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Lemley Yarling Management Co
15624 Lemley Drive
Soldiers Grove, Wi 54655
Bud: 608-624-5777       Kathy: 630-323-8422

Comments on activity in client accounts

9 December 2016

Rather than fight the crowd or watch it pass us by, we added shares of FITBIT, Twitter, Under Armour, BP, Cisco Deutsch Bank, AT&T Marathon and Chipotle during the week. We also traded Gap and Ford for gains.

We are as fully invested as we feel is prudent but don't plan to stay that way for long (invested we are always prudent). We are trying to catch part of the 'Trump will solve all of the worlds problems' move without exposing ourselves to too much risk. It is tiring to try and understand this market but we have realized gains in the rally and hope to keep them. While we think that markets will have clear sailing until the inauguration - and possibly for a few months after - we aren't going to stay around. All-time highs and many up days with no corrections are worrisome. Mr. Market marches to his own tune and many times fools the greater number. As we said last week the market is seeing the roses and not the thorns.

We currently own Chipotle, Sprouts, Novo, Abbott, AT&T Cisco, Abercrombie, Under Armour, HAIN, Stratasys, Twitter, Fitbit, Deutsch Bank, British Petroleum and Marathon Oil. They are all anchovies.


Chipotle Stock Slammed After CEO Says He's Nervous About Hitting Full-Year Guidance

In an October earnings call, Chipotle co-CEO Steve Ells described 2016 as "one of the most difficult years in our history." Unfortunately for Ells, the difficulties appear likely to continue: in comments made during an investor conference Tuesday, Ells said that he is nervous about achieving the numbers Chipotle put forth in its full-year guidance.

Before an E. Coli and norovirus outbreak rocked its reputation and sales, Chipotle was something of a darling of the fast-casual restaurant industry. It finished 2014 with an impressive 16.8% gain in same-store sales, and its name frequently appeared on lists of brands that Millennials love. In the wake of the food-borne illness outbreaks in mid- and late-2015 that quickly changed the company's trajectory, the burrito chain has posted four straight quarters of comparable store sales declines. Investors have been eager to see Chipotle return to its former glory -- but according to Ells' remarks on Tuesday, they may have to wait a bit longer for a comeback.

"I'm not satisfied with the rate of recovery and the quality of the restaurant experience," Ells said during a Barclays conference on food, gaming and retail Tuesday morning. He went on to say that Chipotle has lost focus on customer service, and that a barrage of new food-safety operations have slowed throughput (the number of customers it can serve in one hour).

As a result of these issues, Ells said, he is nervous about the hitting the full-year guidance Chipotle put out earlier this year.

In the company's third quarter earnings results, Chipotle forecast fourth quarter comparable store sales declines in the "low single digits." For fiscal 2017, the company projected a "high single-digit" increase in full-year same-store sales.

Ells also said Tuesday that he expects to make an announcement "shortly" about new board members. Activist investor Bill Ackman took a 9.9% stake in Chipotle in September and in the months since has not been quiet about his desire for a seat at the table and a revamped board.



More on Chipotle from Bill Ackman whose hedge fund took a 9% position in the shares. It should be noted that Ackman also has a huge position in Valeant that crashed from $260 a share to $15 a share in the last year so a grain of salt might be in order.

Chipotle Mexican Grill (CMG)

On September 6th, we announced a 9.9% stake in Chipotle Mexican Grill which we purchased at an average price of $405 per share. Chipotle has built a superb brand pioneering the "fast casual" restaurant industry with the success of its outstanding product offering, unique culture and powerful economic model. We have followed the business for years, noting how it has disrupted the fast food industry with its high quality, delicious and customizable hot meals that are prepared quickly and sold at affordable prices. The company has been significantly negatively impacted by food safety issues beginning in the fourth quarter of 2015 which caused a peak decline in average unit sales of 36%. In response, the company has implemented best-in-class food safety protocols over the past year, and worked to win back lost customers. While traffic and sales have begun to recover, average unit volumes are still 19% below peak levels.

We have always believed that a good time to buy a great business is when it is in temporary trouble. While Chipotle's reputation has been bruised, we think that with the passage of time and improved marketing, technology and governance initiatives, the business will not only recover but become much stronger. Chipotle's sales recovery will be neither smooth nor predictable over the next few quarters; yet, we believe that all of the key drivers of Chipotle's powerful economic moat and long-term success remain intact. These drivers include:

A strong and relevant brand built by visionary leadership

A differentiated product offering with a highly attractive value proposition

Substantial scale in the fast casual industry and first-mover advantage in real estate

Strong unit economics and extremely high returns on capital, driven by a well-honed model that facilitates best-in-class throughput

Enormous growth opportunities including new units and operating enhancements such as mobile ordering and catering

Strong Brand

The Chipotle brand was developed by founder Steve Ells with the philosophy that food served fast does not have to be a traditional "fast-food" experience. This vision later evolved into an ambition to change the way the world thinks about and eats fast food. Chipotle's authentic brand developed a loyal following, which allowed the company to grow from one restaurant to more than 2,100 relying primarily on customer word of mouth, supplemented by non-traditional marketing techniques including digital and social media, owned content, and local events. Today, we believe that Chipotle is one of the most compelling and authentic large-scale food brands in the U.S.

