A former Wall Street analyst discloses the topics that equity analysts and hedge fund managers are currently talking about. 

Chipotle (CMG) has been through quite a wild ride over the last several years. Prior to the health safety issues, the stock was facing slowing sales and maturation questions, and the stock was hovering in the $600s. However, as was well-reported, the company went through a series of food safety issues, and the stock declined towards the $400s. 

As I wrote about ~6 months ago, the key debate on Chipotle was whether the company was going to return to prior restaurant level volumes over time as customers return to the store, or if it was going to see a smaller degree of recovery.

So what are the key debates on CMG today, almost 1 year into its recovery?

Bears See Increased Competition and A Difficult Path Back Towards Prior Margin Levels

The bear thesis is that sales will struggle due to a more competitive environment, and margins will struggle as well as Chipotle's expenses are now higher with a lower base of sales.

Environment has become more competitive

Bears believe that the competitive landscape has changed drastically since the days when Chipotle was reporting double digit comps in 2014. Chipotle sales climbed higher on the strength of a brand that offered healthy, affordable, and tasty food. However, new options have popped up over the years that have had similar food service models, including:

• Healthy eating: Dig Inn, sweetgreen, LYFE Kitchen, and freshii
• Burgers: Shake Shack, Five Guys, Habit Burger, Smashburger, and hopdoddy
• Pizza: MOD and Blaze Pizza
• Subs and sandwiches: Jimmy Johns and Jersey Mikes

Outside of quick-service restaurants (QSRs), there has also been increased competition for consumer's stomachs through prepared meals for pick-up (at Whole Foods, for example) or through more home delivery options (Seamless, Blue Apron, Postmates, etc.).

Ultimately, consumers now have more options to eat healthily than ever before. And while Chipotle may have weathered this in the past through a loyal customer base, the health safety disruptions presented consumers the opportunity to try out some of these other food options and become frequent visitors elsewhere. Bears believe that many consumers will now not be coming back to Chipotle.

So far, this thesis has been supported by a recovery that has been more muted than expected. For the last four quarters, Chipotle's comps have fallen short of consensus estimates.

Chipotle has worked hard to try to get customers to come back into the store. The company ran a number of promotions, including its first customer loyalty program, Chiptopia, as well as a free burrito promotion last year. Additionally, the company rolled out a new meat, chorizo, to stores. These efforts have not helped the company meet investors' expectations however, and have further built up support for the bear thesis.

Chipotle's recovery has lagged other similar situations

As I had mentioned in my prior note, many other quick-service restaurants have had health outbreaks, and many of these restaurants began to recover to prior volumes after a year or so. Taco Bell, Jimmy Johns, Jack in the Box, Wendy's, and other restaurants have all had health safety issues in the past. Generally, comps at these concepts declined in the teens for a year before recovering at mid- to high-single digits in the following year. Essentially, restaurants were able to quickly put the incident behind them. Today, it's not likely that many of us will even remember these health incidents at any of these chains.

Again, as highlighted in sales trends above, this hasn't exactly happened in Chipotle's case. Bears have noted that today's environment is different, not just in competitors, but also in how information is translated and conveyed. Social media and the internet has made news travel much faster and more pervasively. Group think has become more dominant. And some bears believe that, due to the attention from social media, would-be customers have been turned off to a greater degree than in the past, especially given that Chipotle's brand has been built upon quality ingredients. This may have contributed to the more severe sales disruption, and to what many investors have perceived to be a slower-than-anticipated recovery.

Bears believe sales will struggle to sustain mid-single digit comps longer-term

Going forward, the company will be lapping very easy comparisons, which should help CMG post stronger comps in the coming quarters off of a lower base. However, the key question for bears is whether it will be sustainable beyond next quarter. Bears believe that given the competitive environment, the recovery will continue as it has; sluggishly and underwhelmingly. Comps will likely spike upwards in 1Q (simply due to the math) but afterwards may languish in the mid-single digits or lower (consensus estimates currently sit in the low mid-single digits), and average unit volumes (average sales at each store) may fall well-short of the prior $2.5m peak.

Restaurant margins may not recover above the low 20s

Bears also believe that profitability will struggle to recover to prior levels. When discussing Chipotle's profitability, investors primarily look at restaurant-level operating margin, which is essentially profitability at a store level. With sales recovering sluggishly, bears believe that restaurant margins will not recover to its prior 26-27% peak restaurant operating margin, and may not even return to 22-24% levels (where consensus estimates currently have CMG moving towards), for several reasons:

1. Several costs are now higher than in the past, including labor, food costs, and handling for food safety procedures
2. With the brand now tarnished, the company will need to invest more in marketing and promotions to drive traffic back to the store. Efforts have not fully paid off, and further efforts will likely dilute margins even further
3. As will be detailed later, bulls believe a price increase will be instituted given the increase in food prices. However, bears believe that the price increase will not be received well by customers with sales still struggling, and that much of it will not fall to the bottom line (and will have to be reinvested in the form of discounts and promotions)

Store openings could slow

With lower sales per store than expected, and efforts on turning the core business around not paying dividends, bears believe store openings may also begin to slow. Investors currently expect management to open 9.0% more stores in 2017 and 8.4% in 2018.  However, if unit volumes and new store productivity do not turn higher, management may be forced to slow store openings even further.

