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We are moving Chipotle (CMG) from the BENCH to the Hedgeye Restaurants Best Ideas SHORT list.

 

Please join us Today, November 17th at 1:00PM ET for a LIVE Flash Call regarding our SHORT thesis on CMG.

CALL DETAILS

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Confirmation Number: 13625259

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When we added CMG to the short list on 9/30/15 (NOTE HERE), one of our primary concerns was focused on potential issues surrounding the supply chain and increased growth pressures coming from more expensive real estate and associated costs.  In addition, following the introduction of the Friend or Faux game, the company detractors were getting more aggressive exposing the Hypocrisy of the company. 

The hypocrisy movement has been elevated to a level that could seriously expose the company’s business practices and hurt the brand image.  The issues coming to light right now at CMG, remind us of what happened to Whole Foods (WFM) with their overpricing scandal in June of 2015. This caused detrimental damage to the perception of the brand that they are still working on shedding. The central issues about the CMG SHORT thesis are centered on:

  1. The hypocrisy over CMGs advertising is gaining momentum.  If CMG loses a class action lawsuit it might have to stop advertising that it serves non-GMO food
  2. The challenge is even greater when we come to grips with the notion that the company will likely outgrow the supply chain over the next couple of years 
  3. Four separate issues of foodborne outbreaks in the last year suggest the company is having a difficult time managing its supply chain
  4. The company’s relentless attacks on other restaurant companies and more recently attacking the entire supply chain suggests there are many who will revel in the anguish of CMG
  5. Over the last five years, capital spending has grown 131%.  Returns on capital over the next five years will come at much lower returns   

BRAND PERCEPTION ISSUES

Back in September we asked the question, “Has CMG gone too far (in attacking the supply chain), who is fighting back?”  There is clearly a group attacking the company with its Chubby Chipotle ads and the article, “Chipotle Hypocrisy: American Antibiotics Bad, British Antibiotics Good.”

The Hypocrisy movement is growing and gaining momentum!

The CMG detractors are clearly calling out CMGs business model and challenging some of the ways the company does business.  In August and September 2015, two false advertising class-action lawsuits were filed against Chipotle Mexican Grill alleging that the restaurant falsely advertises that its food does not contain genetically modified organisms (GMOs) when it actually does. As the publicity of these lawsuits go more mainstream, CMG will have a difficult time defending itself in the eyes of public opinion. 

The lawsuits also put a spotlight on the supply chain issues and some of the complications the company faces as it gets bigger.  Added to these questions, the company is facing new creditability issues as it deals with four separate foodborne illnesses in 2015.  Importantly, each successive outbreak was worse than the last and there was even one that went unreported. 

CMG FLASH CALL | SHORT | HYPOCRISY THEORY GAINING MOMENTUM - CHART 1

It’s clear that the company is having growing pains with its supply chain and this issue is being manifested in the lack of controls over its suppliers.  While they have not found the source of the E. coli outbreak, it’s usually found in produce.  Given that CMG sources most of it produce locally, to keep up with its growth, it has been increasing the number of local suppliers. The constant need for supply could have led CMG to speed through the testing and qualification process for suppliers, potentially leading to the infected produce.

We would also note that in the 2014 10-K the Company changed how it defines the type of produce it supplies to its restaurant.  CMG removed the word "sustainably and replaces it with “responsibly grown produce.”  Meaning produce grown by suppliers who we believe respect the environment and their employees.  To the degree this change altered how the company looks for suppliers could be the origination of why things are different with the CMG supply chain.

GROWTH RELATED ISSUES

Taken a step further, it’s well within the realm of possibilities that this is a sign of bigger issues at the company.  What other growing pains will be bubbling to the surface in the coming months? 

All of the companies Chipotle’s size or larger, (MCD, SBUX, CAKE, EAT, DNKN etc.) have at one point pushed too hard on new unit openings, only to be forced to regroup and slow down.  Despite how great or different Chipotle’s food is from every other concept, the foodborne illness issues demonstrate that the company is just like every other restaurant concept.  When it comes to pushing the rate of growth to a level that will cause internal problems, like other companies before them, CMG will be no different.  We suspect we are closer to that date than we have ever been.

