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How Chipotle Can Recover From Its Newest Rash Of Bad News

Since 2015, Chipotle (NYSE: CMG) has done a lot to make their food safer for consumers, but apparently the issue still isn't solved. After reports of more food safety issues and norovirus broke a few weeks ago, the stock plummeted to the lowest levels it's seen since 2013.

In this week's episode of Industry Focus: Consumer Goods, Motley Fool analysts Dylan Lewis and Sarah Priestley talk about how Chipotle could recover from this, and the most important numbers that listeners should be watchful for in their earnings report this week.

Also, the hosts look at Lululemon's (NASDAQ: LULU) climb back to the top after their fall from grace in early 2017, Michael Kors' (NYSE: KORS) acquisition of fashion company Jimmy Choo, and more.

A full transcript follows the video.

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This video was recorded on July 25, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday July 25th, so we're talking Consumer Goods, doing a rundown on some retailer news, and a little update on Chipotle. I'm your host, Dylan Lewis, and I'm joined in the studio by Fool.com Sarah Priestley.

Sarah Priestley: Hi! It's nice to be here!

Lewis: Yeah. I think maybe some of our Tuesday listeners were a little surprised to hear my voice.

Priestley: Yeah, they wanted to hear Vince's voice, but sadly not to be. Back next week.

Lewis: Yes. We'll be talking CG, but I think really we'll be doing our best Vincent Shen impression today. [laughs] 

Priestley: [laughs] Absolutely.

Lewis: He's out of the office, so we're covering for him. Sarah, what do you think a good Vince impression be? What would it be based on?

Priestley: Oh, it would definitely involve flip flops, of course.

Lewis: I am wearing my office moccasin slippers right now, which is about as close as you can get to Vince's flip flops.

Priestley: I'm sure our listeners really wanted to know that. And, it would involve food. Any impression has to involve something with food.

Lewis: Maybe something about endless buffets.

Priestley: Yes, gaming a buffet.

Lewis: Going to a gym, Fool Fitness.

Priestley: Yes. Being swole, is that the word?

Lewis: Yes. Swole guy, Vincent Shen. So, we're talking retailers today. A decent amount of retailer news, and a company that has struggled for a long time but might be getting back to its winning ways. Lululemon was one that we wanted to talk about. This stock is almost back to where it was in early 2017, before the company issued some weak guidance and predicted its first same-store sales decline in the past 28 quarters. Sarah, you actually bought shares of them after that post-earnings sell-off. Do you want to talk a little bit about what you saw and what you liked in the company then?

Priestley: The stock was down 20% on what I would deem to be an overreaction on some sort of short-term bad news. Revenue for that quarter was actually up 12%. EPS came in slightly short of the $1.01 anticipated, it came in at $0.99. Total comps were up 8%, gross margin was crazy good for the industry at 54.2%, up 4%. What really knocked the share price was the fact that the spring apparel collection missed the mark, it lacked a lot of color, and they noticed this was going to happen watch on these first quarter trends.

Lewis: When you say color, because ... I don't know what I'm talking about, [laughs] when it comes to the apparel world, do you mean literal color?

Priestley: I mean actual color. If you go into their store, everything was very much blacks, and maybe some maroons and dark blues, things like that, whereas the spring trend was very much for whites and neutrals and splashes of color here and there.

Lewis: So the kind of missed the mark with planning what the fashion taste would be.

Priestley: Absolutely, they did. It was kind of an issue with their design team, and they were very upfront about that, and quickly moved to correct what they were doing. So, my belief was that the drop and share price presented an opportunity. I've been looking at the stock for a while. The current P/E now that it's up is 26X, which is still quite high compared to the industry average. But I still think it has a lot of growth potential ahead of it, in international and in the men's segment, they're probably $1 billion each. I also think they command some pricing power from their loyal customer base.

I honestly do believe that they offer a very good premium product. I think they focus on form fit and function, and they're quite technology advanced, and you can see that in some of their more recent announcements.

Lewis: Checking in on some of those thoughts and the results that have backed them up, because we now have two quarters to look at what your case was and how it's played out, what has it been? How has the company performed?

Priestley: The lower projection that people panicked about, they lowered the revenue projection for between $510-515 million. That actually came up $520.3 million. So, it's up to 5% year over year. EPS was at $0.32 per share. It had been estimated between $0.25-$0.27. So, they did better than people were expecting. However, the big blow was the brick and mortar comps decline of 1%. And that was the first comps decline that they'd anticipated for 28 quarters. So, that was a shock, but it shouldn't have been a shock because it was expected.

Lewis: In some ways, that reminds me of Under Armour (NYSE: UA) (NYSE: UAA).

Priestley: Yes, exactly.

