Was Chipotle Downgraded Just Because It Overpays Its Workers?

By Lee Jackson Updated Jan 12, 7:04AM EST · Published Oct 18, 10:55AM EDT

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Was Chipotle Downgraded Just Because It Overpays Its Workers? — © Thinkstock

If there is one company that has had a multitude of problems over the past few years it has been Chipotle Mexican Grill Inc. (NASDAQ: CMG). The company has suffered through outbreaks of e-coli, salmonella and norovirus back in 2015, and it had yet another case reported this past summer at one of the restaurant locations in Virginia. Toss in customers posting pictures of rats falling from the ceiling at a location in Dallas, also back in the summer, and the public relations nightmares have dog-piled the company once again.

Despite the multiple issues, many Wall Street analysts have stayed positive on the company, and activist investor Bill Ackman and his Pershing Square hedge fund are currently the largest shareholder.

One company that is not bullish on the stock is Merrill Lynch, and today analyst Greg Francfort cut his rating on the stock from Neutral to Underperform, with a price target of $285. That compares with a Wall Street consensus price target of $371. The 52-week trading range for the shares is a stunning $295.11 to $499.00. The Merrill Lynch analysts also dramatically cut earnings estimates for 2018 and 2019.

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One of the main reasons cited in the Merrill Lynch report was labor costs:

We believe Chipotle has done a very strong job managing labor in a tough sales backdrop but this limits further margin gains. We estimate production labor minutes per entrée will be 6.7 in 2017 on 216,00 entrees per store, which is substantially below 8.0 mins in 2009 when the company did 219,000 entrees per year. We believe further gains from trimming hours will prove difficult which limits the opportunity to get labor below 27% of sales even if traffic recovers.

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The report also noted this in the investing thesis:

Chipotle is one of the few high-growth restaurant companies and has numerous appealing attributes that support continued unit growth. But while we believe the company has done a solid job of maintaining costs, particularly around labor, this likely limits further upside to margins. The company continues to trade at an expensive level on aggressive street earnings consensus and therefore we see risk to the stock going forward.

Clearly the cost of paying employees is not the only reason for the Merrill Lynch downgrade, but it is a major issue for the company, and going forward it does not appear that things will get any better.

It is also important to remember that short sellers have targeted the stock for years, and currently almost 4 million shares are sold short, a stunning 17.9% of the float. Those looking to be long the shares should do so with caution.

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About the Author Lee Jackson →

Lee Jackson has covered Wall Street analysts' equity and debt research and equity strategy daily for 24/7 Wall St. since 2012. His broad and diverse career, which included a stint as the creative services director at the NBC affiliate in Austin, Texas, gives him unique insight into the financial industry and world.

Lee Jackson's journey in the financial industry spans over 30 years, with nearly two decades as an institutional equity salesperson at Bear Stearns, Lehman Brothers, and Morgan Stanley. His career was marked by his presence on the sell side during pivotal Wall Street events, from the dot.com rise and bubble to the Long Term Capital Management debacle, 9/11, and the Great Recession of 2008. This is a testament to his resilience and adaptability in the face of market volatility.

Lee Jackson’s practical financial industry experience, acquired from a career at some of the biggest banks and brokerage firms, is complemented by a lifetime of writing on various platforms. This unique combination allows him to shed light on the intricacies and workings of Wall Street in a way that only someone with deep insider experience and knowledge can. Moreover, his extensive network across Wall Street continues to provide direct access for him and 24/7 Wall St., a privilege few firms enjoy.

Since 2012, Jackson’s work for 24/7 Wall St. has been featured in Barron’s, Yahoo Finance, MarketWatch, Business Insider, TradingView, Real Money, The Street, Seeking Alpha, Benzinga, and other media outlets. He attended the prestigious Cranbrook Schools in Bloomfield Hills, Michigan, and has a degree in broadcasting from the Specs Howard School of Media Arts.