This post is part of the On the Margin blog.
Chipotle Mexican Grill Inc. has built a reputation over the years for being an atypical restaurant company. Bill Ackman is about to find out that it’ll be an atypical target for an activist investor.
Ackman is one of Wall Street’s best-known activists. This week, as my colleague Lisa Jennings reported, Ackman’s Pershing Square Capital took a 9.9-percent interest in Chipotle. The move promises more headaches for the big burrito chain as it works to recover from the steep sales decline that has followed its food-safety crisis last year.
Chipotle had its first introductory call with Ackman on Wednesday, Chipotle spokesman Chris Arnold said in an emailed statement.
“We just learned yesterday of Pershing Square’s acquisition of Chipotle shares,” Arnold said. “We welcome their investment, and appreciate the confidence they’ve expressed in our brand, differentiated offering, visionary leadership and strong growth opportunities.”
Activists typically target companies that are undervalued, and that have relatively easy levers to pull to create more value for shareholders. The activist then profits off the increased share price.
But Chipotle doesn't have a lot of easy strategies that could yield a quick turnaround. It might not even be undervalued.
A year ago, Chipotle was trading at more than $750 a share. But a series of foodborne illness outbreaks led to a steep same-store sales plunge that is worse than any other food-safety-related sales decline in modern restaurant history. Chipotle stock has since fallen to $400 a share.
Even so, Chipotle remains one of the most highly valued companies in the restaurant industry, trading at a price-to-earnings multiple of close to 60 times earnings over the past 12 months. By comparison, fellow fast-casual stalwart Panera Bread Co. is trading at 36 times. Starbucks Corp. is at nearly 32 times.
Several analysts have Sell ratings on Chipotle stock. Stifel analyst Paul Westra said Ackman’s entrance creates a “selling opportunity” because the stock is rising on the news — it’s up 6 percent Wednesday. Maxim analyst Stephen Anderson said that Chipotle’s “fundamentals remain challenging.”
Because of those challenging fundamentals, and the arguably high valuation, Ackman could find it difficult to find short-term solutions to bolster the company’s valuation.
Ackman is no stranger to the restaurant industry, and he seems to have a thing for counter-service concepts. In 2005, he targeted McDonald’s Corp., and suggested that it sell real estate and franchise more restaurants. He later targeted what is now The Wendy’s Co. with much the same idea. He ultimately found a soulmate in 3G Capital, which had bought Burger King, sold off company units, and focused on international development and franchising.
Ironically, in the years since Ackman divested his McDonald’s and Wendy’s stakes, both companies have moved in the direction he advised, at least on franchising.
Unlike McDonald’s and Wendy’s, Chipotle is unlikely to franchise. Although some observers have mentioned franchising as a possibility, it’s difficult to start a franchising program at a fully company-run concept from the ground up.
Ackman would seem likely to push for board changes. But keep in mind that earlier this year, Chipotle shareholders beat back an effort to replace two members of the company’s board.
The activist might push Chipotle to slow down development further, or ditch experiments with ancillary concepts that can distract management from the primary chain, including its upcoming foray into the better burger business.
Some analysts suggest that the company look at its marketing programs. “The multiple promotions run this year have seen little apparent success, and we believe a new approach may be necessary to drive a quicker pace of sales recovery,” BTIG analyst Peter Saleh wrote in a note.
The cost structure might also be due for some scrutiny. Sara Senatore, analyst with Bernstein Research, suggested in July that a lack of scrutiny has led to “surprisingly little operating leverage over time.” Chipotle’s margins are 300 basis points lower than average for fast-casual chains, she wrote, while general and administrative expenses are $40 million to $50 million higher than average.
Mark Kalinowski, analyst with Nomura, recommended in a note “a timely and thorough review of the cost structure of the entire organization.”
One thing we’d pay close attention to is Chipotle's unusual co-CEO arrangement. A lot of the company's high G&A expense comes from the large pay packages given to co-CEOs Steve Ells and Monty Moran. Combined, the two received more than $27 million last year, even though their pay was cut in half. While that pay has received plenty of shareholder scrutiny over the years, it’s nevertheless an easy target for an activist.