Is Bill Ackman Right About Chipotle's Enormous Growth Potential?

By Markets Fool.com

Hedge fund operator Bill Ackman faces a tough task in getting customers to trust Chipotle products once again. Image source: The Motley Fool.

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What does Bill Ackman see in Chipotle Mexican Grill (NYSE: CMG) that much of the rest of the market does not? The billionaire hedge fund manager recently revealed a near-10% stake in the troubled Mexican fast casual chain, stating in an SEC filing that he believes there remains an "enormous growth opportunity", whilemost investors see continued trouble ahead for the company.

Not exactly the flavor of the month

Chipotle has yet to recover from the outbreak of foodborne illnesses that plagued it last year, causing 500 customers to be hospitalized, sales to evaporate, and its stock to crater by nearly half. While such events are often seen as a one-off episode and an opportunity to buy into a once high-flying stock at a bargain, the consensus outlook on Chipotle is not quite so optimistic.

Analysts are still forecasting sales to fall 10% in 2016, and profits are expected to drop 75% on average.

Chipotle Mexican Grill

2016
(estimated)

2015

Change

Revenue

$4.04 billion

$4.50 billion

(10.2%)

Earnings per share

$3.75

$15.10

(75.2%)

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Data source: S&P Capital IQ.

But Ackman and his fund, Pershing Square Capital Management, must see a silver lining after taking a $1.2 billion position in the company, arguing that Chipotle still "has a strong brand, differentiated offering, enormous growth opportunity, and visionary leadership." After some particularly bad bets on Herbalifeand Valeant, he may just be hoping for absolution on a burrito rebound.

One hot tamale

Yet despite the superlatives, the problems with the chain remain. Analysts at Stifel Nicholas "cannot fathom Pershing's operational or mathematical investment thesis."

  • Plunging sales:Even with free burrito giveaways, revenue fell 17% in the second quarter to $998 million on top of a 23% drop in the first quarter. Over the first six months of the year, comparable-store sales have tumbled 26%, and the number of transactions conducted is down 20%.
  • Evaporating margins:Not only are free burritos failing to bring customers back -- though Chipotle announced it will continue the promotion throughout the month -- it's eating away at profits even as costs climb. First-half restaurant operating margin has plummeted to 11.7% from 27.7% a year ago. Higher food costs, expensive food safety procedures, and higher labor costs also bedevil the chain.
  • Too many restaurants:Lower sales and lower profits per restaurant hasn't deterred management from committing to opening even more locations. Chipotle opened 58 new stores in the second quarter and 56 in the first, and it expects to open at least as many in the back half of the year.

Ackman, though, has some ideas in mind for turning things around with a focus on Chipotle's operations and cost structure, as well as potential changes to its management, capitalization, and strategic plans.

A lot on his plate

Ackman may be hinting at reining in the compensation the company typically lavishes on its executives, cutting back expansion plans until the company stabilizes its customer base, and reducing its investment in -- or even completely shedding -- its fast casual pizza chain and the better burger joint concept it just opened.

Shareholders previously railed against executives for their compensation packages in 2014, and though the food quality scandals hit bonuses in 2015, the structural imbalance remains intact, suggesting Ackman could seek out a more permanent, lower level of compensation. Additionally, some board members have enjoyed exceptionally long tenures, meaning they may be ripe for replacement, or perhaps they will be joined by Ackman or one of his surrogates.

All of these ideas, though, even if successful, will take time, but none will have any impact on the main problem the restaurant faces: restoring the trust of its once-loyal customers.

Although Ackman's flameouts mentioned above have made him a target of derision for some, he is clearly a smart investor who has seen much success, including winning investments in Burger King, McDonald's, and Yum! Brands. Chipotle Mexican Grill, though, seems to be a special case with no quick solution to cure its ills.

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Rich Duprey has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill and Valeant Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.