Chipotle and Taco Bell Are Feeling the Love

In today's episode of the MarketFoolery podcast, host Mac Greer talks with contributors Aaron Bush from Motley Fool Supernova and Crypto Society and David Kretzmann from Hidden Gems Canada about the market's biggest stories.

Oh, the irony. Chipotle (CMG 0.40%) has finally found its new CEO... in Taco Bell's Brian Niccol. What can Niccol bring to the table, and will Steve Ells be able to give up the reins in his new position? Fossil (FOSL -3.42%) is up huge on its most recent earnings report, but there are still some big question marks around its long-term future. Baidu (BIDU 0.98%) is also up big on earnings, and announced plans to IPO its video streaming service. Tune in to find out more.

A full transcript follows the video.

This video was recorded on Feb. 14, 2018.

Mac Greer: It's Wednesday, February 14th. Welcome to MarketFoolery! I'm Mac Greer, and joining me in studio, we have Aaron Bush from Motley Fool Supernova and Crypto Society, and David Kretzmann from Hidden Gems Canada. Gentlemen, welcome!

Aaron Bush: Hello, hello!

David Kretzmann: Hey, Mac!

Greer: How you doing? Happy Valentine's Day!

Kretzmann: Oh, feeling the love.

Bush: So much love around here.

Greer: There's a lot of love, and we're going to share the love. We're going to share the love. Baidu getting a lot of love today, and Fossil getting a lot of love. We'll talk about that in a minute. But guys, when I think Valentine's Day, I think Chipotle and I think Taco Bell.

Kretzmann: It's a match made in heaven. [laughs] 

Greer: We're going to see if it's a match made in heaven. On Tuesday, Chipotle naming Brian Niccol as its new CEO. Niccol was the CEO of Taco Bell. Chipotle founder and CEO Steve Ells will now become Chipotle's executive chairman. David, investors seem to love this news. Shares of Chipotle up around 15% at the time of our taping. What do you think?

Kretzmann: There's no shortage of irony here, that's for sure, that Chipotle has gone for throwing constant shade and backhand remarks to Taco Bell to now bringing on Taco Bell's CEO as their own CEO. So, it's certainly ironic. But, I think this is a really positive move. Niccol, in the press release, announcing this transition, he specifically called out improving Chipotle's branding or cultural relevance, and also wanting to focus more on digital communications and digital marketing. I think those are two areas where Chipotle has severely lacked over the past few years, especially since the E. coli outbreak a couple of years back. It's always baffled me that Chipotle hasn't prioritized building out a digital loyalty program, especially when they had Chiptopia about a year and a half ago, which really just ended up being a one-time loyalty program that didn't even tie into their digital or mobile platform. At that point, it just seemed like such a natural way to build a sticky relationship with customers and bring them back into the store, and build that repeat business which they so desperately need. 

But, I think Niccol has the right mindset. I think the two biggest question marks I have here is, how much of a backseat can Ells really take here? Because Chipotle is his baby. He's the founder, he's been the leader, really, through the entire lifespan of Chipotle. So, can he really take a backseat and let Niccol do his thing? Then, also, Niccol has more experience with Pizza Hut and Taco Bell, with franchised restaurants. Chipotle is entirely company-owned. So, seeing how his expertise with franchisees translates to a company-owned concept like Chipotle.

Bush: I like the move, too. It's going to take me a long time to get over how hilarious and ironic it is. But I think it's very telling of Chipotle. What it shows me is, they're prioritizing fixing broken processes. And if the best person for the job is the person who ran, essentially, the anti-Chipotle for a few years, then so be it. And I think that's a pretty positive sign. I do think there's some of that risk with Steve Ells. I have a feeling that Brian Niccol will try to do things that Ells has been so slow to do: drive throughs, nachos, even, breakfast, all these different things. It could be an uphill battle in some ways, but just the fact that he's coming here in the first place and Chipotle was OK with that, I think that's a pretty positive sign.

Greer: And their backgrounds are really, really different. You have Steve Ells, who's a chef turned entrepreneur. Then, you have Niccol -- David, you mentioned this -- he spent a decade at Procter & Gamble, six years at Pizza Hut, seven years at Taco Bell, two of those years as CEO. Is this going to be an opposites attract, or at least complement? Or are we going to have Niccol constantly pushing the envelope in a way that Ells finally says, "Wait a minute, we're food with integrity, I can't abide by this."

