Rebel Yell: Why Chipotle Might Be The Next Taco Blow

On December 30, 2015 we turned bearish on Chipotle Mexican Grill (NYSE-CMG) and recommended it as a short in our SuperStockTrader's Morning Matters Portfolio. The entry price was $485.98 and is now at $456.65 as of 2:15 p.m. EST.

The nationwide burrito restaurant chain with 2010 restaurants has now been in the throes of an E. coli crisis for over 3 months. Initially CMG was forced to temporary close restaurants in 11 states after more than 50 people suffered food poisoning. A second outbreak of a different strain of E. coli in December affected five people in three states and then Health officials in Massachusetts linked a Chipotle in the Boston area in December to a norovirus outbreak that sickened more than 130 Boston College students.

The outbreaks initially forced the Mexican food chain to temporarily close a small number of its restaurants, but the effect has been substantial. Despite implementing new safety standards and food-handling procedures nationwide the tainted food crisis is hammering both the fast food company's reputation and earnings. Tuesday it announced that Tuesday its fourth-quarter net income plummeted 44%.

Net income for the Denver-based company totaled $67.9 million vs. $121.2 million a year earlier. Earnings per share for the three-month period that ended Dec. 31 totaled $2.17, down 43.5% from $3.84 a year ago. Analysts polled by S&P Capital IQ had estimated $1.85 of per-share profit.

Same-store sales fell 14.6% during the quarter, in line with the company's estimate updated on Jan. 6. In December, as more news broke about food contamination at Chipotle, same-store sales were down about 30%.

Total revenue for the quarter fell 6.8% to $997.5 million. Analysts polled by S&P Capital IQ had estimated $1 billion in fourth-quarter revenue.

While cult following of this immensely popular food chain may be returning, its legal troubles are far from over. In December 2015, Chipotle was served with a federal grand jury subpoena in connection with a criminal investigation being conducted by the U.S. Attorney's office for the Central District of California and the U.S. Food and Drug Administration. The funny thing about this subpoena was that it was served on January 28th and they did not disclose it until yesterday’s earnings call. So much for full disclosure.

The company's management has already acknowledged "Future sales trends may be significantly influenced by further developments”. Our research piece highlighted several other quotes along these line.

The subpoena required Chipotle to turn in a broad range of documents related to a restaurant in Simi Valley, Calif., that "experienced an isolated norovirus incident" in August 2015, Chipotle said. "We intend to fully cooperate in the investigation," the company said.

While CMG management says it's new "enhanced food safety program," at the company and its restaurants, imposes quarterly audits by third-party auditors, using bar codes to track supplies, testing high-risk items such as meat and vegetables, quickly boiling some non-testable items such as avocados and onions, and tying store managers' bonuses to audit results. We think the problem is beyond its new food safety program and increasing its marketing spending this year to a new historic high.

Chipotle will hold a "national team meeting" on Feb. 8 and won't open restaurants until 3 p.m. that day in order to update employees of new developments and procedures.

While Chipotle plans to open 220 to 235 more in 2016 we think the company's management and investors are missing the bigger picture. While the company's CFO CFO Jack Hartung said during Tuesday's earnings call that "2016 will be a very different year for Chipotle". "We expect to see a lower operating margin this year". It's not the entire story.

Food handling is a serious business. The handing of fresh food is especially difficult and requires professional food preparers. Not a part-time work force of below poverty wage employees. Setting new food safety standards is one step, hiring and paying a livable wage to retain properly cautious and trained staff is needed.

While the costs to enhance public relations efforts and overhaul its restaurant inspection system will eat into the bottom line in 2016 and beyond. The reality not being voiced by Wall Street's analysts remains the diverse nature of the possible food contamination errors that require higher waged full time food preparers and as a result higher prices at the counter.

Until the low wage part time food preparation problem is addressed CMG runs the systemic risk of remaining truly poisonous to those investors betting on the longs side. CMG remains a short in our opinion.

Danger, danger Will Robinson, your burrito may be hazardous to your health.