Can Bill Ackman save Chipotle?

October 16, 2016 09:00 AM
Rising labor costs will provide strong headwinds to activist hedge fund manager Bill Ackman’s attempt to recover value for Chipotle stockholders.

Last month, activist manager Bill Ackman announced a 9.9% stake in Chipotle Mexican Grill (CMG). Ackman plans to engage the firm’s management after investing roughly $1.2 billion in the casual dining giant. 

Shortly after Ackman said the firm had a “strong brand, differentiated offering, enormous growth opportunity and visionary leadership,” shares rose 6%. Analysts expect that Ackman will aim to address the firm’s board, its cost structure and its operations. But this may be one of Ackman’s greatest challenges. The company is facing a series of cost pressures that continue to weigh on the stock. 

Chipotle is a burrito factory trading at a price-to-earnings ratio (P/E) multiple north of 60. Its aggressive growth strategy has benefited the firm as investors anticipate greater expansion and sales. With roughly 2,000 company-owned stores around the country, investors are starting to wonder if its growth strategy can justify its high price. Before Ackman entered the picture, management had already embraced tools to bolster shareholder value in the face of falling profits. The firm repurchased more than two million shares after the stock fell from $757 to a 52-week low of $384. 

Ackman may call for someone to exit the executive suite to make way for a hand-picked acolyte. But no one expects that founder and co-CEO Steve Ells, co-CEO Monty Moran or CFO Jack Hartung are going anywhere, even if faced with activist pressure. The key issue is that the brand has lost a big share of its customer base following a series of food safety outbreaks including salmonella, norovirus and E. coli. The problem was made worse by a weak public relations response. Wall Street barely reacted in August when it announced plans to give away drinks to high school and college students with the purchase of an entrée. 

It will be interesting to watch if younger customers can boost sales, but statistical data indicates that may be a losing strategy (see “Bad demographics,” right). 

Chipotle Has a Labor Problem

Chipotle spends more money on its food inputs than its labor costs, the reverse model from many fast-food companies. For the last few years, the total cost of food as a percentage of revenues has hovered around 33%. Store locations lack freezers. The theory goes that customers are willing to pay a premium for healthier, fresh food. 

BTIG analyst Peter Saleh has suggested that the company move away from its “food with integrity” marketing strategy. Not only is it unbelievable given last year’s E. coli outbreak, but it’s also very expensive. Labor is the second-largest store cost. It is one that has risen dramatically in recent quarters. In 2014 and 2015, labor costs represented 22% of sales and 23.2% of sales, respectively. Since the outbreak, labor has increased to roughly 30% of sales. 

Saleh argues that the firm needs to reduce costs. However, that would affect the operational success of the company. Author Sam Li at Harvard Business School argues that its operating model relies heavily on human labor to be highly efficient. “The most popular stores turn over 300 customers per hour and an average store made $2.5 million revenue in 2014 with each bill averaging $10,” he writes. “In order to achieve high efficiencies, the ordering system is arranged like assembly lines. From start to end, customers construct their perfect burritos with help from multiple servers, each taking ownership of only a small portion of the work.”

Should the company cut back on labor, it could dramatically impact this efficiency. And the cost of labor will likely go up as Congresswoman Rosa DeLauro (D-Conn.) has called on the U.S. Labor Department to investigate the company after a class-action lawsuit accused the firm of underpaying employees and denying them overtime. 

Thousands of employees have claimed that time clocks would automatically punch out employees at midnight while employees would remain to clean up and prepare food for the next day without compensation for their time. The case Turner vs. Chipotle has been named for former Colorado store manager Leah Turner. The court case says, “Chipotle routinely requires hourly-paid restaurant employees to punch out and then continue working until they are given permission to leave. Turner said she was told to work overtime without pay and to tell subordinates to do so as well.”

The company argues that the blame lies with just a handful of rogue managers. But roughly 10,000 employees have joined the lawsuit. If the allegations are true, this represents a much bigger problem than investors have been led to believe. And regardless of who wins, one can expect greater scrutiny of Chipotle’s labor practices. 

