Could Chipotle Begin Franchising?
Badly burned in recent years with three ugly stock market bets—Valeant (VRX), Herbalife (HLF) and JC Penney (JCP)—Pershing Square Capital’s Bill Ackman on Tuesday announced a $1.2 billion wager on the beleaguered Chipotle Mexican Grill (CMG) restaurant chain.
Pershing reported ownership of 9.9% of the outstanding shares of Chipotle, consisting of 554,213 shares of common stock and 2,328,250 shares in forward purchase contracts. Pershing’s basis is roughly $415 per share, while Chipotle, which closed Tuesday at $414.07, is off 45% from it 52-week high of $757. Not surprisingly, Chipotle’s shares jumped in aftermarket trading on news of the investment.
Pershing’s filing referred to Chipotle’s common stock as “undervalued” and “attractive,” something Wall Street’s investment community has debated since the 2,000-unit restaurant chain was implicated in a series of E. coli and norovirus outbreaks in 2015.
Pershing said that it intended to engage in discussions with the company’s management and board of directors related “to the governance and board composition, business, operations, cost structure, management, assets, capitalization, financial condition, strategic plans, and the future of the issuer.”
What, pray tell, might Ackman have in mind for Chipotle?
First off, Ackman’s current 9.9% interest dwarfs the combined 2.86% interest held by co-CEOs Steve Ells and Monty Moran. He will probably seek board representation, although in Pershing’s 2014 annual report, Ackman said it wasn’t necessary to have a board seat if he is “confident that the existing board already has appropriate shareholder representation, and a management team with exceptional operating and capital allocation discipline.”
What Ackman will do to engage the board is clear. Based on public disclosures made in connection with Ackman’s investment in Burger King and Tim Horton’s, his previous stakes in McDonald’s and Wendy’s, and his written comments, Ackman likes the franchised business model. In Pershing’s 2015 annual report, Ackman extolled the virtue of franchising, saying it was “a capital-light, high-growth annuity.”
Franchising versus company ownership will definitely spark a discussion. Chipotle has never franchised, and company management has disdained the practice, preferring to operate company stores. In a 2015 Bloomberg article, co-CEO Monty Moran admitted the company once franchised eight restaurants at the request of its majority owner, McDonald’s, but that it was “an uncomfortable time for us.”
Chipotle’s communications director Chris Arnold told Business Insider in 2014 the company had no reason to franchise. "When you franchise, you give up control over how restaurants are run and that can compromise the experience. What’s more, our business model is so strong, we would rather not sell off our revenues to franchisees in exchange for only a small percentage of that," said Arnold.
Not so strong anymore. Franchising might be back on the table if Ackman has a say, now that Chipotle’s sales are trending $2 million on an annual basis down from $2.5 million before the foodborne illness cases came to light. Store-level operating margins have also dropped to 15.5% in the second quarter, compared to 28% a year ago.
Franchising would reduce Chipotle’s ongoing investment costs, something the asset-light crowd holds dear. The company’s net investment per store is roughly $800,000 after landlord contributions. With a store-opening program consisting of 225 new restaurants per year, the company would immediately save $180 million in capital costs by passing on the risk of new store development to franchisees.
Bank of America Merrill Lynch analyst Joe Buckley thinks Ackman might also focus on Chipotle’s generous compensation given to Ells, Moran and CFO Jack Hartung. According to Chipotle’s latest proxy statement, Ells was paid a total of $67 million in salary and stock awards during the past three years. Moran was paid $66 million. In 2014, shareholders voted against the company’s executive pay package and rejected the company’s plan to reserve shares for an equity incentive plan.
Buckley also suggests Ackman might take aim at Chipotle’s investment in the Asian concept Shophouse, and recently in Tasty Made Burger, a me-too burger concept. Especially when the “flagship brand is in trouble,” said Buckley.
Baird analyst David Tarantino is skeptical Ackman will have any impact on Chipotle’s share performance, citing an already lofty valuation at 22x EBITDA. “In the absence of a sales recovery,” said Tarantino, “we still consider risk/reward on Chipotle fairly balanced.”