Kretzmann: I'm hoping this is a sign that Ells is being humbled, and that he recognizes that he needs help right now. Obviously, he loves Chipotle, and rightfully so. He's done an incredible job bringing Chipotle to this point. It's still a $7 billion company, still very profitable, even despite all the hardships over the past couple of years. So, he has done a wonderful job bringing Chipotle to this point. But I think this is a sign that he, and certainly the board, recognizes that they needed some outside help. And over the past year or two, they have been bringing on new executives from more established brands, including Yum! Brands. They brought on a new marketing officer last year who had previously been at Yum! So, this is kind of a path that Chipotle is slowly but surely going on. I think this is them completely ripping off the Band-Aid and going all-in with this rebuilding. But, I agree with Aaron. I think we'll see a lot more innovation in the menu. Rolling out breakfast seems like something that would be doable. Just, things that will attract people back to the stores. And if they can do that -- and I think digital certainly complements that, they have some sort of digital loyalty program. Chipotle has fixable problems. If they can get people back into the stores, I think profitability and cash flow can get closer to where they were a few years ago, before the E. coli levels. Maybe not completely getting there, but I think they can get close to there.

Greer: OK, how would you prioritize opportunities?

Kretzmann: I would personally focus on the menu innovation, and then some sort of loyalty program. I think those are no-brainers, the low-hanging fruit that should have been done a lot sooner. But, better late than never. So, I would focus on those two things. I think you could probably add one or two new menu items to accommodate breakfast, like eggs and maybe something along with that. Obviously, I think the danger, and part of Chipotle's strategy up to this point, has been keeping a very limited menu. Because then, the assembly process is so much quicker, it's less complex. So, I think they should be careful branching out too much further. But breakfast seems like a no-brainer that they could do without making it too much more complicated.

Bush: Yeah, definitely some type of digital program, app, loyalty program would be my No. 1, without a doubt. And second, whatever it is that drives the most new foot traffic coming in. I don't know if that's a complete menu overhaul, but it probably means, steadily, new things coming out slowly over time.

Kretzmann: Which Taco Bell has been pretty good at doing.

Bush: Yeah. So, I totally see some more frequent announcements like that. And I think that strategy or that tactic makes a lot of sense. Then, after that, I would say drive throughs, because cars make a lot of sense. And in a time where delivery is more of an option, I think that'll be good for people who are working that, too.

Greer: So, don't skimp on the ingredients, though, right?

Bush: I mean, food with integrity, we'll see what happens with that.

Greer: [laughs] You're skeptical.

Bush: I'm a little skeptical, yeah. I tweeted this morning a poll of whether Chipotle's new slogan should go from food with integrity to either food with "integrity" or "food" with integrity. So far, "food" with integrity is winning. We'll see what happens there.

Greer: My bellwether will be when I see if they go the route of the squeezable guacamole. That, to me, will be the test. That would not be a good sign.

Kretzmann: [laughs] I would be surprised if they went that direction, at least right away. I think there are ways to improve the existing brand and concept without compromising the quality of the food, which I think, still, for the majority of Chipotle customers, that's still a major selling point. So, I wouldn't expect Niccol to completely try to just reinvent the entire concept including the food. Personally, I would see that as a little bit more of a yellow flag, because I think that has been a big differentiator for Chipotle. It certainly helped them to get into more trouble, because when you're talking about food with integrity and then you have E. coli outbreaks and norovirus, it's a little bit harder to defend yourself against that. But, I think those are things they can recover from. And hopefully they can find ways to get back to the glory days without compromising food quality.

Greer: Let's wrap this up by talking about the stock. I think we're all Chipotle shareholders, right?

Kretzmann: Yep.

Bush: Yep.

Greer: What do you think about the stock going forward?

Kretzmann: Chipotle today has over $500 million in cash, no debt. Annually, they're still producing about $250 million in free cash flow. They were producing close to $1 billion a few years ago, so they're still a ways off from where they were a few years ago before the E. coli crisis hit. But, this is still a strong business as far as restaurants go. I think the issues that Chipotle has are fixable, and I think Niccol is bringing a fresh set of eyes. He's done a great job with the Taco Bell concept the past few years. I think with a renewed focus and prioritizing a loyalty program, digital communications, and then finding some common-sense menu innovations, I think it's just a matter of time before people start coming back into the stores. I think, from today, the stock beats the market over the next three years.

