At the pinnacle of Wall Street’s love affair with Chipotle Mexican Grill (NYSE:CMG), it seemed the restaurant chain could do no wrong. After debuting in an enormously successful IPO in 2006, the stock rose nearly 1,500 percent over the next nine and a half years. That’s not to say there weren’t any downs-the company lost 70 percent of its market value during the late-2000s recession, only to later embark on an epic rise. Chipotle again suffered a steep decline of 45 percent in 2012 amid concerns of slowing growth and an attack from famed short seller David Einhorn. Within a few years, it had tripled off the low to a high of over $740 a share, and Einhorn quietly covered his failed short.

But the biggest publicity of the past ten years has been reserved for Chipotle’s apparent fall from grace in 2015. The story of a company built on the slogan “Food with Integrity” weathering a food poisoning scandal proved irresistible to the media. The company had grappled with food safety in the past, but the problem finally came to public attention after a string of high profile incidents beginning two years ago. The papers seemed to blare a fresh headline every week. E-coli! Norovirus! Salmonella! Business at once busy restaurants with lines out the door slowed to a trickle. The stock plunged over 50 percent to a low of $360, and as of this writing has climbed only slightly to $409.

Will the company be able to return to growth? Is the stock fairly priced at $409? How did Chipotle become so successful in the first place?

The Art of the Burrito

Chipotle was founded in 1993 by classically-trained chef Steve Ells, who clearly did not foresee just how popular the concept would become. Initially Ells intended to use the first store’s profits to pursue his dream of opening a high-end restaurant, but he eventually abandoned that idea when the little burrito joint turned into a huge success. By 1998, the 16 store chain had attracted the attention of McDonald’s (NYSE:MCD), whose investment allowed Chipotle to expand rapidly to 500 stores by 2005. While that capital injection allowed Chipotle to become a nationally-known brand, the chain’s success is rooted in its many innovations to fast food.

Let’s start with the food itself. Chipotle’s rise took place amid an immense shift in consumer attitude toward food, especially at the quick service level. Factory farms, genetically-modified crops, artificial preservatives, and heavy sugar content have all come under heavy fire from activists. Documentaries such as Super Size Me and Food, Inc. rocked the fast food industry in the same manner as Upton Sinclair’s 1906 book The Jungle, further cementing a negative view of fast food into the public consciousness. Ells’s vision of a fast food experience where customers consumed fresh, organic, and locally-sourced ingredients prepared onsite turned out to be incredibly well-timed. The company’s all-natural brand led to the perception of its food being healthier than the typical fast food conglomerate.

Two unique aspects of the preparation process underscore Chipotle’s wholesome self-image. Whereas most other restaurants carry out their operations in a back room away from prying eyes, Chipotle’s open kitchen format allows customers to watch their meal being prepared. What other mass-market chain lets customers view its workers putting an entire block of cheese into a grater? Where else can a customer see their steak sizzling on the grill? Even today it’s a rare sight.

Then there is the assembly line, which goes hand-in-hand with the restaurant’s simple menu. It can’t be stressed enough how much this innovation is integral to Chipotle’s appeal, especially since it often flies right over Wall Street’s head. First, the assembly line gives customers a measure of control over what goes into every burrito or taco. Although I can’t prove it, my own experience is that Chipotle is a favorite of gym rats and dieters who want to customize meals. The chain delights in touting its tens of thousands of possible combinations, and Walter Hickey over at Business Insider claims that the number is over 650,000 (depending on how you differentiate the ingredients).

At the same time, the assembly line format makes it astoundingly simple to order a meal. The menu board need only contain the four “builds” (burrito, bowl, tacos, or salad), the prices of the meats, and a few extras like chips and drinks. Most stores also have an additional panel or two advertising a special or a kids menu. The simplicity echoes the success of the In-N-Out Burger chain out West, which has thrived for nearly 70 years and built a cult following on a limited menu of simple burgers, fries, and shakes.

Once upon a time most fast food chains featured simple menus, but in true stupidity the corporate bureaucrats insisted on cramming in as many items as possible. The complexity reduced the operational efficiency of the kitchens while also stressing out customers who have a difficult time navigating the menu. Ells and Chipotle frequently stress in the annual reports that the company remains committed to its less is more philosophy. New offerings are introduced infrequently, and only after much consideration.

Another item often overlooked by analysts is the physical look and feel of the restaurant. Chipotle exudes modern industrial vibe, bursting with exposed pipes, brushed metal, and finished with light-colored wood reminiscent of IKEA. In the early days, Ells designed and built many of the fixtures with his own hands, but today there is an entire team of people dedicated to bringing Chipotle’s signature style to every new store. The contemporary, minimalist look accentuates the simple yet superior experience that the restaurant seeks to deliver to customers. Chipotle takes the physical layout of its stores so seriously that they actually trademarked the design. Even the paper takeout bags are a nice touch, often featuring prose and artwork commissioned by the company. Like Apple, the company’s spiritual sister in the computer industry, the entire Chipotle experience is designed to make the product feel special, and yet it is an indulgence available to the masses. Maybe Chipotle didn’t invent the “fast casual” format, but they certainly made it what it is today.

