- Chipotle will struggle with sales following the E. Coli incident.
- However, there's new data suggesting a significant uptick in consumer sentiment around the brand.
- Therefore, I'm forecasting a relatively brisk recovery to sales, which creates a compelling deep recovery play.
I’m initiating coverage on Chipotle Mexican Grill. This isn’t meant to be a preview for Q1’16 results but rather a fundamental break down of revenue/cost drivers for the full duration of the year.
For the most part, Chipotle Mexican Grill (NYSE:CMG) shareholders have struggled this year due to weakening same store sales comps driven by the E. Coli incident in Q4’15. Quite frankly, the impact was significant due to the implied credibility of the brand, which was centered around organics, which is generally perceived to be safer. However, that built-up perception of value/quality/safety has diminished quite significantly, which resulted in 15% comparable restaurant sales declines in Q4’15. The comp sales become crucial to determining margins this year as average unit volumes (AUV) determine break-even for both new and existing restaurants.
There’s a lot of variability to sell side revenue models as revenue has become difficult to model this year. Given the data points provided by third-party surveys, the recovery of same store sales comps has become more predictable. Anticipating a rapid V-shaped recovery seems a bit of a stretch at this point, but comp sales will likely ramp on a q-o-q basis for the duration of FY’16. A decline in consolidated revenue seems unavoidable despite 220 to 235 restaurant openings this year, therefore I’m anticipating comparable restaurant sales to fully recover in FY’17.
Sentiment has become too negative following the breakout of E. Coli, which creates a compelling deep value recovery opportunity despite the cautious tone from the analyst consensus. The stock is 38.13% below its 52-week high, which implies significant upside once operating results recover. While the revenue decline is likely meaningful, the stock is unjustifiably undervalued creating an opportunity for a contrarian call on the company.
Keith Siegner from UBS AG conducted surveys in the past couple weeks, which points to recovering sentiment among the Chipotle customer base with opportunities to further penetrate into older demographics.
Source: UBS Evidence Lab Research
The company seems better positioned to drive store visits among the demographics that matter most (regular customers and medium frequency customers). Therefore, the recovery to same store sales will likely layer on a quarter-by-quarter basis.
The recent survey results compares to prior management commentary on the Q4’15 earnings call:
When we look at the research, we actually saw a falloff in both the top loyal and the new customers, which isn't unexpected with regard to the new customers, they're not as familiar with the brand. We saw a small drop off in that top loyal, so it is definitely one of the targets that we're going after with our proactive communications. They tend to be people that we can communicate with relatively easily via social media, and many of them are part of our mobile and email marketing databases.
Our most current research indicates that 63% of Chipotle customers and 60% of fast casual diners in general are aware of the food-borne illness issues at Chipotle. Of those who are our customers and who are also aware of the issues, right around 60% have indicated that it would cause them to visit less.
Source: UBS Evidence Lab Research
It's hard to make a judgment call here, but we basically went from 60% of customers deciding to visit Chipotle less to now 22%, according to UBS Evidence Lab. This implies a recovery rate of 63%, which I will average over the course of four quarters in conjunction with new sales additions from incremental stores to arrive at my top line revenue forecast. Full normalization seems unlikely over the next 12-months, but a significant recovery to sales should sufficiently drive investor sentiment over the duration of 2016.
I’m anticipating revenue to grow sequentially throughout the year and anticipate a modest revenue beat in the upcoming quarter. Expenses will remain elevated throughout the year. Therefore, investors should anticipate a significant decline to y/y EPS metrics. Even so, I’m fairly confident that visible progress in average restaurant sales along with increasing store count will significantly offset the sales slump.
I’m forecasting revenue of $4.392 billion for FY’16, which is roughly a 2.42% decline and compares to consensus revenue estimates of $4.35 billion. I anticipate diluted EPS of $7.15 for FY’16, which is roughly a 52.63% decline and compares to consensus diluted EPS estimates of $6.13. Despite some recovery in revenue, the expenses will remain elevated as management indicated that there’s going to be a lot of promotional activity. Furthermore, costs for implementing a more rigorous program for food safety adds a couple hundred basis points to costs. The management team also mentioned that they’re not going to adjust or manage staffing levels too significantly, so labor costs will remain elevated this year despite the massive drop-off in revenue.
I believe the consensus is overly conservative here, so there’s a fairly compelling window to capitalize on the stock. After assessing the cost/revenue drivers and arriving at my own forecast assumptions, I’m assigning a price target of $543.11 (75.95x diluted EPS). This translates to 15.73% upside from the time of writing.