understand that.
 
My immediate term upside target for the SP500 is the YTD high up at 934. With my downside support at 877 (a higher low), the immediate term risk/reward to owning stocks today is about even. Being long ahead of yesterday's meltup was the shot that we wanted you to take. As prices change, I will.
 
Best of luck out there today,
KM
 
 

LONG ETFS  

 

EWA - iShares Australia-EWA has a nice dividend yieldof 7.54% on the trailing 12-months. With interest rates at 3.00% (further room to stimulate) and a $26.5BN stimulus package in place, plus a commodity based economy with proximity to China's H1 reacceleration, there are a lot of ways to win being long Australia.
 

XLE - SPDR Energy- We bought Energy on 5/13 with the dollar up. We think it works higher if the Buck breaks down.  Bullish TRADE and TREND remain.
 

XLY - SPDR Consumer Discretionary-The TREND and TRADE are bullish for XLY.  The US economy is showing faint signs the steep plunge in economic activity that began last fall is starting to level off and things are better that toxic.  We've been saying since early January that housing will bottom in 2Q09 and that "free money" for the financial system will marginally improve the US economy in 2H09, allowing early cycle stocks to outperform.  The XLY is a great way to play the early cycle thesis.
 

CAF - Morgan Stanley China Fund- A close end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the wave of returning confidence among domestic Chinese investors fed by the stimulus package.  To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth.
 

EWD - iShares Sweden-We bought Sweden on 5/11 with the etf down on the day and as a hedge against our Swiss short position. From a fundamental setup, we're bullish on Sweden. The country issued a large stimulus package to combat its economic downturn and the central bank has effectively used interest rate cuts to manage its economy. Sweden's sovereign debt holds a strong AAA rating despite Swedish banks being primary lenders to the Baltic states. We expect Sweden to benefit from export demand as global economies heat up.
 

XLK - SPDR Technology - Technology looks positive on a TREND and TREND basis. Fundamentally, the sector has shown signs of stabilization over the last eight weeks.   As the world demand environment becomes more predictable, M&A should pick up given cash rich balance sheets in this sector (and the game changing ORCL-JAVA deal). The other big potential catalyst is that Technology benefits from various stimulus packages throughout the globe - from China to USA. Technology will benefit from direct and indirect investments.
 

XLV - SPDR Healthcare-Healthcare looks positive from a TRADE and TREND duration. We've been on the sidelines for the last few months, but bought XLV on a down day on 5/11 to get long the safety trade. 
 
TIP- iShares TIPS -The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%.  We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.
 

GLD - SPDR GOLD -We bought more gold on 5/5. The inflation protection is what we're long here looking ahead 6-9 months. In the intermediate term, we like the safety trade too.  
 

 

SHORT ETFS
 
UUP - U.S. Dollar Index -We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. Longer term, the burgeoning U.S. government debt balance will be negative for thegreenback. The Euro is up versus the USD at $1.3624. The USD is up versus the Yen at 96.3400 and down versus the Pound at $1.5462 as of 6am today.
 
EWW - iShares Mexico- We're short Mexico due in part to the repercussions of the media's manic Swine flu fear.  The country's dependence on export revenues is decidedly bearish due to volatility of crude prices and when considering that the country's main oil producer, PEMEX, has substantial debt to pay down and its production capacity has declined since 2004. Additionally, the potential geo-political risks associated with the burgeoning power of regional drug lords signals that the country's economy is under serious duress.
 
IFN -The India Fund-We have had a consistently negative bias on Indian equities since we launched the firm early last year. Despite recent election results likely proving to be a positive catalyst, long-term we believe the growth story of "Chindia" is dead. We contest that the Indian population, grappling with rampant poverty, a class divide, and poor health and education services, will not be able to sustain internal consumption levels sufficient to meet targeted growth level. Other negative trends we've followed include: the reversal of foreign investment, the decrease in equity issuance, and a massive national deficit.
 

LQD  - iShares Corporate Bonds-Corporate bonds have had a huge move off their 2008 lows and we expect with the eventual rising of interest rates in the back half of 2009 that bonds will give some of that move back. Moody's estimates US corporate bond default rates to climb to 15.1% in 2009, up from a previous 2009 estimate of 10.4%.  

 

EWL - iShares Switzerland - We believe the country offers a good opportunity to get in on the short side of Western Europe, and in particular European financials.  Switzerland has nearly run out of room to cut its interest rate and due to the country's reliance on the financial sector is in a favorable trading range. Increasingly Swiss banks are being forced by governments to reveal their customers, thereby reducing the incentive of Switzerland as a tax-free haven.

 


V-SHAPED RECOVERY TO BENEFIT IGT

It's not all ball bearings these days, Fletch.  And it's not all Video Reel either.  As the following chart shows, almost 60% of the 950,000 slot machines on casino floor in North America are Reel Spinning and Video Poker machines.  Nobody is replacing the Steady Eddie Video Poker until the machine physically disintegrates.  Aside from video poker, the oldest machines are almost all Reel Spinning. 

 

V-SHAPED RECOVERY TO BENEFIT IGT - NA SLOTS BREAKDOWN

 

The shelf life of Video Reels is less than half of a Reel Spinner.  I'm not talking about functional life, but life as a contributor above the house average play level.  Virtually all of the replacement demand we've seen in the last few years has been on the Video Reel side.  My contention is that once the operators' balance sheets are in order - they are on their way thanks to the opening of the credit/equity markets - the old Reel Spinners will be replaced fairly quickly.

 

The good news for IGT is that they dominate the Reel Spinning market.  It is likely that most of the old Reel Spinners will be replaced by new Reel Spinners.  Video Reels have probably replaced as close to all the Reel Spinners the will ever replace.  There remains player demand for Reel Spinners, especially now with the advent of 5 Reels versus the traditional 3 Reels.  Incidentally, the only video product that could replace a Reel Spinner is IGT's Multi Layer Display game that looks like a Reel Spinner.  We've gotten very good feedback on the performance of these products.

 

We've made the case that improving balance sheets should finally expedite the re-acceleration of the replacement cycle (5/15 - "IGT: MGM, CREDIT MARKETS, AND REPLACEMENT DEMAND").  The casino floor is as old as it has been since 2001 and the age is concentrated in the Reel Spinning category.  IGT could generate well above its normal share in a recovery.


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