The second major labor challenge comes in this political season: Democratic nominee Hillary Clinton has embraced the $15-per-hour Federal minimum wage that would also be indexed in the future to inflation. Republican nominee Donald Trump has, at times, also supported a $15 minimum wage. According to Glassdoor, Chipotle pays crew members and cashiers between $9.14 and $9.41 per hour. Service managers receive an average of $12.73. A $15-per-hour minimum wage would ultimately mandate a more than 60% increase from current compensation.

Chipotle has higher labor costs than traditional fast food firms like Taco Bell, McDonald’s and Burger King. Analysts suggest that these firms could quickly embrace automation, replacing the human employees demanding $15 per hour and benefits. Chipotle, however, doesn’t lend itself to automation given the operational structure in the store. Frank Levy, an emeritus professor at the Massachusetts Institute of Technology, argues that automation would hinder the benefits to customers. “Computers are best at doing very structured tasks,” Levy says. “The ingredients and required manipulation make it hard [for Chipotle] to automate.”

The firm will continue to rely on human capital to prepare foods. Naturally, a wage mandate wouldn’t happen overnight. But wage increases by 2018 have the ability to carve into profitability.

In May, Credit Suisse issued an update to a 2015 report on rising concerns of labor inflation fueled by government fiat. The firm projected that recent changes to overtime compensation, increased benefits and mandated wage increases weigh down restaurant stocks. Under a model where federal wage mandates increase to $10.25 by 2020, the bank sees a scenario of labor inflation of 8% each year and the erosion of store level profits by about 20%. Movements to $12 an hour (a figure suggested by Donald Trump) or the $15 per hour that is part of the Democratic Party platform exacerbates the problem of store-level profits. Credit Suisse projects that firms will hike prices, introduce automation or slash workers to contain costs.

When the company failed to meet investor expectations, labor was the primary factor. 

“Labor inflation, especially in the last year, has been significant,” said CFO John Hartung during their second-quarter sales call. “We haven’t passed on the cost of higher wages [to customers].” Despite that claim, Chipotle has tried to move those costs onto customers. The company has instituted massive price increases in markets that already mandate $15 per hour. In July 2015, an American Enterprise Institute survey of Chipotle restaurants in 10 markets found that prices increased in Denver, Minneapolis, Chicago and Orlando by about 4%. A lot of that, however, appears to be more tied to rising food costs than labor. The outlier in this situation is San Francisco.The city increased its minimum wage to $12.25 in May 2015 and saw prices increase by an average of more than 10%. AEI economists place the blame squarely on minimum wage laws. And San Francisco will continue to push wages higher, with wage increases to $14 in 2017 and $15 in 2018.

Higher prices may work in San Francisco where the median income is much higher than the U.S. average, but will likely impact Chipotle’s expansion strategy in areas  where income levels and the cost of living are much lower.

There’s one last consideration that investors must take into account before betting on the stock: The U.S. economy. Paul Westra of Stifel Nicolaus offers the most bearish forecast of Chipotle stock of anyone tracked on TipRanks (see “Chipotle trackers,” right). Westra said that U.S. restaurants entered a recession in Q2 2016. His bearish view on restaurants and his expectations for a broader recession fueled the downgrade of 11 restaurant stocks. Also, Stifel doesn’t believe that Ackman and his hedge fund will be able to provide much value. “Frankly, we predict that Pershing’s activist effort is most likely to accelerate and further assure CMG’s “tail operational risk” of increasing management and hourly turnover rates,” Westra said in a recent conversation with Benzinga.

Still, the overall sentiment is better than Westra’s outlook. On TipRanks, 12 analysts rate the stock a “Buy,” 6 a “Sell” and 11 have it as a “Hold.”

Based on consensus expectations, the price target sits at $443.95, representing 7% upside.

About the Author

Garrett Baldwin is the Managing Editor of the Alpha Pages and the Features Editor of Modern Trader. An author and Baltimore native, he earned a BS in journalism from the Medill School at Northwestern University, an MA in Economic Policy (Security Studies) from The Johns Hopkins University, an MS in Agricultural Economics from Purdue University.