Since 2010, the company has increased its capital spending by 131% to an estimated $262 million for the full year 2015.  The company increased its 2016 unit growth target on the last earnings call, but that may have been a response to slowing same-store sales trends.  The stocks performance following the call suggests that the market is no longer rewarding the company for faster unit growth.  If the company is experiencing, internal growth related issues, the accelerated pace of development will only add to the existing problems. 

CMG FLASH CALL | SHORT | HYPOCRISY THEORY GAINING MOMENTUM - CHART 2

Adding to this issue is the confusing remarks the company made during the last conference call versus what they put in the 10-Q.

  • On the 3Q15 call management said ― “We've built a fantastic development program as our real estate, design, and construction teams are finding favorable new restaurant sites and negotiating some of our best lease terms.”
  • In the 10-Q the company said ― “occupancy costs as a percentage of revenue increased for the three months ended September 30, 2015 primarily due to increased costs for leases entered into during 2015.” 

In a slowing sales environment expensive leases can hurt the P&L.

THE GROWING HYPOCRISY ― CMG's WHOLE FOODS MOMENT

CMG has been a significant beneficiary of the non-GMO movement and those days may be over.  In August and September 2015, two false advertising class-action lawsuits were filed against Chipotle Mexican Grill alleging that the restaurant falsely advertises that its food does not contain genetically modified organisms (GMOs) when it actually does.

Beginning in March 2013, Chipotle released a comprehensive list of all of its ingredients on its online website, which was reportedly a first among fast-food chains.  When Chipotle first listed its ingredients online, 12 of the 24 ingredients listed contained the presence of GMOs, including Chipotle’s tortillas, rice, salad dressing, potato chips, and its meat products.  Chipotle stated, however, that it was committed “to removing the GMOs from” it’s Food Products “to the fullest extent possible.”  For the next 10 quarters same-store sales averaged 10.5%.  Undoubtedly the company has benefited from the news and consumer acceptance that the food has no GMOs.

On April 27, 2015, Chipotle announced and began advertising that it would only prepare food with ingredients that are free of GMOs.  Steve Ells, Chipotle’s founder and co-chief executive said that, “Just because food is served fast doesn’t mean it has to be made with cheap raw ingredients, highly processed with preservatives and fillers and stabilizers and artificial colors and flavors.  Despite that, same-store sales have softened and the numbers of company detractors are growing. 

LAWSUIT

According to the lawsuit “The California Consumer Legal Remedies Act (“CLRA”), Civil Code section 1750, et seq., was designed and enacted to protect consumers from unfair and deceptive business practices. To this end, the CLRA sets forth a list of unfair and deceptive acts and practices in Civil Code section 1770.

Chipotle's practices in connection with the marketing and sale of its Food Products violate the CLRA in at least the following respects:

(a) In violation of section 1770(a)(5), Defendant knowingly misrepresented the character, ingredients, uses and benefits of the ingredients in its Food Products;

(b) In violation of section 1770(a)(7), Defendant represented that the ingredients in its Food Products are of a particular standard, quality or grade, which they are not; and

(c) In violation of section 1770(a)(9), Defendant knowingly advertised its Food Products with the intent not to sell the products as advertised.

The complaint says “Chipotle represents that all of its Food Products contain “non-GMO ingredients” and fails to disclose that its Food Products necessarily contain GMO ingredients in order to convey to consumers that they are obtaining a product that provides more benefit and are safer for consumers than other restaurants which offer similar or substantially similar food products. These representations are false and misleading in that many of the ingredients composing Chipotle’s Food Products do contain GMOs.”

For further proof of the merits of the lawsuit you only need to look at the company web site.  “In the United States at this time, most of the grain used as animal feed is genetically modified. This includes most of the grain used to feed the animals that provide our meat and dairy. While we are striving to eliminate GMOs from our supply chain, there is currently not a viable supply of responsibly raised meats and dairy from animals raised without GMO feed.”

