Last week we discussed what it means to be a contrarian investor. And why, when done successfully, it can lead to substantial market outperformance.
Today we are going to discuss a specific contrarian opportunity in the chain restaurant business.
If you haven’t already guessed, I’m talking about investing in shares of burrito chain Chipotle Mexican Grill (ticker CMG).
Over the last 15 months, shares have suffered a -50% slide falling from a high of $758 a share to a low of $352, where they still hover near today.
This collapse is mostly connected with a food-safety crisis centered around an E. coli outbreak which has sickened 485 people in 13 US states, and caused same-store sales to drop 21.9% in the three month period ending September 30.
Other less critical issues also plague the share price such as “smaller than average” per restaurant cheques, a deferral the company took in connection with unredeemed Chiptopia rewards, and a generally sluggish environment for fast-casual restaurants.
But this is precisely why I believe there is such a fantastic opportunity to earn market beating returns by investing in Chipotle while the company is down on its luck.
First, even though the environment for fast-casual restaurants is somewhat sluggish and people are opting to stay home to eat more these days, I believe the trend in chain restaurants is intact and will continue to grow.
In a recent Bloomberg article, Global Chain Restaurants Are the Future of Food, the author puts forth a well thought out argument, with which I agree.
I consider myself a bit of a “foodie,” although I hate that overused term since everyone now considers themselves one. (I’m a Taurus so I didn’t just jump on the bandwagon either).
I love to discover a new independent restaurant in my local city, and even sometimes when I travel, I’ll do the necessary research to ensure I have a wonderful dining experience.
However, in the article I cited above, the author states that “many customers aren’t buying meals near home; we’re often turning to restaurants when we’re away from our known turf. Quite often, in that situation, we really just want to know what we’re getting.”
I think about my own experience in my travels, most often from Utah to Southern California, traveling by car, for kids sporting activities. Without fail I stop to eat at Chipotle in Barstow every time.
Why? Because I know exactly what I’m getting, I love the fact that they source “cleaner” ingredients (no hormones, organic etc.), I don’t have to research Trip Advisor and other rating services to find a trustworthy local independent restaurant, and I’m a huge fan of their product and so are my four children (it’s a rarity that everyone likes the same thing).
With rising real estate and labor costs, not to mention it’s inherently labor-intensive to cook food to order, it’s tough for independent restaurants to compete with chains who gain economies of scale by buying in bulk and even processing ingredients into identical units of production.
I believe this will ensure that chain restaurants, although food quality is certainly less than your favorite local independent restaurant that has gained a following, will continue to grow and thrive globally.
The incident of the E. coli breakout is unfortunate for Chipotle and those that got sick, but it creates a great buying opportunity for contrarian investors.
You see, such a point of maximum pessimism is the perfect time to buy. For Chipotle, the outbreak will soon be forgotten, and sales and earnings will return to normal and continue to grow, and by getting in now you’ll see gains from that return to growth.
Case in point, in 1982 50 people in Oregon and Michigan fell ill after eating burgers at McDonald’s (MCD). The confirmed outbreak was the first time E. coli was linked to food poisoning.
In 1993, more than 500 people were infected after eating undercooked beef patties at Jack-In-The-Box (JACK), which resulted in the death of four children and hundreds of permanent injuries including kidney damage.
in 1997, Burger King (now part of QSR) recalled over 25 million pounds of meat that made 16 people ill in Colorado. This resulted in 650 restaurants in 28 states removing burgers from their menu.
In 1999, Kentucky Fried Chicken, a part of Yum Brands (YUM), suffered an E. coli outbreak that led to 18 illnesses and 11 hospitalizations. And in 2006, Taco Bell, also a part of Yum Brands, was responsible for 71 illnesses in five states.
Please understand, I’m not celebrating the unfortunate sickness. I’m simply pointing out that these things happen, and when they do, the share price of well recognized brands suffers accordingly, which creates an opportunity for contrarian investors to buy shares on the cheap.
Over the last five years, Chipotle has grown revenues at a blistering pace of 21%, earnings at 27%, and book value at 22%.
How much would you be willing to pay for that kind of growth? Of course there is no guarantee the same rate of growth continues in the future, but I believe the company will continue to grow at above average rates.
Over the last five years, the average PE ratio the market has assigned to shares of CMG for this kind of growth has been 41.46.
Earnings per share are expected to rebound to $14.35 in 2017. If they were to then continue to grow earnings at even 15% over the following five year period (2018 – 2022), the earnings per share would be $28.86 in 2022.
Of course, it’s doubtful the market would then assign a price-to-earnings multiple of 41.46. But even if it assigned a multiple of 25, the share price would trade for $721, implying an average annual rate of return of just under 13% over the next six years (2017 – 2022).
In my opinion, this opportunity for a fantastic return, especially in an otherwise very overvalued market, would also come with a relatively high margin of safety, due to the negative news surrounding the company and the recent -50% drop in the share price.
And love him or hate him (I’m not a fan), activist billionaire investor Bill Ackman, who runs the notorious Pershing Square Capital Management, recently disclosed a near 10% stake in the company saying he believed the stock was undervalued and an “attractive investment.”
Yes, Pershing Square is suffering some short term challenges due to its 9% holding of toxic drug giant, Valeant Pharmaceuticals. However, since its inception in 2004, the hedge fund has posted net gains of 567.1%. That’s a 17.1% compound annual return versus a 7.4% annual return for the S&P 500.
To good food and great returns,