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No. of Recommendations: 13
I’m pressed for time this week, so I’m going to keep this short and sweet (or at least short ;-).

Chipotle Inc. is a restaurant business with three concepts at the moment: it’s mature namesake burrito business (nearly 1800 locations), a small asian-food business called Shophouse (9 locations), and a brand new pizza concept called Pizzeria Locale (2 locations) as of the end of 2014. The vast majority of locations are in the U.S., but there are handful of Chipotle restaurants in Canada and Europe. All restaurants are company-owned (no franchising).

Chipotle has always distinguished itself by trying to take a fine-dining approach to fast food, using fresh ingredients prepared by hand on-site using traditional cooking methods. It’s able to provide speedy service (up to 300 customers per hour in some locations) through a combination of disciplined organization and a very simple menu with only a few primary options which can then be customized to provide variety. For example, Chipotle's namesake restaurant only serves three major items -- burritos, tacos, and salads -- but it offers many customization options: choices of four different meats or tofu, multiple salsas, two different kinds of beans, optional guacamole, cheese, lettuce, and so on.

The company has further separated itself from the image of traditional fast-food by advertising that it sources its meat and produce from ranches and farms utilizing sustainable, humane, and environmentally friendly practices. It has even stated that it endeavors to source locally when feasible. The company believes that consumers are increasingly concerned about where their food comes from, what’s in it, how it was raised, and the broader impact its production is having on the environment.

Chipotle has combined the above to create a premium fast-casual brand that has fueled rapid growth of its namesake burrito restaurants. In 2011, the company decided that the elements that set Chipotle apart from the competition (fine-dining approach and sustainable sourcing) could be leveraged into additional restaurant concepts, and it started an east-asian chain called Shophouse with that goal in mind. In the last two years it has also formed a partnership to explore a third concept, Pizzeria Locale.

But there are problems. Chipotle has regularly struggled to live up to its promises of sustainable sourcing, often substituting standard products (with signage explaining the situation to customers). In 2014, a huge percentage of restaurants couldn’t offer carnitas because one the company’s major supplier of pork was found in an audit to be violating its standards, and the company had no alternate sources. Furthermore, while the company touts locally-sourced product, it defines local as within 350 miles of a restaurant, and even then it has emerged that it sources 10% or less of its ingredients locally. Finally, despite the marketing, its sourcing standards are arguably somewhat low (for example, not insisting on organic produce or pasture-raised meat), forcing it to walk a fine line between high costs and supply shortages on the one hand, and being accused of green-washing on the other.

Further threatening the brand is a recent E. coli outbreak across multiple states (along with a bit of Norovirus and Salmonella in some areas). Management has been very aggressive at getting in front of these contamination issues, and I believe any consumer fear will blow over with time. But a larger long-term threat comes from changes management is putting in place to avoid future contamination: moving some food preparation out of the stores and to a centralized facility, as well as further reducing its already meager supply of locally-sourced ingredients (which, as an aside, seems like an odd move since the E. coli outbreak was nationwide and therefore unlikely to be the result of local sourcing). Centralized preparation is also a bit of a vote of no-confidence in its store employees, which perhaps is warranted: after re-opening following the E. coli outbreak, a Seattle area restaurant was subsequently shut down by health authorities after three consecutive inspections found red-flag problems with the restaurant’s preparation of meat that continued to be left unresolved.

As mentioned above, the company is already walking a fine line between brand integrity and green-washing, and looking ahead it appears to be moving further away from the integrity of its traditional branding. I don’t necessarily see that as a problem as long the company evolves its brand in a way that continues to resonate with consumers, but that’s going to be a challenge and likely means we’re facing a company at the beginning of a new transitional period. Transitions are always risky, and even successful ones can be rocky at times.

The above probably sounds bearish, but I’m not actually bearish on Chipotle: I’m just neutral. I think there’s a good chance it will move past these issues and go on to resume growth, but I think there’s also a reasonable chance that this transitional period could take longer, or be bumpier, than investors expect, and/or result in slower growth once it does resume. Given that the stock is currently trading at 34 times trailing adjusted EPS — which does not yet incorporate any pain from the E. coli outbreak yet (the company has already warned that same-store-sales have collapsed in the current quarter) — I think it’s possible that significantly better buying opportunities could present themselves if things don’t go completely to plan.

Finally, I suspect that one of the reasons for the high P/E is anticipation of future growth from the company’s new concepts, Shophouse and Pizzeria Locale. But both are predicated on leveraging the competitive pillars of the burrito chain: a fine-dining approach to food preparation coupled with sustainable sourcing, and I see a couple of issues with that. First, we’re now seeing the company take a few steps back from those pillars in the wake of the E. coli outbreak, and the ramifications of that are unknown. But second, even before those changes, Chipotle has consistently struggled to supply its burrito restaurants: is it really feasible that they could rapidly grow a second and even third concept relying on that same approach to sourcing when they can't even consistently supply their primary chain? I note that Shophouse has only expanded to 9 locations since the company started it in 2011, and it’s not like this is their first rodeo. It seems possible that growth of these concepts will be much slower than investors expect simply due to the constraints of the business model.

On the other hand, perhaps the company’s recent steps away from sustainable sourcing and in-house food preparation will largely free it from those growth constraints if it can figure out how to transition its branding to something that still resonates with consumers.


Overall, I’m interested in Chipotle: I think it’s a well-managed restaurant with an intriguing future. But as with any investment, I want to feel that the field is heavily tilted in my favor, and I don't think that's the case today at Chipotle's current value point given that we’re very possibly at the beginning of a transitional period.

My hypothetical real-money portfolio rating: 2.5 stars (out of 5 possible).

My CAPS call: honestly I could see the stock going either way, but since I have to pick: thumbs down (underperforms the market over the next year or so).

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