Chipotle Mexican Grill (CMG 1.07%) can't catch a break these days. The fast-casual chain temporarily closed 43 locations in its Seattle and Portland markets after an E. coli outbreak left 35 Chipotle customers ill and dozens hospitalized. Health concerns and slowing sales at the fast-casual eatery have pushed shares of Chipotle down by more than 17% in the past quarter. However, negative publicity surrounding food poisoning is only part of the Chipotle story. Let's take a closer look at whether investors should think twice before taking a bite out of this Wall Street darling.
Hidden red flags?
Food-safety issues such as this tend to blow over, especially when it comes to a strong brand with loyal followers such as Chipotle. However, this is the Mexican chain's third encounter with food-safety problems this year, which could indicate there is a deeper issue at play here.
In August, as many as 80 Chipotle customers and 18 of the chain's employees in California contracted norovirus from contaminated food at its restaurants in the region. That same month, there was an outbreak of salmonella linked to Chipotle restaurants in Minnesota.
With three separate food-borne-illness outbreaks at Chipotle in the past 10 months, investors must consider the possibility of underlying supply-chain issues at the restaurant chain. The company was forced to switch tomato supplies in September, after the salmonella incident, and we could see more supplier shuffles following this latest outbreak.
In Chipotle's fiscal 2014 annual report, the company warns that it may, in fact, lose customers if it's forced to "pass along to consumers any higher ingredient costs resulting from supply problems associated with outbreaks of food-borne illnesses, which would also have a negative impact on our sales and profitability."
Source: The Motley Fool.
Credit where it's due
To be fair, Chipotle responded quickly and proactively to its latest food-poisoning issue. The company voluntarily closed 43 restaurants in the Pacific Northwest linked to the outbreak, for example, even though only eight of those locations had been directly tied to the E. coli incident.
Additionally, unlike other fast-casual rivals such as Panera Bread, Chipotle doesn't use artificial preservatives in its food or antibiotics in its meats. Consumers want healthier fast-food options today. However, without such additives there is a greater risk of certain food-borne illnesses. This, too, is something Chipotle warns shareholders of in its annual 10-K.
"We may be at a higher risk for food-borne-illness outbreaks than some competitors due to our use of fresh produce and meats rather than frozen, and our reliance on employees cooking with traditional methods rather than automation," according to Chipotle's fiscal 2014 report.
Closing 43 restaurants out of what Chipotle called "an abundance of caution" is still a drop in the bucket compared with its overall U.S. footprint, which includes more than 1,900 locations. Still, the temporary store closures could deliver a $0.22 blow to the company's earnings in the fourth quarter, according to some analysts.
Nevertheless, this by all indicators appears to be a near-term challenge that probably won't have a lasting impact on the stock.
Rival fast-casual chains that have run into similar public-relations problems were quick to recover, and many didn't share the intangible asset that is Chipotle's loyal customer base. Darden Restaurants (DRI 0.87%), for example, was under fire in 2013 when a cyclospora outbreak at some of its U.S. restaurants made national news. Hundreds of patrons of Darden's Olive Garden and Red Lobster restaurants in Iowa and Nebraska fell ill with the parasite. A handful of victims filed lawsuits against Darden Restaurants, and the stock temporarily nosedived. That incident received widespread media coverage, but it was quickly forgotten and had no impact on the company's full-year sales.
Therefore, it isn't unreasonable to expect that the latest food-safety problem at Chipotle will blow over as well. Investors should instead shift their focus to the bigger picture and the overall health of Chipotle's business.
Taking stock
Sure, the E. coli scare could result in an additional 75-basis-point decline in same-store sales for Chipotle this quarter, according to restaurant analyst Stephen Anderson with Maxim Group. However, one weak quarter does not make a trend. Moreover, the Mexican-food chain boasts industry-leading comparable sales and some of the highest margins in the business. Chipotle's margins could top 30% in the next five years, according to data from Morningstar.
Ultimately, this stock should reward long-term investors who demonstrate patience toward the company's recent setbacks.
The chain also has other growth drivers in the pipeline today that could fuel future earnings. Chipotle is in the process of expanding its on-demand pizza chain, Pizzeria Locale. Using a format similar to Chipotle, customers choose their pizza toppings in line and then watch as their food is prepared in front of them.
Chipotle expanded its pizza concept outside Colorado earlier this year and plans to open new locations across the U.S. in the quarters ahead. While it could take years for Chipotle's investments in Pizzeria Locale and its Shophouse Asian kitchen concept to pay off, these are smart long-term bets that could spur future growth for the company.
Ultimately, I believe consumers will choose fresh produce and antibiotic-free meats over the alternative every time -- even if that means putting up with the occasional side dish of food poisoning. For that reason, investors would be wise to ignore the recent sell-off and continue to hold shares of Chipotle for the long haul.
