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Chipotle misses EPS expectations but with strong top line numbers it is not cut and dried.

The EPS miss definitely spooked the street with the stock trading down as low as $313 post-market from the $333 close.  Looking at the overall picture, Chipotle’s top line metrics are very healthy but the margin side of the story is less stellar with restaurant-level margins now declining for the second consecutive quarter.  This is primarily as a result of high levels of food cost inflation.  The reaction of the Chipotle customer to the price increase being taken by the company to protect margins in the face of these costs is going to dictate the overall direction of the stock. 

Top Line

 

Same-restaurant sales for CMG came in at 10%, well in excess of already-high expectations of 8.6% according to StreetAccount.  Two-year average trends for 2Q11 came in at 9.4%, a 100 basis-point sequential acceleration from 1Q.  Management attributed this strong performance to awareness being raised around the company’s Food With Integrity mantra as well as continuing loyalty to Chipotle.  Initiatives such as the new affinity program that is being rolled out currently, and will anchor off social media from a participation perspective, are designed to retain and grow customer loyalty going forward. 

New unit volume was another driver of revenue growth during the quarter, increasing by 20% year-over-year versus 16% year-over-year growth in 1Q.  A-models are also a medium through which the company is looking to grow; during today’s earnings call the company, for the first time, indicated that the A-model is now proven enough to develop in developing (rather than solely established) markets. 

From here, the company is implementing a price increase, the customer’s reaction to which will be crucial for comps as we transition through the second half of the year.  During the second quarter, Chipotle took 1.5% which mostly pertained to the Pacific region.  The broader price increase, across the system, will be fully rolled out during August and will affect all markets.  The average magnitude of the hike will be 4.5%.  This is the first price increase Chipotle has taken in three years and management will be hoping that traffic doesn’t react as severely to this price increase as it did in 2008.

CMG: MISS AND RAISE - cmg pod1

Margins

Restaurant level margins were down again, year-over-year, for the second consecutive quarter.  As a percentage of sales, Food, Beverage, and Packaging costs increased 250 basis points year-over-year.  Management expects the impact of the price increase being taken in the current quarter to offset most if not all of the inflation impact on margins.  Labor as a percentage of sales decreased 50 basis year-over-year despite an increase in worker’s comp claims and an increase in employee turnover.  The company stressed several times that there is more fat to be trimmed on the labor line.  Occupancy costs were down approximately 50 basis points from last year due to sales leverage.  Marketing as a percentage of sales was 1.7% versus 2.1% a year ago which accounted for the 40 basis point decrease in other operating costs. 

Protecting margin is critical for Chipotle, particularly given their practice of not locking in commodity costs.

CMG: MISS AND RAISE - cmg pod2

CMG: MISS AND RAISE - cmg quadrant

Conclusion

The current (third) quarter is highly significant for Chipotle and there are several factors that we will be monitoring closely. 

  1. The last time Chipotle took price was in 2008 and the consumer did not react well at all.  One would hope that management will have learned from that experience and will have completed all of the necessary research to ascertain the optimal magnitude of the price increase for profitability.  Ultimately, the result won’t be known by us until the next quarterly earnings report is released.
  2. The increase in employee turnover that management highlighted is an interesting data point.  Rising from an average of 100% to 120% during 2Q hardly constitutes a crisis for a company in an industry where the norm is closer to 160%, but if the trend continues it will certainly catch our attention.  Training new people increases labor costs, newer employees are generally slower which impacts throughput, and if manager turnover is increasing, it may signal deeper issues than just low job satisfaction.  The situation is clearly not there yet, but we will be watching this closely.
  3. Any new information about the ICE investigation into CMG’s hiring practices will obviously be important to the extent that it may impact labor costs or EPS via a one-time charge.  However, to be frank, hiring 12,000 people since March must surely have improved CMG’s image in the eyes of the government!

Howard Penney

Managing Director

Rory Green

Analyst