A Case For Why Chipotle Shares Could Fall Below $250

The following article is from Hedgeye Risk Management, an independent research firm that publishes long and short reports. The views in this article are the recommendation of Hedgeye and do not reflect those of Benzinga. Hedgeye is not long or short the stocks mentioned.

Chipotle Mexican Grill, Inc. CMG has been on the Hedgeye Best Idea short list for an astonishing 674 days. As one client said, “That’s a lot of hate on one company.”

We’re ready for this to be over so we can move on, but not before it ends with a bang. In honor of the upcoming two-year anniversary in November, we are planning on doing another short thesis deck, including a “Best Of” the past two years section. 

The question we are debating internally is whether or not CMG will hang on as a short to November 14. Oddly enough, Chipotle has not officially scheduled its Q3 earnings release date, but past dates put it around October 24. There is a real possibility that the upcoming earnings release could be a catastrophic event for the company, which would force the investment community to finally realize that Chipotle is just another restaurant company run by a mediocre management team.

The highlight of the “Best Of” section of our upcoming short deck will be the current management team, which has also been our primary reason for staying short for so long. We have argued over the past two years that Chipotle needed a major growth related “reset” and that CEO Steve Ells was a one-trick pony.

Mr. Ells essentially got lucky when McDonald’s invested $50 million into the company back in 1998, and proceeded to infuse ~$360 million into CMG from 1998-2006. 

Over the past two years, Mr. Ells has more than demonstrated that he does not have the right skillset to fix Chipotle and that he has surrounded himself with “friends”, rather than experienced executives trained in how to execute a turnaround strategy.

As a company, Chipotle is ill-prepared to take on the challenge that exists in the current restaurant environment. The company was late to the game when deploying mobile technology to its store base and has no loyalty program to speak of. Today, deploying a digital strategy is a defensive move, not an offensive one.

Until last month, the company did not have a test kitchen that allows for the development of potential new products, and the test kitchen they did open in NYC is open to the public and its competitors. How do you get a competitive advantage over your competition when they can walk right into a store and see and taste what you are testing?

The company was so desperate to get new food news out that they rolled out and touted a queso product with very little consumer testing. For years, Mr. Ells told his personal friends he never wanted to serve queso in his restaurants, and now we know why, as it goes against what the company stands for and seems desperate. Serving queso is CMG’s Hail-Mary play, and odds are that they will not be celebrating in the end zone when it's all said and done.

Furthermore, we still believe CMG is headed to sub-$250 for the following reasons:

• There is no cohesive strategy to fix the brand and the consumer experience.
• Consensus estimates are still too aggressive.
• Same-store sales will decline 1-3 percent for Q3 17 and 4-5 percent for Q4 17. For 2018, same-store sales will decline 1 percent vs. the current 4.2 percent estimate.
• Incremental food and labor costs will continue to put pressure on margins (the short supply environment for avocados continued to pressure food costs in Q2 17).
• The traditional CMG economic model will be impaired for an extended period of time.
• The company will likely announce they are pulling the queso from the stores to reevaluate the flavor profile.
• The company needs to announce a major reduction in unit growth in 2018-19, leading many to question the growth profile of the company.
• Investment to right-size operations could lead to flat EPS growth in 2018.
• Valuation is still unreasonable.
• Management’s credibility is impaired forcing the largest shareholder to respond more aggressively.
• We are inching closer to the day we can pull the SHORT on CMG, but we are not there yet, as hubris still rules at the company.

Howard Penney is a Restaurants analyst at Hedgeye Risk Management.