There's Good and Bad in Chipotle Mexican Grill's Latest Earnings

By Markets Fool.com


Chorizo now makes up 7% of orders since its rollout nationwide. Image source: Chipotle Mexican Grill.

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As of this writing on Oct. 26, shares ofChipotle Mexican Grill, Inc.(NYSE: CMG) are down more than 8% following release of the company's third quarter earnings report after market close on Oct. 25. And while the market is clearly voting to the negative on the embattled burrito seller's results so far, it wasn'tallbad for Chipotle this past quarter.

Let's take a closer look at Chipotle's results and what management has planned going forward. There's plenty to be disappointed about, including steadily rising costs and what's looking like a failure with the ShopHouse concept, but also signs the company has put the worst behind it.

The numbers, and some added context

Metric Q3 2016 Q2 2016 Change (YOY)
Revenue $1,037 $1,217 (14.8%)
Net income $7.8 $144.9 (94.6%)
Earnings per share $0.27 $4.65 (94.2%)
Comparable restaurant sales (21.9%) 2.6% (2,450 BPS)

Revenue and net income in millions. Data source: Chipotle Mexican Grill, Inc. YOY = year over year.

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Chipotle continues to struggle with bringing customers back to its restaurants, but some added context on the trends is worthwhile:

  • Comparable transactions -- which is a better measure of traffic, and accounts for the impact of aggressive promotions on revenue -- was down 15.2%. Not great, but less bad than the comp sales decline.
  • Comps bottomed in Jan. 2016 with a 36.4% decline, compared to the 20.1% decline in September. Similarly, transaction comps have improved from a 33.7% decline in January, to a 13.4% decline in September.
  • Earnings were impacted by two things that investors should note: An asset impairment related to ShopHouse (keep reading for more on this below), and a revenue deferral related to the company's "Chiptopia" rewards program. Combined, these GAAP accounting requirements reduced earnings by $26 million, or $0.52 per share. The company will recognize the Chiptopia deferred revenue in a later quarter, while the ShopHouse writedown was non-cash and doesn't materially impact the company's cash earnings.

Expenses remain high, but this is deliberate

The benefits of the Chiptopia promo program won't be fully recognized until next quarter, due to GAAP accounting rules which required Chipotle to defer $11.5 million in revenue. The table below shows Chipotle's results with and without the benefit of the revenue it had to defer:

Category Q3 2016 Reported Results Percent of Sales Q3 2016 Including Deferred Revenue Percent of Sales Q3 2015 Reported Results Percent of Sales
Revenue $1,036,982 100% $1,048,482 100% $1,216,890 100%
Food, beverage and packaging $363,900 35.1% $363,900 34.7% $401,051 33%
Labor $286,144 27.6% $286,144 27.3% $270,076 22.2%
Occupancy $74,201 7.2% $74,201 7.1% $66,391 5.5%
Other operating costs $166,045 16% $166,045 15.8% $134,879 11.1%
General and administrative expenses $78,405 7.6% $78,405 7.5% $70,066 5.8%
Depreciation and amortization $37,434 3.6% $37,434 3.6% $33,145 2.7%
Pre-opening costs $4,490 0.4% $4,490 0.4% $4,367 0.4%
Loss on disposal and impairment of assets $16,637 1.6% $16,637 1.6% $2,156 0.2%
Total operating expenses $1,027,256 99.1% $1,027,256 98% $982,131 80.7%
Income from operations $9,726 0.9% $21,226 2% $234,759 19.3%
Interest and other income, net $672 0.1% $672 0.1% $1,518 0.1%
Income before income taxes $10,398 1% $21,898 2.1% $236,277 19.4%
Provision for income taxes $(2,599) -0.3% $(2,599) -0.2% $(91,394) -7.5%
Net income $7,799 0.8% $19,299 1.8% $144,883 11.9%

Data source: Chipotle. Chart: Author.

What does the table tell us? A couple of things. First, the revenue deferral more than cut net income in half. The good news is Chipotle will recognize this revenue in the fourth quarter, when customers redeem their Chiptopia rewards.

But we can also see that, as a percent of sales, Chipotle continues to spend more money in essentially every operational part of its business, including labor, food, and occupancy. This is the case whether you factor in the deferred revenue or not. In other words, greater sales leverage -- the benefit of selling more food on its current operating cost structure -- remains the key to driving profits back up.

However, management told us this would be the case as it has invested in recovering lost customers. Co-CEOs Steve Ells and Marty Moran have been steadfast and clear that taking short-term steps -- such as reducing restaurant staffing -- in order to reach better profits in the short term, was more likely to negatively impact customer service. And since that could permanently damage Chipotle's reputation, it's not a step management is willing to take.

The end of ShopHouse signals a tighter focus with limited resources

Chipotle also took a $14.5 million impairment in the quarter related to ShopHouse, its Asian-themed restaurant concept. Chipotle opened its first ShopHouse in 2011, and at quarter-end, had opened 15 locations in three markets. Unfortunately, the concept hasn't worked out as well as Chipotle management had hoped, with Ells saying it "simply has not demonstrated the ability to support an attractive unit economic model."

Ells further elaborated on management's thinking when it comes to new concepts:

[W]e continue to believe that our approach to food, people and unit economics with the right cuisine, with the right concept, can lead to a compelling growth strategy. And we are optimistic that our other growth seeds, serving pizza and soon burgers, both of which have broad customer appeal can become further growth strategies for us. While this was not an easy decision, we trust in our overall growth seed approach where we can innovate and develop new concepts, with a relatively small capital investment and little or no distraction to the Chipotle business. And we'll only invest additional resources, both time and money into growth seeds that show the potential to become meaningful growth vehicles, and a compelling way to enhance shareholder value.

Image source: Tasty Made.

The company also announced plans to open 195-210 new restaurants in 2017. This will be well short of the 220-235 new restaurants Chipotle says it will open before the end of this year. This shouldn't be a surprise to anyone who listened to the second quarter call, as management indicated at that time that the plan was to be more deliberate with new locations next year.

Furthermore, the company is opening its first Tasty Made burger restaurant, a segment with both very high interest and extreme competition. Combined with Pizzeria Locale and continued pressure on earnings as sales slowly recover, the company has limited resources that it must carefully manage.

Looking ahead: Easier comps are coming, management optimistic but focused

The fourth quarter will be Chipotle's first period where its performance will be measured against the foodborne illness events that drove so many customers away. But at the same time, each passing month has showed improved traffic and sales results, as both longtime and new customers (30 million over the past six months, responsible for half of orders) steadily grow in numbers. On the earnings call, management said they expect Chipotle to see "low-single-digit comp declines" in the fourth quarter.

At the same time, the company will continue to spend more on marketing, food safety, and restaurant staffing going forward, making sure that the customer experience isn't impacted simply to make short-term profit goals. But at the same time, the company is taking steps to manage expenses where it can. This includes holding firm on general and administrative expenses, as well as other initiatives it expects will reduce recurring expenses by $100 million per year.Management anticipates these actions, combined with the sales growth it expects to continue, will generate $10 per share in net income in 2017.

Bottom line: Chipotle has made progress, but it's still pretty early in the recovery. It's going to take continued steady focus on the long-term health of the business to rebuild trust with many customers. If Chipotle can continue delivering the steady progress it has so far this year, patient investors who ride this out could be very happy in years ahead.

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Jason Hall owns shares of Chipotle Mexican Grill. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.