Food Safety Crisis

For most part, all was going well until 2015. The company’s fast casual concept, timely branding, and superior customer experience allowed it to weather an industry downturn during the Recession that drove several sit-down chains into bankruptcy. Aside from Einhorn’s completely ridiculous short thesis in 2012 (comparing Chipotle to Taco Bell? Really?), the stock continued to climb unobstructed. That is, until the food safety scandals that hit the company in 2015. I won’t waste time recounting what happened, so let’s get right to the damage. Revenue plummeted 14 percent, and same store sales growth clocked in at a pitiful -30 percent in the first quarter of 2016.

The company’s reaction was satisfactory but sometimes jumbled. In an unprecedented move, all Chipotle locations were shuttered and strict safety protocols were enacted. Steve Ells went on the Today show and claimed that Chipotle would be the “safest place to eat” after the cleanup. Yet, the perception among analysts was that the company bungled its response. It continued with its plans to open new stores in the midst of the crisis, prompting complaints about a lack of focus. A campaign of free food ended up being costly and largely ineffective, and the company has lurched from one initiative to another with little coherence or tangency. More recent criticism has focused on Chipotle’s board, which is seen as too friendly toward management. The company’s unusual arrangement where Steve Ells and Monty Moran served as co-CEOs also came under fire, and a month ago it was announced that Moran would step down and leave Ells as the sole leader. Activist investor Bill Ackman also injected himself into the debate after his hedge fund purchased a $1.2 billion stake in the company, his intentions still largely unclear.

Here’s the thing: this fretting and hand-wringing is all for nothing.

Food poisoning at a national chain is not an unprecedented event. Take Jack in the Box (NASDAQ:JACK) circa 1993, which experienced an E. coli outbreak that killed four children and sickened hundreds more. Under pressure to meet demand for a special promotion, the company’s restaurants let safety concerns slide. This somewhat mirrors Chipotle’s own situation, which I will get to later. As James Surowiecki writes at The New Yorker, the company’s initial reaction was a textbook case of what not to do in reaction to a food safety scare-first do nothing, then blame the meat distributer. Although Jack in the Box ultimately made a total about-face and implemented vigorous safety protocols, the company lost money for two years following the incident.

There are two important points here. First, Chipotle at least reacted proactively, and fortunately nobody died. Second, Jack in the Box’s sales eventually made a full recovery. From a psychological standpoint, the initial fall in sales followed by a slow recovery makes sense. Daniel Kahneman and Amos Tversky’s influential prospect theory describes how people tend to be more sensitive to the possibility of loss, which explains why customers avoided Chipotle in droves even though the probability of contracting an illness on any given trip was astronomically low. The good news for Chipotle, as demonstrated by other food safety scares, is that memory of the incident will ultimately fade and customers will resume their previous behavior.

Show Me the Money!

Now that I’ve spent sufficient time waxing poetic about Chipotle’s brand and examining the food poisoning crisis, it’s time to get down to the numbers. First of all, Chipotle is a straight up cash machine. From 2009 until the food poisoning scandal, gross margins and ROE both averaged well over 20 percent, generating free cash flow on the order of 10 percent of revenue. Following the IPO, expansion has been funded entirely from the chain’s earnings. The $12 billion dollar company’s strong balance sheet shows over $350 million in cash and zero debt. Chipotle has eschewed franchising; all profits and losses accrue directly to the company, meaning that analyzing this company is relatively simple.

If we assume, as I argue is reasonable, that Chipotle’s sales and profitability will soon return to prior levels, then taking a look at the counterfactual could provide some measure of the company’s true value. That is, how much would Chipotle be worth now if the food safety crisis never happened? Let’s do the math. In 2014, Chipotle was raking in about $2.3 million in sales annually per store on average, so assume that gets multiplied by the 2,200 locations they have today. Revenue in this alternate history comes out to $5 billion versus the $3.8 billion that the company actually earned. The rest of the calculation involves using the pre-crisis margins to determine the cost of goods sold plus various other expense lines. Operating profit under this scenario amounts to $870 million for a net income of $543 million. To get a sense of what the earnings multiple should be, divide the net income into the current market capitalization.

The answer? A mere 22.

While an attractive figure, this isn’t enough to declare victory and rush to the broker with a buy order. Even without the food safety crisis, Chipotle might have been overvalued at 50 times earnings. It is difficult to tell how much of the company’s current malaise is due to lingering effects of the crisis and how is attributable to a slowdown in sales that would have happened anyway, which brings us to the next topic of analysis.

Future Growth

Chipotle’s revenue expansion is basically a function of both new store openings and same store sales growth. Regarding the former, assume a future where Chipotle’s nationwide popularity reaches the level of its Colorado stronghold, where the number of Chipotle restaurants per capita is the highest among the 50 states. Solving for store count in each state, it turns out that the country could support about 4,300 restaurants in this best-case scenario. And that’s not even counting the international market, where the overall revenue contribution is still barely perceptible. Again, I can’t prove this scientifically, but Chipotle is very popular among the Chinese expats I know. The small, chopped bits of meat found in Chipotle dishes are the norm in China (rather than huge slabs that require a knife and fork). The “food with integrity” branding, if the company could credibly pull it off in the Middle Kingdom, also holds potential in a country beset by constant food safety scandals.

