What the Chipotle Investigation Means for Investors

Hiring was back in the news again for Chipotle (NYS: CMG) last week. The burrito chain filed a report with the Securities and Exchange Commission revealing that the U.S. Attorney of the District of Columbia was investigating the company for "violations relating to our employee work authorization verification compliance." Shares dropped as much as 2% in intraday trading when the news came out.

In other words, the company is again being probed for hiring undocumented workers, and violations relating to the Department of Homeland Security's E-Verify system, intended to prove applicants can legally work in the U.S. After a DHS audit of employment documents in late 2010, the company fired 450 workers in Minnesota who couldn't prove their work status, and was forced to let go of others amid an inquiry in the Washington, D.C., area last year.

Management did not seem overly concerned about the investigation, and Chipotle was not charged with any criminal wrongdoing in past investigations, though they have caused the company to spend more than $1 million in legal fees.

Still, the renewed investigations serve as a reminder of the hidden risks in the restaurant industry, especially with the Obama administration's decision to target employers who hire illegal workers instead of the employees themselves. Last year, local authorities raided a Pei Wei Asian Diner, a subsidiary of P.F. Chang's (NAS: PFCB) , in Phoenix, arresting 26 people accused of stealing IDs. The chain was eventually forced to close eight restaurants in the area, putting a $1.3 million dent in operating profit. Last April, Immigration and Customs Enforcement officials raided a McDonald's (NYS: MCD) , arresting several illegal aliens who also apparently used stolen identities. Authorities have carried out a number of similar arrests at other McDonald's in recent years. In 2009, Krispy Kreme (NAS: KKD) was fined $40,000 for hiring illegal immigrants at its Cincinnati factory.

The issue of illegal workers in restaurants is far more widespread than these isolated instances indicate, and should be a concern for any investors holding stock in restaurants. According to the Pew Hispanic Center, more than 700,000 of the industry's 12.8 million employees are working illegally, though others believe the numbers to be higher. The research center also said that illegal aliens make up 20% of the nation's chefs and cooks, and 28% of its dishwashers.

As a Chipotle shareholder, one of my biggest concerns is a catastrophic event such as a criminal accusation, a food-borne illness outbreak, or some other kind of sudden news that could dramatically change the company's image and kill the stock along with its pumped-up valuation. We've seen this in the past with other restaurant chains. A Hepatitis A outbreak in 2003 helped drive Chi-Chi's into bankruptcy. An E. coli outbreak at Jack in the Box (NAS: JACK) in 1993 scarred the fast-food chain for several years to come.

Since Chipotle doesn't franchise, it may be more at risk of these kinds of investigations than a chain like McDonald's, which can distance itself from franchisee-owned locations that come under fire. Chipotle acknowledges in its 10-K that it faces such a risk since it only operates company-owned stores. In the report, the burrito chain makes clear that it requires "government-specified documentation evidencing their employment eligibility," but also allows that "some of our employees may, without our knowledge, be unauthorized workers." The company also recognizes the risks to its brand image and labor costs and quality that a discovery of unauthorized workers would bring. The Minnesota DHS audit, which resulted in the firing of 450 employees, led to a temporary increase in labor costs to train new employees as well as some negative publicity. Current investigations could have similar consequences.

I trust management to handle the situation appropriately, but I'll be keeping one eye on the investigation. They seemed to take care of the Minnesota audit as well as possible, escaping without any fines or criminal accusations, and the company has since begun using the E-Verify system. Co-CEO Monty Moran seemed confident that his company would emerge unscathed. "We didn't do anything wrong, so at the end of the day they aren't going to find anything. And we have made sure our practices going forward are beyond mere compliance," he said.

For now, investors shouldn't ignore the inquiry, but there's no reason to run from the stock.

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At the time thisarticle was published

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