THE HEDGEYE EDGE
Chipotle Mexican Grill (CMG), the one-time restaurant “insurgent”, will recover to become a “scale insurgent.” Nearly all of the country’s best restaurant brands have suffered a down cycle, only to go on to recover and become better than the previous iteration; and we believe that CMG will be no different.
Chipotle CEO Brian Niccol will be the key component in the greatest turnaround the industry has ever seen. A company’s culture begins with its values, and step one for CMG, and its new CEO, will be to obsess over the customer and instill a new set of values that inspire and re-invigorate the employee base.
The issues that CMG faces are not terminal and can be remedied. In order to move out of the free fall phase, the company needs to re-discover the love of “fast food with integrity.” The company must once again serve food that consumers can feel comfortable eating.
INTERMEDIATE TERM (TREND)
The issue is not if Chipotle has the opportunity to grow, but rather how fast the company should be growing. According to the book, The Founder’s Mentality, “Growth creates complexity, and complexity is the silent killer of growth.”
Understanding what happened to Chipotle is the key to what the company must do next:
- Overload: Overload afflicts growing companies that have failed to prepare adequately on the inside for the strains of size and complexity. CMG was… trying to rapidly scale natural & organic/non-GMO food to thousands of units had unique challenges that went unmet.
- Stall Out: The rapid growth gives rise to organizational complexity and dilutes the mission that defined the company. CMG had…inefficient planning to deliver the quality food it had promised to deliver to the consumer. In the years before the incident, CMG had significant supply chain issues
- Free Fall: A company in free fall has completely stopped growing in its core market, and its business model suddenly no longer seems viable. Time feels scarce for a company in free fall. CMG’s… supply chain issues manifested into a brand crisis of epic proportions. The foodborne illness crisis damaged consumer trust in the brand and thus the financial model of the company.
The issues CMG faced heading into the downfall have occurred at other great companies, including companies not in the restaurant space. CMG should cut unit growth, to improve returns and cash flow. The change to incentive compensation signals strategic shift to the company focusing on 4-wall profitability.
TIME FOR A STRATEGIC PIVOT
All signals coming from CMG are that we will see store growth slow as the company focuses on 4-wall profitability. The fastest way to a sustained recovery in profitability is a sustained recovery in average unit volumes, and slowing unit growth is a critical component in that effort. Another benefit to slowing unit growth is a reduced pressure on the labor pool and reduced G&A costs. As CFO Jack Hartung said, “we really have to allow our 70,000 employees out there to focus on the existing restaurants”… Amen to that!
OBSESS OVER THE FRONTLINE
A combination of obsessing over the food and the frontline will drive average unit volumes back toward $2.5 million. While historical peak margins and AUVs will likely not happen anytime soon, the historical averages are not out of the question! CMG hit a peak EBITDA margin of 20% in FY14, and a low of 4.9% in 2016. Going back to 1Q08, CMG has an average EBITDA margin of 16.2%. Getting AUV’s back is a first priority, and that in and of itself will drive margins higher.
THOUGHTS ON THE PRINT
Comps came in at an impressive +2.2% vs FactSet +1.3%, as the company saw check increase by 5% and traffic fall by approximately -3.3%. However, despite the lackluster traffic figure, we are very optimistic, as the new-look management team has not had an opportunity to implement any traffic driving initiatives. Restaurant level margin for the quarter was 19.5%, compared to 17.7% in the same period a year ago. According to the management team, the current restaurant level margin guidance of 17.5% - 18.5% is conservative, as beating it is well within the realm of possibility. As the company reevaluates spending habits and redirects capex to more impactful / higher return initiatives, we can expect margins to reach our 2020 target of 21-22%.
Laying out a preliminary version of the brand’s new way ahead, we were happy to see that many of the management team’s key points mirrored what we laid out above. Going forward, a focus on the frontline and simple blocking and tackling within the four walls will keep the brand on course in the near term.
With a strategic pivot underway, we are confident that CMG will ride this wave to become a scale insurgent and create significant value for shareholders. Over the next 12-18 months CMG shares could be up 30%+.