Editor's Note: The following note written by Hedgeye Managing Director Howard Penney (originally entitled CMG | This Is Why I Play) was sent to our institutional subscribers yesterday. It was written in response to news that activist investor Bill Ackman's Pershing Square has taken a 9.9% stake in Chipotle. Email firstname.lastname@example.org for more info on Penney's research.
Chipotle (CMG) is on the Hedgeye Best Ideas list a as a SHORT.
Obviously, the fact that Pershing filed a position in CMG does not change my short thesis overnight. Should I try to understand their bull case? Absolutely! I hope one day we can meet to talk about what they see that I don’t.
I have a good track record in sniffing out when activists are going to get involved in a restaurant name, but I clearly missed this one. As I see it, CMG does not have the common traits of an activist name.
First, there is no real estate to sell or significant non-core assets to sell like in Darden. The G&A is fairly lean given it’s a growth restaurant company and management is loved by shareholders. According to the proxy vote, Chipotle's co-CEOs, including founder Steve Ells, were reelected and received more than 95% of the shareholders' votes.
CMG has no funded debt, so we could see him push to leverage the company and buy back stock, but that is just financial engineering and will not get anyone very excited. The company has previously announced they are looking for a new board member so I’m sure the new shareholder will be happy to help in that regard and maybe a few other corporate governance issues.
Pershing’s big wins in the restaurant space were WEN, MCD, and QSR. In the case of WEN, at the time of the investment the Tim Horton business represented the entire vale of the company so you were getting the Wendy’s business for free. The MCD story was to refranchise the company store base and spin it out as a separate business. The deal never happened but the stock worked any way (the turnaround was well underway). QSR story was a straight sell all company stores and become an asset light model. This was a home run!
An asset light business model was the common characteristic of all three of Pershing’s previous restaurant investments. The “asset light models” are clearly the safest way to invest in the restaurant space. Obviously, CMG is anything but an asset light model and will likely never become one as it is not in their DNA. Converting CMG to an asset light model would be very expensive and dilutive to EPS.
As with most activist situations, that leaves the Pershing investment in CMG dependent on an operational turnaround as the way to create significant shareholder value. While they are familiar with the industry, rarely can an activist be much help in fixing operations. In most cases, the activist’s ideas are short term in nature to get a pop in the stock and then they are gone.
Putting it all together, this leaves me to conclude they see a big operational turnaround as the way to make money in CMG. This thought process is confirmed by the 13D. According to the 13D "Pershing argues Chipotle has "a strong brand, differentiated offering, enormous growth opportunity, and visionary leadership."
Let’s take these one by one:
- A strong brand – I agree it’s a strong brand and one day it may return to the glory days but that is going to take time and will require an investment in better advertising.
- Differentiated offering – That may have been true 10 years ago, but the rest of the industry is catching up. We made this point in the CMG black book.
- Enormous growth opportunity - Could CMG double its store base from here? Yes! Right now the company needs to slow growth, fix operations and repair the brand. The law of diminishing returns is impacting the numbers. Importantly, there is a lack of great real estate right now and it’s getting too expensive to grow.
- Visionary leadership – I agree that Steve Ells is a visionary, but it ends there. Being a visionary will not get the company out of the problems they are experiencing today. The company needs new management to help get it to a better place. I have no doubt Pershing can help in this regard, but replacing the founder is going to be very difficult!
The Pershing investment does not change my thesis for the time being, but I have been put on notice. As we noted in our CMG deck, the FDA’s Office of Criminal Investigation does not get involved with many companies and when they do its usually a serious situation. I’m very surprised Pershing stepped in front of this ticking time bomb. On the other hand, if criminal charges are brought against some CMG executives, Pershing will have an easier time finding a new management team.
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