Chipotle Investors Need To Learn a Valuable Lesson
You are supposed to pay up for quality. But what if that quality walks out the door?
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On this week’s Power Hour (links above) we of course discussed the surprising Brian Niccol move from Chipotle to Starbucks.
Narasimhan wasn’t that guy, and the board realized it. Although I think they should have realized this much earlier. Triple Shot Reinvention with Two Pumps strategy? Give me a break.
Chipotle is a great business. Is it a wide moat business? No. But it has a great concept and (still) a long runway for reinvestment. Who doesn’t like robotized Mexican slop with an American twist?
However — and this is true for all restaurants — Chipotle needs a high quality CEO at the helm in order to work. This is not a ham sandwich business.
I am not opposed to investing in a company such as Chipotle that demands a good CEO to succeed. This need for a good operator means I need a higher forward return outlook, though, before buying the stock. With more uncertainty requires more upside.
In other words, given the key-man risk, I do not “pay up for quality” with restaurant stocks. I think this is a good rule of thumb to follow.
According to our friends at Finchat.io, since the end of 2021, Chipotle has never traded at a P/E below 40:
The stock has actually done well over this period, mainly because operating margin has expanded from 11% to 17%.
Chipotle has been run flawlessly by Brian Niccol and Jack Hartung (the CFO who just retired). Which is why the stock has still worked over the last few years even if you bought at a nosebleed P/E.
Now, both are gone.
In April, people were saying with a straight face that Chipotle can deliver a 20% IRR over the next five years because they made the math work. Look, I can make the math work for any stock if I predict a high enough earnings growth rate. It doesn’t mean the estimates are based on a sensible view of the potential future scenarios for the business.
To hammer home the point, imagine the below chart as a stock you buy. Historically, it has posted monster returns, but this was not guaranteed. You however believe they were all but guaranteed because of the historical outcome for the stock, and predict the only possible future outcome will therefore be more monster gains.
Many other people come to this worldview, driving the stock up to a P/E of 70 before a meaningless stock split. The shareholders believe the future is guaranteed to be bright because the prior history has been all sunshine and roses.
You don’t sell any shares this whole time.
Then, the company “chooses” the path where Brian Niccol and Jack Hartung leave.
I would like to point out a few things I think investors in Chipotle could be missing by still owning this restaurant at a 50x P/E with the CEO and CFO leaving:
The last few years have been perfection for Chipotle. This was not guaranteed.
Multiple compression has not been a headwind. It will be eventually.
The board of directors are not guaranteed to pick a winner as the next CEO
Operating leverage is possible with wholly-owned restaurant concepts. But it is limited. Chipotle may be reaching its limit.
Restaurant concepts are difficult to grow quickly
Downside risk is always there whether you believe it is or not. With Chipotle, I don’t see anyone considering them.
Hope everyone had a good weekend and survived earnings season!
Brett
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