Differentiated Product Offering

Chipotle's product offering is differentiated by the fact that it successfully competes in all the desirable attributes of out-of-home fast food. As part of our research, we compared Chipotle's customer value proposition to those of fast casual, quick service, and casual dining competitors across six key metrics: food quality, taste, in-store experience, customization ability, speed, and value. We believe Chipotle's food quality is superlative given the focus on cooking from scratch with the best available ingredients. Chipotle's "burrito line" service format engages customers from the moment they walk in the door, allows exact customization of each order to accommodate individual preferences, and facilitates the fastest throughput in the industry. The product price point offers outstanding value given the quality and quantity of food served. While some other concepts can successfully compete on one or more of these attributes, we believe that few are able to replicate the Chipotle offering at comparable price points at scale.

Enormous Growth Opportunity

Prior to the recent food safety issues, Chipotle's average unit volumes were approximately $2.5 million, nearly the highest in the industry, despite only serving two day-parts, and with limited store hours, i.e., 11 versus as much as 24 hours for other fast food competitors. We believe that initiatives such as mobile and digital ordering, loyalty program development, catering, and menu innovation including dessert will drive an accelerated rate of same-store sales growth for the foreseeable future, incremental to the impact of recovering lost customers. Returns on capital for new units remain extremely compelling even at today's lower sales levels. We believe that the U.S. can support about 3,000 additional Chipotle restaurants, a total of 5,000 units representing 2.3 times the current store base.

Food Safety

We have researched the initiatives that Chipotle has taken to address food safety. While food safety risk can never be completely eliminated in any restaurant, we think the company has done an excellent job of significantly reducing the risk of another incident while maintaining the freshness and taste of its food.

Chipotle has a number of other attractive attributes which include limited global macroeconomic sensitivity and foreign currency exposure, a simple business model with limited non-GAAP earnings adjustments, a high effective tax rate of nearly 40% (which means the company will be a big beneficiary of lower U.S. tax rates if implemented by the Trump administration) and an unlevered balance sheet with a strong net cash position.


Given Chipotle's depressed near-term earnings due to the recent decline in sales and its detrimental impact on operating margins, we do not believe it is appropriate to value Chipotle using a multiple of next year's earnings based on comparables or estimated growth rates. To estimate the intrinsic value of Chipotle shares, we have valued the discounted cash flows of the business over its life using reasonable assumptions. In our base case, we have assumed a long-term restaurant count of 5,000 units, some recovery of lost customers over the next several years, and moderate same-store sales growth over the long-term driven by the impact of new technology initiatives (like mobile, online ordering and loyalty) and day-part extension initiatives (like catering). We conservatively have assumed that profit margins will be at a discount to peak levels reflecting the cost of new food safety procedures as well as increased investments, offset over time by thoughtful management of overhead costs and increased operating leverage.

Apple Watch sales plunge as Fitbit continues to rule wearables



2 December 2016

During the week we traded (bought and sold) British Petroleum, Chevron Phillips and XOP (domestic petroleum ETF) for nice profits. We added to Marathon Oil before the OPEC announcement and realized a nice gain selling on Thursday. (After 11 months of trading MRO we finally have a scratch loss/profit in most accounts.) We also repurchased Deutsch Bank lower (Trump) and added Ford which was on its 52 week low with a 5% yield.

Our outlook remains that markets will trend higher into inauguration an then??????.

Right now markets are interpreting every Trump tweet as positive. Markets are pricing in Trump and Congressional Republicans to do all things well with no negative consequences. Ain't gonna happen- never has, never will.

Until then happy December.


So much for the economy in the tank:

Corporate profits continued to rebound in the third quarter alongside solid growth in the broader U.S. economy.

The Commerce Department on Tuesday reported that a key measure of business earnings rose 3.5% from the second quarter, its third straight quarterly increase.

Compared with a year earlier, after-tax profits rose 5.2% in the third quarter, the first annual increase since late 2014 and the strongest growth since the fourth quarter of 2012. The profits data don't include inventory valuation or capital consumption adjustments.

"We had been anticipating a turnaround for profits as nominal growth picked up; but the firming, at least so far, looks more rapid and stronger than we had expected," J.P. Morgan Chase economist Daniel Silver said in a note to clients.

Tuesday's report also showed that gross domestic product, a broad measure of the goods and services produced across the economy, expanded at an inflation- and seasonally adjusted annual rate of 3.2% in the third quarter, the strongest growth in two years.

That was up from last month's estimate that output rose at a 2.9% pace in the third quarter and beat economists' expectations for a revision up to 3% growth. The latest reading was boosted by stronger consumer spending, though business investment came in weaker than earlier estimated.

"The U.S. economy is in good shape in the second half of 2016," Gus Faucher, deputy chief economist at PNC Financial Services Group, said in a note to clients.

Business profits represented 9.1% of U.S. GDP in the third quarter, up from a recent low of 7.8% in late 2015 though down from the 10.2% average seen in 2012 through 2014.



Brent crude soared above the key $50-per-barrel mark Wednesday after OPEC reportedly finalized a deal to cut production at its official meeting in Vienna. Saudi Energy Minister Khalid al-Falih said the Organization of the Petroleum Exporting Countries was "getting close to a deal," and a delegate cited by Bloomberg said the group has agreed to lower output by 1.2 million barrels a day to 32.5 million barrels per day. If OPEC can agree on a cut, it will be its first since 2008. The production deal will last six months, according to Iraqi Oil Minister Jabbar al-Luaibi. He hopes the accord will push prices to over $55 per barrel. But such an outcome would spur U.S. shale companies to produce more.





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