There are some businesses that contain a capital structure that is doomed from the start. I had that on my mind when I was reading through the Sports Authority bankruptcy which was almost a matter of predestiny dating back to the early 2000s. When Sports Authority was rapidly expanding, it was not using organic profits to fund growth–it was diluting shareholder and filling itself up to the gills with debt to expand the store count.
When competition from Amazon, Dick’s Sporting Goods, and even general retailers turned $25 million profits into losses in the $50 million range, Sports Authority had to shutter underperforming stores. This required upfront cash to handle the one-time fees associated with closing, and also meant that Sports Authority had to enter the interest rate death spiral in which it kept refinancing its debt at higher and higher interest rates while shrinking the store count base that would be capable of delivering profits. By 2016, debts at Sports Authority had mounted to over $1 billion and the annual losses hit the $150+ million range. Creditors refused to budge, and Sports Authority had no choice except to file Chapter 11 bankruptcy and make immediate plans to close a third of its remaining stores. What would have happened if Sports Authority had no debt in the early 2000s, and had hundreds of millions in ready cash instead?
That question is not just a hypothetical when you look at the capital structure of Chipotle Mexican Grill.
After some E. Coli outbreaks that received a significant amount of media coverage in the past year, Chipotle found itself having to deal with: (1) a loss of customers when business resumed; (2) a loss of revenue when stores were idle for inspection and overhaul; (3) the expenses associated with adopting new safety protocol and upgrading equipment as well as the initial overseers; (4) higher than usual advertising spending to entice customers to returns; and (5) a halt on expected price increases and new food offerings.
All told, these expenditures have cost Chipotle about $250 million in direct costs and about $300 million in foregone earnings from the closings and lower foot traffic.
But you know what? Chipotle had the financial strength to persevere through the business turmoil. On the eve of its business turmoil, it was pumping out $475 million in profits, had $663 million in cash on hand, and no long-term debt on the balance sheet. The balance sheet was anti-fragile and primed to handle adversity.
After seeing profits dip to the $124 million range and the cash position decline to $250 million, Chipotle is now expecting a return to profits in the $400+ million range next year and even managed to buy half a million shares at the lower stock prices while going through the storm (that’s more impressive than it sounds when you’re talking about a business with only 30 million shares).
Sure, no one likes to see a stock decline from $750 to $390 while the rest of the stock market advances. But the issue with Chipotle’s stock price was mostly a result of extreme valuation that clouded almost had investors doomed from the start. Last August, when Chipotle was priced at $750, it was only making $15 per share in profits. It was a company with a valuation in the tens of billions trading at a P/E ratio of 50. You need something approximating perfection for that to work out well; that’s why I’m leery of Facebook at $115 per share. The premise for success is years and years of 15-20% earnings growth which is great if you get it, but should only be the rationale for making an investment a few times in a lifetime.
Even if Chipotle returns to form within a year and earns $16 in profits, the current price of $390 is still 24x earnings. It’s important to understand the mechanics of why Chipotle got hammered here. Investors didn’t get hammered here because they owned a nice business at a nice price and then everything fell apart; they got hammered because the stock transitioned rapidly from severe overvaluation to fair value as the E. Coli outbreak made all stock price excess get burned off in nearly real time.
It’s an unpopular opinion, but it’s where the facts lead me: The management time has done an excellent job running Chipotle and continues to do so. You can’t look at the recent share price change to argue their incompetence. It is not their fault that everyone else lost their mind and valued Chipotle stock at a price that had almost no bearing relationship to the underlying fundamentals.
Since the January 2006 split-off from McDonalds, Chipotle has grown earnings by 27% annually and has still given investors 24% annual returns. The P/E ratio at the time of the IPO was 40x earnings, and so the three percentage points lost is a result of P/E compression. That is a fantastic result–the business growth stuck to the owners’ ribs because there was no debt issuances or stock dilution to fund the growth. Chipotle has always funded its store count growth from retained profits, and that is why investors have done so well. While Sports Authority was opening new stores with 8.25% notes, Chipotle was taking that week’s profit and opening a new store.
There is a place and time for highly leveraged businesses. Royal Dutch Shell, AT&T, and Anheuser-Busch all carry large debt burdens, but they have the likely cash flow over the long haul to back it up. But I have long held that cash-rich balance sheets don’t get their due and perpetually underestimated in the eyes of investors.
One of the worst trends among MBA teaching in the past few years has been the notion that a business is being unproductive if it isn’t borrowed to near the max. When unexpected poor business news arrive, the taught answer is: (1) issue stock or (2) take on more debt.
Little attention is paid to the dilutive effect of issuing stock at a time when a business is unfashionable or the required rates that lenders will demand under such a scenario. And worse yet, almost no attention is paid to the question: What if no one wants to buy freshly issued shares of the business or lend to it? The answer to that question begins with the word: “Chapter.”
Don’t let the shift in Chipotle’s valuation this past year fool you. That’s a red herring that provides an instructive lesson on valuation. But the management team at Chipotle was well prepared for this and has responded responsibly. There was no stock issued at bargain-basement prices or debt taken on at high rates that would act as future skeletons to haunt the next batch of Chipotle’s shareholders. There was no punitive moment. Chipotle has no debt, $250 million in cash in the bank, and is on the verge of returning to profitability soon. The well-funded capital structure is a part of the recovery story you shouldn’t ignore.