Priced For Perfection - Why This Burrito Market Is Heading For A Fall

During the 150 days since August 4th, Chipotle’s share price has plunged by 45%. Nearly $11 billion of market cap has been obliterated——including $4 billion in the last three weeks.

Accordingly, its market value has now retraced back to March 2012 levels. The hyperventilating CMG bulls who rampaged for 1250 days in the interim have now been taken out back and summarily shot.

Stated differently, what had been $12 million per copy burrito shacks are now on sale for just $6.5 million each and are heading far lower, very fast. But the culprit in this stunning markdown is not the alleged once-in-a-blue-moon outbreak of E. coli, as CMG’s apologists claim.

To the contrary, CMG’s shares have been irrationally priced for perfection and beyond all along.

Chipotle’s recent $24 billion market cap, in fact, is the bubble in extremis which explains the entire financial bubble at large. It is surely the poster boy for the manner in which the Fed-sponsored Wall Street casino has hyped the mundane into the miraculous; and substituted paint-by-the-numbers hockey sticks for substantive analysis and judgment.

That is, a financial market which can value rented burrito joints which generate just $750k of store level cash flow at $12 million per copy is just plain off it rocker; it’s a greater fools gambling den that would make the moguls of Los Vegas envious.

Yet the astonishing level of complacency that took CMG shares to a peak of $750 a few months ago, is not a one-off aberration. It embodies the sum and substance of financial markets that have been destroyed by massive central bank intrusion and systematic falsification of interest rates and asset prices.

Thus, at its early August peak, CMG’s $24 billion market cap represented 48X the $500 million of net income it had posted in its most recent LTM filing. But the 1,900 Chipotle restaurants that fetched this nosebleed PE multiple are not high-end food emporiums serving gourmet fare at luxury prices to the top tier of affluent households.

Actually, they slop out burritos, tacos, salads, black beans, salsa and chips at $9 per ticket. Its customers are mostly millennials, who have an average of $155 per month of discretionary income, including the ones living in mom and pops basement.

The business has no barriers to entry and miniscule brand advertising. It is being assaulted by an army of competitors including established chains like Taco Bell, and newcomers like Qdoba and countless more, who have belatedly discovered the popularity of Tex-Mex fare. And CMG is also now running into saturation of prime locations and markets—–the fate that always and everywhere brings down high-flying retail and restaurant roll-outs.

Yes, CMG has a clever marketing gimmick and value proposition. That is, that its food is fresh, organic, locally sourced and that the pigs and chickens which end up in the burrito bowls have not been ill-treated on an industrial farm.

So what? Is there anything in that proposition that could not be eventually duplicated by aggressive competitors——even if they needed to play catch-up ball for awhile?

The fact is, no company has ever permanently dominated a new chain restaurant category indefinitely——-from hamburgers joints to pizza chains, seafood eateries, pasta places and high end steakhouses. Nevertheless, Chipotle’s absurdly high PE multiple reflected exactly that proposition—–hyper-growth and complete dominance, world without end.

In fact, Chipotle’s approximate 25% annual earnings growth since 2009 was taken exactly out of a tried and true cookie cutter. Profits were growing because the company was rolling out 200 new stores per year based on leasing costs that were dirt cheap due to the Fed’s repression of interest rates and an abundance of gig-based labor at the minimum wage.

During that period they also aggressively raised menu prices by capitalizing on their first mover position in chain-based Tex-Mex segment and the temporarily faddish popularity among millennials of their purportedly unique “quality” proposition.

But the latter was the obvious Achilles heel of the whole operation. CMG promoted itself as being in a quality tier way above all of its competitors. Yet it did not spend much more on food and its supply chain than most of its competitors.

For instance, Panera’s food costs is 34% of sales compared to 33% for Chipotle. Even in the case of the burger chains, food and paper costs run in the same zone, and were about 32% in Wendy’s most recent quarter.

Now, there is a reason that most national restaurant operations are based on centralized supply chains fed by industrial farm production of meats and other major menu ingredients. Namely, industrially produced food costs are far cheaper and centralized supply chains are more efficient, reliable and bureaucratically stable than decentralized procurements from neighborhood farms.

That’s especially true for a wholly owned restaurant operation that now has upwards of 2,000 locations and 53,000 employees paid at an average rate of just $20k per year.

In a word, CMG was selling a quality-based, anti-industrial, healthy life-style value proposition, but wasn’t paying for it. And since it didn’t have the organizational infrastructure and cost levels needed to deliver on its brand promises, it was essentially harvesting phantom profits that weren’t sustainable.

It was only a matter of time before E. coli or dozens of other potential supply chain assaults on its fundamental brand equity erupted into the public domain. Indeed, here’s how one analyst, who had apparently been a Chipotle regular, reacted to the news. As he explained on Seeking Alpha, the blow to CMG’s consumer franchise has been devastating:

As someone who was a regular at Chipotle, I can tell you that I won’t be returning until the company announces exactly what the source of the E. coli outbreak was and until a few months have passed after the E. coli outbreak source has been identified and remedied (just to make sure they’ve figured things out).

Even after returning, however, I am already certain I’ll be eating at Chipotle less than before, because I’ve now discovered nearby fast casual competitors that I’m enjoying equally as much. I suspect my behavior won’t be unique. Humans are creatures of habit. Chipotle will likely discover that after the E. coli scare completely blows over, some of its customers will dine at Chipotle much less than before. This is a natural consequence of people having developed new lunch time and dinner time habits during the time they avoided Chipotle.

So payback time has now arrived with a vengeance. According to its most recent 8-K filing, the former king of comps experienced a 30% same store sales plunge in December and there is no relief yet in sight. Accordingly, management has now slashed it Q4 outlook to $2 per share and does not expect improvement any time soon.