Lewis: Any time you have this company that has this long history of blowing it out of the water, and I think it Under Armour's case, it was double-digit growth --

Priestley: Yeah, over 20%.

Lewis: -- for 20 straight quarters or something like that, any time that starts to sink and it's been the flagship metric that management has pointed to for a really long time, it has an outsized impact on investor opinion of the company.

Priestley: Totally. And part of that is the problem of Wall Street analysts, and part of that is also management's own problem for keeping harping on that figure. And it's exactly the same thing. It was in a very high-growth industry in the athleisure segment, and they were really a front-runner, they had the first-mover advantage with the yoga apparel. Now you're seeing as steadying off and a slower growth, which is to be expected. It's still a good stock.

Lewis: What led to that out-performance? That reduced guidance, obviously management didn't think, knowing they were missing the fashion mark with some of the stuff they would be rolling out in the spring, that they were going to be performing all that well. What caused them to wind up beating some of those estimates? 

Priestley: I think that one of the biggest things, if you listen to the earnings call and look at the balance sheet this quarter, they have some one-time expenses for their e-commerce, because they redesigned their website. If you look at their website now as opposed to three months ago, it's much more image heavy. It has some videos in it, it's much more focused on the usability and the function of their products. And that has had some great results for them. They've had two campaigns. The one I'm thinking of, I think it's the This Is Yoga campaign, it's been really successful. It's had 26 million views, it's trying to reach people that don't traditionally know Lululemon's products. They have a rap star on there talking about breathing, and all those kinds of things. So they're really trying to reach out to different segments of the market, and I think they're achieving that. What's driven some of their improvement is, honestly, the gross margin being up, and some of that is some supply chain work that they've been doing to try to get some efficiencies back into the supply chain and make it more of a flexible dynamic supply chain that they can go back into when they notice a trend is really taking off, and that's been successful.

Lewis: That focus on e-commerce and that pivot to digital makes sense when brick and mortar stores are struggling for them. You've enjoyed a nice 20% pop since you bought the stock, in quite a short time. Now that they're back to where they have been historically, I think they're an $8.5 billion company right now, and you look at their long-term market cap and it's between that $8-11 billion, they haven't been able to break much beyond that, do you see a lot of the efforts that they're investing in as being things that make them a company that you want to own for a long time?

Priestley: I do. And I honestly think that some of the recent management moves have impressed me. They're divesting, I'm going to say this incorrectly, their ivivva brand, which is their girls brand. It's now going to be online only, which means it might actually be accretive to their bottom line, which it hasn't been before. I think that's a good move. That show some strong leadership to me, the decision to actually cut something off before it gets bigger and more of a challenge to bring back. The men's segment is still only 20% of the total business, but 30% of new customers coming to the store are men. And I think there's some innovation in products there that are actually very attractive. I think it's going to take a lot to convince some men to shop at Lululemon, but it might be a secret, on-the-side, where-did-you-get-that-from Lululemon, for a while. [laughs]

Lewis: I will say, one of my best friends from college works in a job that's kind of manufacturing, kind of corporate, in that he works in logistics for a company that handles big-time infrastructure and industrial work. So, he spends some of his time on plant floors and some of it in an office, and he wears the Lululemon ABC Pants, the office pants that are these very breathable and flexible pants that look like your average work slacks. He owns three or four pairs, and that's all he wears to work.

Priestley: And I can see why. They're expensive, I think they're $100 a pair, but I think people are willing to pay when something is well-made and functionally excellent. I also think they have a lot of growth in Asia, and you can see that they're expanding heavily over there. They're much more slow and steady in Europe, which I think is good. The approach suits the market. Overall, the bottom line is, I should say I'm an Under Armour shareholder as well, and I'm bullish on the overall athleisure trend. I think there are a lot of analysts right now that are thinking the trend isn't going to last out, it's going to peter out because it's fashion-based. I don't think it is. I think it's a lifestyle, generation change base. I think Millennials are much more focused on health and wellness, they're much more likely to spend money on experiences, and I think these products are tied to experiences. You can wear it hiking, you can wear it to the office in a lot of cases, now, and that makes it a more valuable product.

Lewis: It's something that we see quite often here at Fool HQ. We have a very wellness and health oriented group of employees here, and I think it's very common to see people in yoga pants after they do Fool Fitness, or coming from the gym in the morning and going down to the showers and getting ready for work. I certainly see it a lot. I don't think it's going anywhere. I participate in that trend quite a bit myself. I think, as other people get into the space, you talked about how some of the big retailers are doing it, and there are concerns about that crunching Lulu's margins. But, for a long time, Lulu has been able to command, because of its premium product, these great margins. I know that right now, the gross profit margin is better than Nike and Under Armour.

