The Time Is Ripe for Chipotle Executives to Drop the Other Shoe

By Asit

"OK, crew, can we engineer better throughput this quarter?" Image source: Chipotle Mexican Grill Instagram page.

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ForChipotle Mexican Grill, Inc,(NYSE: CMG), it's been quite an eventful December. Founder Steve Ells finds himself back in sole possession of the CEO role after the departure of co-CEO Monty Moran. A slate of four new board members, two of them backed by activist investor Bill Ackman's Pershing Square Capital Management, will be looking with interest over Ells' shoulder. These momentous changes were preceded, and perhaps signaled, by Ells' comments on Dec. 6 at a Barclays plc investor conference.

At this venue, Ells admitted to being nervous about the company's ability to meet 2017 earnings guidance of $10 per diluted share. After dropping this shoe, and, more significantly, now that he again holds ultimate executive accountability, perhaps Ells should consider relaying one more message to investors.

Newly identified earnings headwinds will make for a tough 2017

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More than a year after a series of food-safety scares pushed Chipotle stock into an extended period of malaise, the company finds itself bemoaning performance issues that are contributing to lower traffic and revenue. Surprisingly, food safety isn't one of them. In a conference call with investors held on Dec. 12, Chipotle executives detailed operational problems that they believe are causing loyal customers to visit the chain less frequently and, by extension, non-core customers to perhaps avoid the chain altogether.

The list includes declining throughput (i.e., speed of service, once a Chipotle strength), as well as messy tables and fountain areas, and frequent understocking of ingredients in some restaurants, all of which naturally frustrate diners' expectations.

A number of factors underlie these shortcomings. Employee turnover has increased as the company has struggled to institute new food-safety procedures in 2016. Ells also blames an overemphasis on "soft skills" within employee culture, to the detriment of operational basics, and he's vowed to reinstate a focus on quality and customer service.

Fixing these issues, which executives claim currently affect at least half of all restaurants, will prove costly. Achieving faster service, higher cleanliness in restaurants, and stable ingredient availability in the service line requires additional training, and likely more hiring.

Yet labor costs are already in the red zone. During the first nine months of 2016, labor as a percentage of revenue has averaged 28.5%. That's roughly six percentage points above last year's labor costs, which equaled 22.4% of revenue over the same period. It wouldn't be surprising to see the labor burden rise another two to three percentage points next year, as management refocuses on its own proven execution principles such as the "four pillars of throughput."

The proverbial "other shoe"

The earnings headwinds we've discussed inform the unease of Chipotle's founder. Since Ells has implicitly admitted that diluted earnings per share of $10 might not be achievable in 2017, this would be a good time for the company to drop the other shoe and issue an interim guidance report that revises the 2017 forecast down to a manageable level.

There's never a good time to recast the numbers you've promised to those who hold stock in your company. Yet investors appear to be reasonably placated by the board and management changes, as Chipotle stock has recovered most of the 7.5% drop precipitated by the Barclays conference. And while a revision is sure to cause some sell-off in the "CMG" ticker, at this point, the shock is likely to be smaller than a mid- to late-year 2017 mea culpa.

Objectively, you have to agree with Ells. The target $10 per share EPS seems a long way off from today's vantage point. Through the first three quarters of 2016, Chipotle has recorded revenue of $2.87 billion and generated year-to-date diluted EPS of just $0.27.

If the company can pause its revenue decline next year and book a top line of around $3.8 billion, it will need to find about eight percentage points of efficiency between its restaurant margin and general and administrative expenses, to finish the year with earnings of $10 per share.

That's a tall order, especially if, in addition to a labor surge, Chipotle has to spend more on marketing to pull in patrons, so that they can experience the faster, cleaner, and higher-quality dining experience.

It might be more reasonable to expect that the burrito giant can achieve four to six percentage points of operating margin improvement next year. This would translate into a diluted earnings per share range of approximately $5.25-$7.75.It may be painful, but ultimately prudent, to announce as much now. Chipotle's assessment of its current operational deficiencies is painfully clear-eyed. It's time to bring the earnings outlook to a similarly unflinching and realistic state.

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Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. The Motley Fool recommends Barclays. 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.