What’s Next For Chipotle?

After stumbling badly on negative publicity about foodborne illness at some of its restaurants, the fast casual dining industry’s once unstoppable frontrunner finally caught a break: On February 1, the Centers for Disease Control and Prevention (CDC) declared Chipotle Mexican Grill (NYSE: CMG) free of the nasty E. coli bug responsible for the illness outbreak.

#-ad_banner-#During the summer and fall of last year, the outbreak affected five dozen Chipotle customers in 11 states, prompting the temporary shut-down of 43 of the chain’s locations. The situation has run its course, the CDC concluded, because no new cases have been reported since December 21.

Besides sullying Chipotle’s reputation for safely providing “food with integrity,” the outbreak is wreaking havoc on the company’s stock and financials. Shares of Chipotle fell more than 40% since the news broke, and its latest quarterly report can only be described as ugly. Plus, there’s still fallout from a couple other recent outbreaks with another foodborne microbe (norovirus) involving single Chipotle locations in California and Massachusetts.

Yet this all amounts to what may well be the best value opportunity of the year. To be sure, it will take time for Chipotle to mend fences with customers and resume impressive growth. But I’m confident it will.

History Favors Chipotle
There’s historic precedent for this optimism involving rivals that, frankly, don’t hold a candle to Chipotle. For example, an E. coli outbreak more than 20 years ago at fast food chain Jack in the Box (Nasdaq: JACK) is long forgotten even though it was far more serious, affecting 732 people and causing four deaths. Today, the chain still has annual revenue of more than $1.5 billion, and its stock is up about 12-fold since the outbreak.

Only a few years ago, Yum Brands (NYSE: YUM) subsidiary Taco Bell was linked to a salmonella outbreak that infected 68 people and sent 20 to the hospital. Yet Taco Bell, too, continues to thrive, expanding aggressively domestically and abroad, generating more than $1.8 billion in annual revenue and posting solid organic sales growth.

Apparently, investors were already starting to forgive Chipotle a few weeks ago. After hitting more than a two-year low in mid-January, its stock rallied strongly despite a stubborn downtrend in the broader market. Shares could face more selling pressure in the near-term, though, thanks to fresh publicity woes. A few days ago, authorities announced that a criminal investigation of food safety practices during Chipotle’s California norovirus outbreak would be expanded nationwide.

However, management should help stem the blow by continuing to publicly accept responsibility for all the recent outbreaks and offer full cooperation with authorities. It’s also proceeding with food safety program improvements such as testing ingredients for foodborne germs throughout the supply chain, working with suppliers to improve their food safety programs, enhancing sanitation procedures at all Chipotle locations and increasing employee food safety training. Marketing efforts are stressing management’s zero tolerance for foodborne illness.

Tough Q4… But A Bright Future
Chipotle’s fourth-quarter report on February 2 was as bad as analysts expected in light of recent events. Revenue was down 7% to $998 million and net income sank 44% to $68 million for the quarter. Comparable-restaurant sales, defined by Chipotle as sales at locations open at least 13 months, fell 14.6% — a shocking decline considering the company’s long track record of double-digit gains in this key growth metric.

Still, the quarter wasn’t a total disaster. At the restaurant level, Chipotle held operating margins to less than a one-point drop at a still enviable 19.6%, with help from higher menu prices and lower ingredient costs. The company added 79 new locations, bringing the total to 2,010.

And it still managed solid full-year performance, including gains of almost 10% and 7% in revenue and net income to $4.5 billion and $476 million, respectively. The past year’s net margin, 11.6%, is Chipotle’s highest in a least a decade. Twelve-month returns on assets and equity also sit at or near decade highs.

Such data reflect fierce customer loyalty, especially among youths. While visits to Chipotle fell 5% overall in 2015, teens and young adults increased their visits by double-digits for the year, reports New York-based market research firm NPD Group. That bodes well for a fairly swift turnaround at Chipotle because the younger demographic accounts for the greatest share of foot traffic, and its spending power is on the rise.

Another positive sign: On February 3, Wells Fargo upgraded Chipotle to “outperform” with a $500-to-$530 price target, citing case study analyses showing that most of the restaurants dogged by food-safety issues in the past 25 years went on to recover. That price target implies roughly 6%-to-11% near-term upside for Chipotle’s stock.

Risks to Consider: The outcome of the criminal investigation of Chipotle remains unknown, and the company could be hit with numerous lawsuits from E. coli and norovirus-exposed customers. Financials are likely to suffer for a while, with most analysts forecasting double-digit shrinkage of earnings this year as Chipotle struggles to win back public trust. Also, the exact source of the outbreaks was never discovered, so foodborne illness problems could resurface.

Action to Take: Foodborne illness is rare at restaurant chains, and lesser restaurants have come through much worse incidents than Chipotle faces now. History and investor sentiment suggest the current damage to its reputation and financials is temporary, positioning the company for a relatively quick turnaround. This gives value investors an uncommon opportunity to own shares of the fast casual movement’s long-time undisputed leader at prices not seen since late 2013.

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