Bush: I don't know if I'm as optimistic. I definitely think that's happening. I think turnarounds like this take longer to happen than people think, so I expect the runway of how things change to actually be pretty slow. And given that the stock still isn't that cheap, it's cheaper than it was but it's still not that cheap, it wouldn't surprise me if issues continue for a while. But, definitely looking longer-term, even five or 10 years long, I definitely think there's a lot of optimism. So, I'm not buying more, but I'm definitely holding on to what I have.

Greer: Guys, we'll keep an eye on that story. Let's talk some Baidu. Shares of the Chinese internet search company up big on earnings. Aaron, Baidu also announcing plans for an IPO of its video streaming service.

Bush: There's a lot to unpack in this quarter. Overall, it was really positive. The past couple of quarters have been like this, too. I think Baidu is now on a trajectory that looks pretty strong. This quarter, sales grew 29%. The number of advertising customers only rose 2%. So, maybe there's some type of yellow flag there. But sales per customer rose 25%. It took Baidu a while to recover from the advertising mandates that the government put on them a year or two ago, but they're showing that they can recover from that and come out stronger on the other side, which is a very positive moment for the business and the stock. And this rebounding on the top line also leads to a much-needed reexpansion of margins. In the fourth quarter, operating profit rose 118%. And operating margin hit 24%. There's still room to improve. It's just the fact that they're growing this quickly, it shows me that the momentum is there, and they will continue to reach new heights there over time. And that makes a big difference when it comes to producing higher cash flows and doing things with those cash flows for the business. 

And part of Baidu's success lately has been refocusing on what works best. Baidu recently has been leaving non-core businesses like mobile gaming and deliveries, which have sucked up resources and didn't quite succeed as planned. They're shifting their focus to artificial intelligence, AI, and really ingraining that in every part of the business so they can see increased results everywhere. It improves search, it solidifies Baidu's lead in autonomous driving in China. If anyone in China is going to lead that market, right now, it's going to be Baidu, I think. It improves their position in voice assistants. In a similar way that we've seen Amazon lead the way with Echo in the U.S., I think Baidu has a pretty good chance of leading the way with that in China. So, their ecosystem is steadily building. Their heavy investment in AI, I think, is leading to gains. 

And you mentioned the spin-off and upcoming IPO of iQiyi, which is Baidu's video streaming platform. It's kind of like a hybrid between YouTube and Netflix. Personally, I'm still trying to wrap my head around what the future competitive landscape will look like in China for video streaming. But I think there's a good chance that this move will unlock significant value. If it's anything like we've seen with Netflix or YouTube, this one business, just iQiyi, could be worth tens of billions more.

Greer: David, there's a lot there to unpack. What do you think?

Kretzmann: Baidu isn't a company I've followed quite as closely as Aaron over the past few years. But I think they have continued to carve out a niche for them within that whole Chinese ecosystem. They are increasingly butting heads with Alibaba (BABA 2.92%) and maybe Tencent a little bit more. Again, Aaron knows more about this than I do. At CES, Alibaba was really showcasing their equivalent to the Echo or the Google Home. How exactly these different ecosystems stand out from each other, it seems like Baidu's focus has obviously been with search and everything that goes with that. But they're still quite a bit smaller than Tencent or Alibaba. Baidu, today, the market cap is around $80 billion. I think Tencent and Alibaba are both $500 billion or higher. So, still, certainly seems like there's room for them to run. Just looking at Baidu's profit margin today, it's about 23%. Alibaba's profit margin is about 30%. So, the fact that Baidu has gotten back to growing revenue as quickly as it did is impressive. 2017 was more of a transition year as they tried to navigate to new advertising rules that the government set forth, but back to 26% revenue growth. And I think for the coming year, they're guiding for 30% or even higher growth. So, a lot of things to like here. I think the stock doesn't look all that pricey to me. So, over the next few years, I think this beats the market, for sure.

Bush: I think so, too. I think a good way to think about Baidu and the other Chinese internet companies is that, they tend to have a monopoly on whatever their core business is. With Baidu, it's search. For Tencent, it's WeChat and messaging. Alibaba, it's not exactly a monopoly, but they have a very big foot hold in e-commerce. And then, all of the other things that they're working on just go to develop their ecosystem and lock people in the best that they can. So, when I see Baidu shift away from things that aren't working and then refocus priorities on things that are, that makes me pretty bullish that they're focusing on the right things that do differentiate them from the competition. Plus, China is such a big market, there's room for many winners in all these areas.

