Penney: The Better Burger Won't Save Chipotle's Investors

Takeaway: The bad news for Chipotle investors isn't going away anytime soon writes veteran analyst Howard Penney on Fortune.

Editor's Note: Beleaguered Chipotle reports earnings tonight after the market close. Bulls (and bears) will undoubtedly be focused on the pace of Chipotle's losses following last year's E. coli outbreak. But, as veteran Hedgeye Restaurants analyst Howard Penney writes in Fortune, Chipotle has committed a "fatal mistake" and "massive shareholder value will be destroyed over the next few years."

Penney: The Better Burger Won't Save Chipotle's Investors - fortune chipotle

On Tuesday, the Mexican fast-food chain is expected to report earnings for the first quarter of 2016.

Fast-food chain Chipotle Mexican Grill on Tuesday is expected to report its first quarterly loss as a public company following last year’s E. coli outbreaks that exposed the chain’s health safety issues. Wall Street analysts are estimating a GAAP earnings loss of $1.04 versus $3.88 last year. I suspect the media will focus on Chipotle’s loss and its decline in same-store sales of roughly 30% during the first three months this year. Meanwhile, anyone who is still bullish on Chipotle’s stock will likely focus on the pace of its recovery in same-store sales and the improving profitability over the next two years.

I’m bearish and think massive shareholder value will be destroyed over the next few years. Up until the E. coli outbreak, Chipotle’s management team has never managed a company crisis. They continue to believe consumer attitudes toward the brand have not changed and that customer traffic will return to pre-crisis levels within the next 12 to 24 months.

That outlook is flawed. The fatal mistake the company is making is all about capital deployment. Chipotle ended 2014 with 1,783 stores and $445 million in net income. By the end of 2018, the company’s estimates suggests that they will spend $1.3 billion to add 1,117 new stores, a 62% increase in its store base. The problem is that during the same period between 2014 to 2018, even the most bullish investors of Chipotle estimate that the chain could earn net income of $506 million or incremental net income of $61 million. So if Chipotle invests $1.3 billion in new stores and generate $61 million in incremental new income, that’s a 4.7% return on investment. That is what I call the definition of destruction of shareholder value.

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