The other potential font for revenue, same store sales, is now tied to operational efficiencies. Here I see a lot of room for improvement. The huge lines at its more popular locations are a positive sign, yet a long wait means that the store forgoes sales when people are unable to wait a half hour for lunch. The laws of economics will eventually limit on productivity growth, but I still see a few opportunities.

To paraphrase George Lucas’s quote on Jar Jar Binks, online ordering is the key to all of this, if they can get it working. The problem is that stores aren’t formatted for pickup. Supposedly the company is trying to create a separate prep area in the back of each store for online orders, but I still see customers come in for pickup to find that their online orders aren’t ready. Moreover, the stores don’t clearly indicate how customers should handle pickup. During my first online pickup, I actually waited in the order line only to find out that I could have bypassed it. There is no signage telling online customers where to go, nor is there a separate register to ring up these orders. Chipotle’s rapid fire assembly also makes butting in to pick up an online order rather awkward. It seems that in the company’s rush to get into online ordering, they forgot all about execution. Over time I think this can and will be fixed, though, because the solutions are fairly obvious.

Competition and Threats

Of course, all of this hypothetical growth could be stymied by the always unpredictable competition factor. Will this seriously damage Chipotle’s prospects? So far it has not, although many chains are vying for the title of “Chipotle of [Whatever].” Even Chipotle briefly entered the race to develop the next Chipotle with its chain of ShopHouse Asian Kitchen restaurants serving Southeast Asian-style fare. But capturing the magic that made Chipotle such a beloved brand is a difficult proposition indeed. Sure, there will be other chains that succeed in the same space, just as McDonald’s had plenty of competitors in its early days. Chipotle has Qdoba and Moe’s nipping at its heels, but these competitors serve up a very different experience. With so much startup capital floating around these days, it seems likely that other budding brands will expand into billion-dollar empires, but I have yet to see one that matches Chipotle in all of the aspects that I described in the first section.

In many ways, the main danger to Chipotle’s brand is itself. Chipotle’s promotion system is notable in that it establishes a process for building ordinary but high-performing hourly employees into full-time managers. Austin Carr’s excellent piece in Fast Company sheds a great deal of light on Chipotle’s operations, which until a month ago was Moran’s domain. I highly encourage anyone reading this to check out Carr’s article, so I won’t recount it here. But I think it suffices to say that Moran’s lauded evaluation system for employees instilled a somewhat poisonous, stuffy corporate culture that might have contributed to the crisis. Where the E. coli came from will remain a mystery, but we know that the norovirus outbreaks came from sick employees. Why were these people on the job while sick? As the Fast Company article details, Chipotle puts incredible pressure on its management and employees. Turnover is high, which means the company constantly hires new employees not yet schooled in food safety. It also wouldn’t surprise me if employees felt obligated to come in to work even while sick (when I once tried to call out sick on a busy day at my teenage grocery store job, the manager told me to “take a Tylenol” and come into work anyway).

But now Moran is out, and a few weeks after that announcement Ells went on record saying that the restauranteur program had become mired in bureaucracy. Although the company didn’t say it, I suspect that Moran’s sudden departure had a lot to do with the chain’s operational failures. While Chipotle enjoyed enormous success, the flaws in Moran’s organization could be ignored. It was only when the tide went out that observers discovered that many people were swimming with no clothes. Whatever his initial contribution to Chipotle’s rise, Moran clearly needed to go.

Conclusion

Despite all of the upheaval, Ells remains in charge of the company. Like Steve Jobs at Apple, Ells is a sort of spiritual guide for Chipotle, and for years he has remained dedicated to a brilliant vision while batting down competing ideas. The chain owes a great deal of its success to rejecting dumb ideas as much as implementing good ones. In the company’s early years, Ells resisted the drive-thrus and rapid international expansion favored by majority owner McDonald’s. He has consistently rejected new menu items that didn’t meet his standards while other restaurants have shoved in as much as possible. If there is anyone who can focus on where Chipotle needs to go, it is the founder himself. The company’s renewed commitment to issues of operation and culture is a positive sign, as is its decision to sell the ShopHouse chain and concentrate on the core Chipotle brand.

The aspects of the company that made it such a success in the first place certainly are not going away. Shares are fairly valued at current levels, and may even be substantially undervalued if future growth materializes at the levels I discussed. Judging by the growth of other international chains, it wouldn’t surprise me to see Chipotle become a $50-80 billion company over the long term. At the very least I think we will witness a recovery to $18-20 billion in the not so far future.

In my opinion, investors should be looking at the current Chipotle instead of searching for the next Chipotle. Therefore, I recommend buying this stock at current levels, which I myself have already been doing for some time.

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