Kretzmann: It seems like one of the main things to watch would be, how much can Baidu improve margins going forward? Because 23% profit margin is still great, but a few years ago, it was closer to 50%. But, right now, Baidu is trading for 7X trailing sales. Alibaba trading for 14X sales, even though their margins right now aren't all that far apart. So, the fact that Baidu is once again accelerating revenue growth, I think compared to some of these other huge Chinese tech giants, it's worth taking a look at Baidu again.

Bush: Sentiment is changing.

Greer: Guys, let's wrap up by talking Fossil. Shares of Fossil up around 60% today on earnings.

Bush: What a day!

Greer: What a day! The fashion designer really getting it done, thanks in part to wearables. The CEO says the plan here is to stay small but increase profitability. Aaron, when I think Fossil, I think watches, and I think things that are too stylish for me to wear. What's the story here?

Bush: [laughs] I think I'm right there with you. I mean, I think there are two pieces of good news that came out here. One is, e-commerce sales are up 31%. And that's pretty good, and, in my opinion, necessary for them to stay relevant. Seeing them make progress on that front is a bullish sign. Second, as you mentioned, wearables, particularly smart watches, are performing much better than expected. To be clear, I do think this is more of a, they're not doing as bad as people thought they would do, instead of, they're just nailing it.

Greer: Expectations.

Bush: It's definitely an expectations game here. Still, the stock rising 60%, that says a lot. If I were Fossil, though, I would still be pretty paranoid. And the reason I say that is, I do believe that smart watches and wearables have a very firm place in the future. Smart watches in particular will take much more market share when it comes to watches. But, what will be increasingly important is flawless interoperability between devices -- so, being able to access messages and weather and whatever else from between your devices. And I think someone like Fossil literally can't bring all of that to the table, because they're not part of a broader ecosystem. So, as that takes more market share over time, my gut tells me Fossil might be left behind. But, live up the good day while you can.

Kretzmann: Yeah, I think this is definitely largely an expectations game. Over 20% of shares were sold short going into this, so we're definitely seeing a short squeeze today. And the stock within the past couple of months was trading for 2X free cash flow. So, the market was basically expecting Fossil to eventually go out of business. But the company, to its credit, has still managed to produce positive free cash flow. And even after today's pop, it's still trading for less than 4X trailing free cash flow. So, the company isn't in danger of going out of business anytime immediately. They have been paying down their net debt position, which I think, if you're a retailer, that's what you need to do. They've been closing some stores. But they are still guiding for overall revenue to drop this year. 

Revenue will continue to drop, but they're expecting their gross margin to bump up a little bit from what we saw in 2017. They've been doing some different things in addition to closing stores. They did less brand advertising on TV. They focused on digital advertising or online advertising, which is just a little bit more effective and it plugs right into their e-commerce channel, as Aaron mentioned. So, for a stock trading at less than 4X free cash flow, it might be worth a gamble. But, this is, what, a $16 stock now, and it was trading for over $110 per share a couple of years ago. So, it's been a painful ride, but kudos to the people who were buying it at 2X free cash flow. You're loving it today.

Greer: OK, it's time for the big finish here. It's my completely arbitrary desert island question. I think I know how this may shake out. We've talked about three stocks, primarily: Chipotle, Baidu, and Fossil. You're on a desert island for the next five years and you can only own one of those three stocks. What are you going with?

Bush: Baidu.

Kretzmann: Chipotle.

Greer: Interesting.

Bush: Interesting, yeah.

Greer: Alright, we'll see. Totally arbitrary.

Bush: Bring your smart watch with you. [laughs] 

Kretzmann: We'll check back in Valentine's Day 2023.

Greer: Yes. And the beauty of the market and the beauty of portfolios is, you can actually own both. So, there you go! Guys, thanks for joining me!

Kretzmann: Thanks, Mac!

Greer: I just want to give a shout out to the listeners that we met in San Francisco. Aaron, we had a great happy hour out there with the podcast listeners. And it's appropriate on Valentine's Day to really share our love.

Bush: I really enjoyed the experience. We had several people come out. We had so many discussions about all sorts of stocks, all types of industries. There are just so many interesting people there working on their own things. It was awesome!

Greer: Dozens of listeners. Dozens of listeners. Thanks again for joining us! Aaron, David, thanks for joining me!

Kretzmann: Thanks, Mac!

Bush: Thank you!

Greer: As always, people on the show may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's it for this edition of MarketFoolery. The show is mixed by Heather Horton, I think, and all sorts of other people today. I'm Mac Greer. Thanks for listening! We'll see you tomorrow!