Priestley: Yeah, way better. Vince and I have talked about this before. We've talked about Under Armour and Lulu and Nike in the same show. The pie is so huge for this market, I think there are some estimates that peg the health and wellness trend, which obviously encompasses a lot of different things, as the next $1 trillion market. And I really feel like people are looking at this as if it's a zero-sum game, and it's not going to be. There's going to be a lot of winners. Lulu already has a loyal base of customers. If they can build on that, I think they can defend their margins.

Lewis: Switching gears over to something I know even less about, [laughs] in other retail news, Michael Kors announced that it was buying Jimmy Choo for £896 million.

Priestley: My money! 

Lewis: [laughs] Which I am told translates to $1.17 billion. I'm going to have to take Sarah's word for that. This really ends a period where JAB Holding Company, the major owner and influencer with Jimmy Choo, had been trying to shop this business for a while.

Priestley: Yeah, they put it up for sale in April. They've been pretty prolific buying up American companies. They bought Krispy Kreme -- was that at the end of last year?

Lewis: Something like that. 

Priestley: They just recently bought Panera, too. As you can see from those two acquisitions, it's much more restaurant and coffee focused.

Lewis: Yeah, one of these things is not like the other.

Priestley: Yes, absolutely. I think they're really trying to focus on that, it makes sense for them. So yeah, Michael Kors has finally taken the bait. They bought Jimmy Choo for $1.17 billion. I think the decision was probably influenced a little bit by Coach's purchase of Kate Spade back in May for $2.4 billion. I think they're really trying to get into different areas of the market. I think Kate Spade is obviously going to offer Coach access to a younger and more fashion-forward, some could argue, market. Michael Kors, known for its handbags, known for issues with commoditization of its products, really wants to break into the designer shoe industry. It's actually grown at 9% in the past decade, as opposed to 5% for the larger luxury sector.

Lewis: This seems a little bit like it's less them aggressively going for growth, and more them trying to keep pace with Coach.

Priestley: That is what it appears to be. They just posted a loss for the last quarter, and they are struggling. I think they recently pivoted away from more of an expansion-based plan to now shrinking back the number of store bases that they have, limiting the amount of products that they put in department stores to have more ownership of pricing. So, they're obviously struggling, they're obviously having problems. I personally believe this is a good move for them. I think Jimmy Choo does have a strong brand. You see people still, like Michelle Obama, I'm thinking Princess Diana because she was one of the proponents for the brand, but recently Michelle Obama. It's a good, current brand, it's kind of timeless. I think it will work well with them if they can integrate it.

Lewis: Switching gears yet a third time, we're going to talk a little bit about Chipotle. Shares of the company took a huge hit last week. They are now down at their lowest levels since 2013 after news broke of another incident of food-borne illness getting customers sick. This time, it was actually at a location in Sterling, Virginia, which is only about 40 minutes from Fool HQ.

Priestley: Yeah, we could go check it out. [laughs] 

Lewis: Be careful. [laughs] The company reports after market close today, and my gosh, it seems like they could use some good news.

Priestley: Oh, absolutely. A lot of the recent issues aren't going to be included in those quarterly earnings, but they definitely have to comment on it. I would say that's probably even the biggest rally cry I've heard about the company so far, is, the lack of response to some of these issues. So, if you've been under a rock for the past couple of weeks, they close a Virginia location after a norovirus outbreak, and then a video went viral showing mice running around a Chipotle restaurant in Dallas. Earlier this year, in April, the company disclosed a payment card security breach. So, they're kind of on a long run of bad news.

Lewis: Of course, this is not the first issue with food-borne illnesses. So, in some ways, it kind of compromises any customer confidence that they had worked so hard to rebuild.

Priestley: Absolutely.

Lewis: And it will not be cheap for them to continue to do that. Before we get over to that part of the discussion, the looking-forward stuff, why don't we talk a little bit about what's going on with the company, and knowing that the report is coming up, what to expect?

Priestley: Absolutely. The report is coming out today. I think people will be focusing on comps. They projected high single digits, so you want to see them deliver on that. Again, as I said, I would like to see them give some kind of projection on what the recent events have done in the past couple of days.

Lewis: I'm sure analysts will ask. [laughs] 

Priestley: [laughs] Yeah. We also want to keep an eye on the store openings. They're projecting 195-210 new stores this year, so we want to see how they are with that plan. Analysts are predicting between $2.21 EPS on revenues of about $1.19 billion. So, again, we want to see them look for that free cash flow. General financial security with the company has always been great, even despite recent troubles. So, I think, free cash flow in the realm of $50 million is what would be expected. Then, generally, look for an update on their online business. Last quarter they disclosed that it was up 50%. It's very new, so the comps aren't going to be right hard to beat, but I would like to see an update on that.

Lewis: They've also made some menu changes, and I hope we get some color there, too.