Well now. Annualize the current run rate and throw in two bucks of windage—–so you get an annualized run rate of $10/share. At its fevered peak last August, CMG was trading for what is looking more and more like 75X current earnings per share.

Here’s the thing. Like in the case of the scores of high flying retail and restaurant concepts in full national roll-out heat that have come before, there is no rational economic basis for capitalizing the one-time earnings growth from store openings at a nosebleed multiple. These high flyers always crash or their stock price hits the flat-line as PE multiples shrink back to earth even as organic same store earnings might continue to expand.

In Chipotle’s case, there was even more foolishness embedded in its high PE multiple. Competitor risk was coming. Supply chain risk was self-evident. Constant prices increases to its less than affluent customer basis were a ticking time bomb. Choice locations in most of the US had been used up. Tex-Mex wasn’t catching on abroad.

And most importantly, CMG has no assets except customer goodwill. It is a pile of off-balance sheet operating leases populated with relatively trivial amounts of equipment and improvements per store. So it can’t even pull an Eddie Lambert and claim that empty Sears stores don’t matter because the underlying real estate is invaluable.

Stated differently, the earnings from intangible goodwill not backed by brick and mortar assets, patents, proprietary know-how, breakthrough technology or super-heavy advertising and marketing on a permanent basis cannot possibly be worth 48X. The fact that CMG reached this lunacy only a few months ago is screaming evidence of the monumental complacency that prevails in the casino.

The rest of the market, in fact, is only a slightly less exaggerated case. Just as in the case of CMG, cap rates at the recent peaks make no sense whatsoever except on a paint by the numbers forward hockey stick basis, reflecting a world in which nothing could go wrong and the business cycle had been miraculously repealed.

Yet you don’t have to be excessively observant to recognize that the 20-year global credit and economic boom led by the Red Ponzi in China is coming to a screeching halt because the central banks have well and truly run out of dry powder and credibility.

The world economy is self-evidently in the midst of the greatest commodity deflation since the 1930s, while industrial prices and profits are getting whacked hard and CapEx is plunging into a veritable depression.

All of this is causing worldwide incomes and profits to fall, and this time the difference can’t be made up by phony credit expansion. That’s because virtually every economy in the world has arrived hard upon the shoals of “peak debt”.

Better to mind the fact that China purportedly grew at 7% last year, yet the truth is that power consumption did not grow at all and rail freight volume plunged by an unprecedented 10%. Note also that the flagship of the China supply chain—–the high tech industrial economy of South Korea—-is in a world of hurt. Its exports are now down by 15% on a Y/Y basis. Note further that crude oil, copper, iron ore and ocean freight rates are now in a death plunge.

Already, honest GAAP earnings for the S&P 500 companies have plunged from a peak of $106 per share in the September 2014 LTM period to $90 in the most recent LTM period. That’s a 15% drop and the bottom line weakness is just beginning to spread outward from energy, materials and industrials. Macy’s anyone?

Even then, the broad market multiple at 22X is not the half of it. Once again the same folks who brought you CMG at what turns out to be 75X have their lazy hockey sticks polished and pointing skyward.

Thus, in March 2014 Wall Street’s ex-items S&P 500 earnings forecast for 2015 was about $133 per share; it ended up 20% lower at $106.

Yet here they go again. The consensus for 2016 started out at $137 per share last spring, and is just now beginning to make its way back toward the high $120s. Given the massive headwinds in the global economy and the emerging signs of the inevitable recession in the US, however, the current consensus hockey stick is truly ludicrous.

But there is something else. It is a barometer of the abject complacency and intellectual sloth that has descended on the casino owing to two decades of Fed coddling and seven year of free money for the carry trades.

To wit, the so-called equity strategists and economist have morphed into brain dead, paint-by-the-numbers perma-bulls incapable of recognizing the obvious macro-economic failures and financial risks which abound everywhere, even in the domestic economy.

There has been no real business investment growth for 15 years; productivity is sliding down the tubes; there are still fewer full-time, full-pay breadwinner jobs than in December 2007; and the Federal debt and entitlement monster has been left completely unattended, meaning a massive fiscal crisis is coming in the years ahead.

Yet here’s what one of these perma-bulls said yesterday. Jeffery Saut has undoubtedly spent too many years baking his brain in the Florida sun, but why not issue hockey sticks and buy recommendations if you believe this:

The U.S. has solved many of its long-term problems,” Saut said. “Banks are less leveraged, the deficit is under control, balance sheets are strong.”

Oh, c’mon. Financial risk is greater than ever before——-the Fed has simply driven it from the banking system into the massive explosion of bond mutual funds, ETFs and other forms of nonbank finance.

Likewise, the Federal deficit will be back at more than $1 trillion annually at the first hint of a recessionary fallback; owing to the baby boom retirement driven costs of Medicare and social security the next ten years will see the public debt explode to $30 trillion and an Italian-style 135% of GDP

So too, business debt in the US has grown from $11 trillion before the crisis to $13 trillion now. Most of it has been wasted on stock buybacks and over-priced M&A deals.

In the case of CMG, it was always just a burrito. In the case of the US and world economy and financial markets, it’s not even that.

Regards,

David Stockman
for The Daily Reckoning

P.S. Be sure to sign up for David Stockman’s Contra Corner —the only place where mainstream delusions about the Warfare State, the Bailout State, Bubble Finance and Beltway Banditry are ripped, refuted and rebuked. Click here and subscribe to receive David Stockman’s latest posts by email each day as well as his personally curated insights and analysis from leading contrarian thinkers.