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  • KPB & Co Research

Chipotle's (NYSE: CMG) stock price has more than doubled since the new CEO - Brian Niccol - took the helm in early 2018, as anxious investors BUY on the fear of missing out on what is called the "greatest comeback story the industry has ever seen". To some extent, I can't blame investors on being somewhat optimistic about this story, as there have been a number of positive news coming out since the new CEO took office. There have been fairly stable comparable sales growth at around 2%-3%, 8% overall revenue growth, and restaurant level margins also improved 2 percentage points to 19.3% (though company level margins remained far lower). However, as we look into what has actually transpired, we think that a true turn around is still 1-3 years away. Buying too early can leave investors significantly exposed should the stock re-trace.

Positive News ARE Based on One-off Events

The current management team at Chipotle has been riding high off the benefit of initiatives that were largely implemented during the Steve Ells era. Steve Ells resigned in late 2017 after overseeing several menu price increases of around 5%, which took effect fully in 2018. At around September 2017, the queso cheese dip was added to the menu, which had early success and was revamped around December-2017. The point this history lesson is to highlight the fact that actions taken in 2017 would make it appear that the business was turning the corner in 2018, as they would certainly lead to bigger comparable store sales. In light of the fact that these initiatives will likely not recur for some time in the future, we think that there are a number of steps to climb before everything goes back to normal. In fact, many of the key issues that pushed the company off the rails - the outbreak of Escherichia coli (E-coli) continues to plague the company. There was an incident in September 2017, and another mid-2018 both of which had wide public attention.

Sales growth overall was strong on account of the continued build-out of stores across the US. During fiscal year 2018, the company opened 97 new restaurants on a total restaurant base of 2,463 (approx 4%). The company mentioned that they closed or relocated 42 stores, most of which we think were relocated. They also did not speak to the average size of each store opened, but we think they will be the same or larger. The company expects to open between 145 to 150 new stores in 2019. While these new stores help to keep the sales growth fairly decent, they come at a huge expense to shareholders. New stores are operating at lower margins than historical norms as the brand continues to face challenges in midst of continued health issue.

Margins Have Not Fully Recovered

Margin Outlook Can Be Challenging Depending on The Economy

Depending on the state of the US economy during the upcoming year, Chipotle could see increased margin pressure. The primary drivers of Chipotle's cost are food beverages and packaging, and labour of which labour is subjected to significant increase over the coming year. Labour market conditions have been tight leading to wage inflationary pressure exceeding 2% for some regions in the USA. As long economic conditions remain strong, wage inflation could continue to eat away at restaurant level operating margins. In a scenario where economic conditions soften wage pressures may abate. Food cost inflation is driven primarily by the cost of avocado, and beef. In recent times, the cost avocado have declined due to a normalization of supply constraints, and this may continue for sometime. Going forward, according to World Agricultural Outlook Board the the price of beef should decline owing also to improving supply conditions. The over overall impact could be a slight headwind on margins as labour accounts for 26% of the total cost while food takes up a fraction of the 34% that is due to food, beverages, and packaging. Our estimates indicate that food accounts for slightly more than half of the amount that is due to the category of food, beverages and packaging.

Chipotle is one of those companies that have good long term value, but a lot depends on managements ability to recover from the current crisis of confidence plaguing the brand. The new management team has implemented quite a few strategies to jump-start sales, including a partnership with door dash, and implementing the second make line. Nevertheless, the number shows that a lot of work needs to be done to get the business back on track. We think the recent stock moves have fully accounted for recovery without any tangible sustainable evidence of a recovery happening. Over the course of the coming year, the price could adjust downwards to reflect a much more somber outlook.

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