Valuation Suggests Fair Value of  ~$250 - $350

With uninspiring comps, lower store openings, and a sluggish margin recovery that suggests that mid 20s may not be possible, bears believe that investors will recalibrate their future projections for the company downward and reevaluate the multiple on the stock. Using inputs that align with this scenario would generate 2019 EPS of ~$13, a multiple at the low end of their trading ranges (~25x), and a target price somewhere in the ~$250 - $350 range. 

Bull case points to high likelihood of improving margins and gradually improving sales trends

Sales trends to improve as customers gradually come back and initiatives play out

Bulls believe that, while the recovery has been sluggish, they have trended in the right direction. And over time, as the company puts the health issues behind them, customers will gradually come back and visit Chipotle again with more frequency. Continued marketing promotions will help, as will several operational tactics, such as online catering, digital ordering, and a 2nd make line. Many of these initiatives are designed to improve their strong throughput (number of customers that can be served within a specified time), which should help both sales and margins.

Bulls would look to those same health incidents at other chains and note that volumes have recovered eventually. While social media has changed things somewhat, customers will eventually put the incidents behind them, as they always have. And as they come back to Chipotle, they will become frequent customers again as Chipotle develops a more consistent track record in their minds.

In the near-term, bulls see comps of high-single digits in 2017 (hitting management's guidance) and a return to $2m in average unit volumes. This seems more than achievable given recent near-term data points. This gets a bit complicated, so stay with me; the details matter as it gives investors confidence that the company can achieve mid-teen comps in 1Q, and sustain high-single digit comps for the rest of the year. In the investing world in general, and in retail in particular, a lot of attention is paid to comparisons - the growth rate in the prior year that the current period will be growing off of (growth rates are frequently reported as year-over-year and not quarter-over-quarter due to seasonality). This is because the math suggests that it is easier to report a higher growth rate off of a lower prior year number.

So here's the math. The Company posted a -4.8% comp in 4Q16 on a -14.6% comparison (that was their growth rate in 4Q15). In 1Q17, the company will be facing its easiest comparison of -29.7%, which should help the growth rate from a pure mathematical standpoint.  By month, management noted that CMG had posted a +14.7% comp in December on a -30% comparison. In January, the comp improved to +24.6% on a -36% comparison last year. Management noted that this was especially impressive given that January was their lowest promotional month. Going forward, the comparisons in February and March will become a bit more difficult at -26% but will remain soft relative to the prior quarter. As a result of these data points, investors are confident that the company will be able to achieve a mid-teen comp with more marketing activity.

Beyond that point, bulls believe comps will be stronger in the upper mid-single digit range and could return at least to the $2.25m level (not quite at peak levels, but a strong level nonetheless).

Strong margin recovery likely

On margins, bulls believe that as the company approaches $2m in average unit volumes (sales per store), Chipotle will be able to get margins back to the 20s. With the initiatives in place above, the company can achieve even higher throughput levels, which should help both sales and margins.

In the absence of a stronger sales recovery, bulls believe that the company will still be able to achieve improved restaurant margin targets for several reasons. Primarily, the company has already shown that they can achieve margins well into the 20s on lower unit volumes (see chart below). The company has historically been able to generate higher unit margins in a smaller store format than other quick service restaurants. While the headwinds noted above by bears are valid, the company was able to achieve 26% restaurant margins in 2011 on $2m unit volumes.  Even if they spot the company 3-4 percentage points due to the headwinds mentioned above, that would suggest potential operating margins in the low 20s.

With that base, the company should also benefit from several other investments that they are making, most notably in digital. In terms of the benefits, with a second make line that will be largely devoted to fulfilling online orders, the company should be able to generate better unit margins. Additionally, the company has launched online catering, which has demonstrated significant top-line benefits at other QSRs.

On the cost front, the company's IT investments appear to already be in the later innings as the company has already begun to see returns on their investments without a significant impact on their financials. While some bears have drawn the analogy to Panera and their IT investments (which dragged company margins down for several years), it appears that the magnitude of the drag will not be as significant for Chipotle. One reason is that the company has stated their plans to use third party providers for services such as delivery (i.e. Postmates), which should help limit IT investment further.

The company has several other initiatives underway that are expected to drive incremental sales and margin benefits. For example, the company will be launching an extensive marketing campaign in April and has continued to push heavily here to get more customers into stores. Additionally, management continues to optimize labor scheduling; Chipotle noted that at peak hours, the company is generally short one worker, whereas during off-peak hours, they have extra crew members. Optimizing labor efforts should improve sales and margins over time.

Finally, bulls believe that Chipotle will implement a price increase later this year, which should alleviate margin pressures from rising food costs. Bulls believe that these price increases will largely expand margins and fall to the bottom line.

Bulls see valuation supportive of a $500 - $600 stock

Bulls see a scenario in which Chipotle's customers begin to come back to stores, sending sales back on a visible trajectory to prior levels before the health incidents. In such a scenario, margin is likely to expand and approach mid 20s, which would generate strong earnings growth and justify a higher multiple in line with its historical averages of ~35x. These inputs would suggest Chipotle is worth somewhere between $500 and $600.

Focus remains on whether Chipotle can get customers to come back

Going forward, the key will be how customers respond to Chipotle's initiatives - will they come back, or will they go to some of the other options that are sprouting up? Keep an eye on comps and restaurant margins as they will tell you where the stock is going next.