Priestley: Yeah, absolutely. Chorizo, desserts, queso, all of these things have been tested. Chorizo actually hasn't been too accretive, because it just replaces the protein that you would have already bought. But, desserts could certainly add a lot, and queso, because it's an added extra.

Lewis: And queso also puts them on par with some of the other fast-casual burrito makers out there. I know for myself, one of the things that separated the Qdoba and Moe's of the world from Chipotle was, if I wanted queso, I had to go there. I couldn't get that at Chipotle.

Priestley: Personally I never want queso. 

Lewis: Really?

Priestley: Yeah, it's an alien concept to outside of the U.S.

Lewis: I think it's delicious.

Priestley: So, generally, updates on those issues, and then, they've been trialing price increases too, and they've suggested it's been going well, so we want to see how those price increases are going to be rolled out.

Lewis: And looking at how some of the recent developments with the company might trickle down into the financial statements, I know the company had talked in the past about how marketing and promotion costs were going to be somewhere in the mid 3% of revenue this quarter, which was going to be up. That's something that reflects the fact that they have had to do quite a bit to get customers back into stores. Some of that is discounting and offering BOGOs, buy-one-get-one's, things like that. In light of a lot of the recent news we've seen, I think that might even inch up more. It won't be reflected in what we see in this financial result, like you talked about, because it doesn't cover that time series. But, you might get some guidance coverage on that as the company provides some commentary. I think, given the flurry of bad news, that's one of the easiest ways to get people back in stores, and interacting with the brand again and building customer confidence. So, I would not be surprised to see that tick up.

Priestley: No, definitely. It really kind of puts them back at square one, in a sense. I don't think this is as serious, obviously, as what happened to them before, but from a PR perspective, it's really bringing them back to where they had been. And their previous campaign, I don't know if you remember the TV ads, they were great, they had some comedians in and it was called As Real As It Gets, and they'd give them hard truths. I'm sure we're going to see some parodies of that coming up.

Lewis: Something that made me laugh with the Chipotle stuff that I've seen is some of the conspiracy theories floating around --

Priestley: Oh, I haven't seen these.

Lewis: -- about these issues with Chipotle. There are two in particular, I think they were circulating back when the original food-borne illness outbreak happened a couple years ago, but they have since resurfaced. One of them is, because Chipotle is anti-GMO, there are people who are doing some sort of biochemical warfare against the company. The other one was that Chipotle shorts are deliberately going out of their way to create problems for the company.

Priestley: Wow. I could see a movie coming out of this. [laughs] 

Lewis: Jeez, that's diabolical. I am inclined to not believe those conspiracy theories, and think this is just something that unfortunately happens in the restaurant business, and it can be inescapable at times. But, you look back at the history of companies that have had to weather this type of issue, I don't know that it's been as much of a snowball effect in the past with repeated incidents, but Jack and the Box was able to navigate this, and they actually had people die from their undercooked meat incidents. And they managed to weather it and come back just fine. So, I think, if you're sold on the concept of Chipotle, this is obviously a really unfortunate thing as a shareholder, because it does set you back to 2013 prices. But, as someone who is a shareholder, I'm holding on and doubling down on the idea that, I like this concept, they're still opening a ton of stores. I think there's still quite a bit to like here.

Priestley: Yeah, absolutely, I agree. And as we talked about with the Lulu thing, it's the same issue. It's, hopefully, a short-term concern that's had an outsized impact on the share price. So, as you said, if you're still bullish on the whole concept. And that really ties into the whole healthy eating trend, and the real food and all that. If you buy into that, then absolutely, now is almost a buy opportunity.

Lewis: And I'm sure Vince will be following up when he's back in the studio next week, with some info following Chipotle's earnings, and probably a little info on the Jimmy Choo acquisition, maybe a little bit more color there as details come out. Sarah, anything else before I let you go?

Priestley: No, thank you for having me.

Lewis: Thank you for hopping on. [laughs] You saved me from half an hour of Dylan rambling into a microphone. Listeners, that does it for this episode of Industry Focus. Like I said, don't worry, Vince will be back next week to talk CG. If you have any questions for me, Vince, or any of the hosts, just shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes, or check out The Fool's family of shows at Fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell stocks based solely on what you hear. Thanks to Ann Henry for all her work behind the glass. For Sarah Priestley, I'm Dylan Lewis. Thanks for listening and Fool on!

Sarah Priestley owns shares of Lululemon Athletica and Under Armour (C Shares). Dylan Lewis owns shares of Chipotle Mexican Grill, Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool owns shares of and recommends Chipotle Mexican Grill, Coach, Lululemon Athletica, Nike, Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool owns shares of Michael Kors Holdings. The Motley Fool has a disclosure policy.