If you buy a burrito from CMG it has GMOs in it!

The plaintiff claims they were injured by purchasing (or overpaying for) Chipotle’s Food Products.  Possibly so!  At the very least as the details of this suit become more widely known it will be very bad publicity for a company whose mantra is 'food with integrity'.

If CMG settles or loses and they are forced to change their entire marketing strategy it will be very bad news.

The GMO loophole

The company’s defense will be that they are in compliance with the laws.  In the past the company has cited the GMO labeling law the state of Vermont passed (the only GMO labeling bill to win voter approval thus far) which goes into effect next year (CMG only has two locations in VT).

“Under that law, meat or dairy from animals that are fed GMO feed are still considered non-GMO. You could also look at the Safe and Accurate Food Labeling Act of 2015 (HR 1599) which recently passed in the House. It would similarly allow food to be labeled non-GMO if it is derived from animals that are fed GMO feed”

The fate of this is now in the California court and the court of public opinion, both of which could be very damaging to the company. 

SAME-STORE SALES

Management is very bullish about the future and that the company is about to start a new three year cycle on same-store sales.  On the most recent earnings call John Hartung, Chief Financial Officer, Chipotle Mexican Grill, Inc. said – “we just finished a three-year trend, and I've talked about this on some earlier calls. If you go back and look to 2013, we started a new trend where we started in low single-digit comps, and we kind of built our comps for the next several quarters. We had a price increase in 2014. But if you combine the last three years – and this is kind of the end of that trend – our three-year comps are up in the high 27%-28% range.  We now need to start a new trend because we started that momentum. And if you look quarter to quarter, you can see that the momentum builds for several quarters, then it levels off. It peaked last year at 19.8%, and then as you are comparing through multiple years, up double digit comps.”

We believe it to be unrealistic to anchor a bullish call on CMG based on three year cycles.  We don’t believe that phenomena truly exist. The only three year pattern we see in the company, is price increases every three years.  The increase in traffic is more cyclical or luck than it is reality.  At the end of 2012 and the beginning of the last "3-year cycle", CMG announced that it was going GMO-free.  Around this announcement, the company generated a significant amount of incremental new customers. 

CMG FLASH CALL | SHORT | HYPOCRISY THEORY GAINING MOMENTUM - CHART 3

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Yet, contrary to the CEO statement, its advertising campaign and instore signage, Chipotle’s ingredient list on its website admits “there is currently not a viable supply of responsibly raised meats and dairy from animals raised without GMO feed”

Non-GMO meat is able to come from cows that have been fed GMO feed. In order for consumers to completely avoid animal products that have been fed GMO feed, you must look for certified organic products, since organic standards prohibit the intentional use of GMOs.

CMG FLASH CALL | SHORT | HYPOCRISY THEORY GAINING MOMENTUM - CHART 6

Bottom line is that CMGs food has GMOs and it’s loaded with excessive calories! In fact, the average burrito in a tortilla will have around 1,000 calories, 2,300 grams of sodium 62 grams of fat and 60 grams of protein. Although the protein count is impressive, the other three stats aren’t as appealing.

VALUATION

Analyst sentiment is entirely too bullish, 53% of analyst have it rated as a buy, 47% as a hold and zero as a sell.

CMG FLASH CALL | SHORT | HYPOCRISY THEORY GAINING MOMENTUM - CHART 7

Short interest is near historical lows, at a time when the company is under the most pressure it ever has been.

CMG FLASH CALL | SHORT | HYPOCRISY THEORY GAINING MOMENTUM - CHART 8

Earnings revisions have barely come down for the company, and they are facing more headwinds then ever.

CMG FLASH CALL | SHORT | HYPOCRISY THEORY GAINING MOMENTUM - CHART 9

We see CMG trading at valuation levels below that of McDonald’s. The below chart implies no upside for the company, but significant downside.

CMG FLASH CALL | SHORT | HYPOCRISY THEORY GAINING MOMENTUM - CHART 10

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Please call or e-mail with any questions.

Howard Penney

Managing Director

Shayne Laidlaw

Analyst