Chipotle’s 4Q16 financial results were a bit of a mixed bag – there were encouraging aspects, while other angles were disheartening.
This earnings report is the first one (since I’ve been covering the company) where Chief Executive Officer (CEO) Steve Ells is the sole man in charge. He seemed to have two messages he wanted to convey as overarching themes for the call – and for the company itself. First, he thinks Chipotle got overly complex, and he’s going to simplify it. Second, everything the company does will focus on providing an excellent customer experience.
Earnings Report Highlights
The earnings press release can be found here: http://ir.chipotle.com/phoenix.zhtml?c=194775&p=irol-new…. Seeking Alpha’s transcript of the conference call can be found here: http://seekingalpha.com/article/4042294-chipotle-mexican-gri…. (Thanks, Seeking Alpha.) Unless stated otherwise, all italicized quotations are from the Seeking Alpha transcript.
4Q16 Revenue: $1.035 billion It’s nice to finally see a positive number for year-over year revenue growth (3.7%). There was a modest decline sequentially (-0.2%), but that is not unusual from a seasonal perspective. Per Yahoo! Finance, Wall Street analysts expected $1.04 billion in revenue, so Chipotle officially missed revenue expectations, but it was a pretty small miss.
(in $ millions)
1Q 2Q 3Q 4Q Comments
2012 640.6 690.9 700.5 699.2
2013 726.8 816.8 826.9 844.1
Y-o-Y 13.5% 18.2% 18.0% 20.7%
2014 904.2 1050.1 1084.2 1069.8
Y-o-Y 24.4% 28.6% 31.1% 26.7%
2015 1089.0 1197.8 1216.9 997.5 4Q15 Food-borne illness crisis
Y-o-Y 20.4% 14.1% 12.2% -6.8%
2016 834.5 998.4 1037.0 1034.6 3Q16 Chiptopia promotion
Y-o-Y -23.4% -16.6% -14.8% 3.7%
4Q16 Comparable Restaurant Sales (comps): -4.8% The prior four quarters had all offered double-digit declines, so this is an improvement. Declining comps are always difficult to stomach, but the trend is favorable. Management had guided towards a low-single-digit decline; arguably that’s accurate, but this sure feels like a mid-single-digit decline to me. For those who want to focus on good news, the December comp (the first month where both months in the comparison are post-E. coli) was +14.7%. January’s comp was even better at +24.6%, made all the more impressive because last January had five Fridays and Saturdays (typically higher-volume days) while this January had five Mondays and Tuesdays (typically lower-volume days).
4Q16 Restaurant-Level Operating Margin: 13.5% I am frustrated to note that restaurant operating margins have declined for the last two quarters. While no one had expectations of an improvement over last year, I was hopeful for sequential improvement, especially in light of revenues that were virtually flat against last quarter. For comparison, 2Q16 and 3Q16 restaurant operating margins were 15.5% and 14.1%, respectively. While this is a significant improvement over 1Q16’s dismal 6.8% result, it falls well short of the 20% figure tossed around as an aspirational goal for 2017. One wonders whether/how they’ll get there from here. I’ll try to explore that in a separate section.
4Q16 Net Income: $16.0 million ($0.55 per diluted share) On the surface, this result might look pleasing – more than a doubling from last quarter, but I don’t think that’s the right way to look at it. 3Q16 included the $0.29 ShopHouse impairment charge, and certain Chiptopia-related revenues were deferred from 3Q16 into 4Q16. Wall Street expected $0.67, and it is unclear whether that amount included earnings associated with the deferred revenue.
Earnings per Share (GAAP)
1Q 2Q 3Q 4Q Comments
2012 1.97 2.56 2.27 1.95
2013 2.35 2.82 2.66 2.53
Y-o-Y 19.3% 10.2% 17.2% 29.7%
2014 2.64 3.50 4.15 3.84
Y-o-Y 12.3% 24.1% 56.0% 51.8%
2015 3.88 4.45 4.59 2.17 4Q15 Food-borne illness crisis
Y-o-Y 47.0% 27.1% 10.6% -43.5%
2016 -0.88 0.87 0.27 0.55 3Q16 ShopHouse write-off
Y-o-Y nmf% -80.4% -94.1% -74.7%
4Q16 Cash Flow From Operations (CFFO): $68 million At $67 million, CapEx consumed almost the entirety of CFFO.
2017 Guidance Management has resumed giving their normal guidance of comps (high single-digit increase), new restaurant openings (195-210), and tax rate (39.0-39.5%, subject to changes in stock-based compensation accounting standards). These are very similar numbers to the “targets” offered last quarter, except their tax rate had been 39.5%. There was no official update on the earnings and restaurant-level margin targets ($10.00 and 20%, respectively), but these were the subject of much discussion during the Q&A. More later. During his prepared remarks, Chief Financial Officer (CFO) Jack Hartung indicated that he expects 2017 CapEx spending to total $225 million. I estimate that translates into 70% towards new restaurants and 30% towards “other” (e.g., restaurant upgrades and technology infrastructure).
CMG earnings day share price: $404.08 -4.54% (vs. S&P 500 +0.73%) The day’s decline seems appropriate given the disappointing (but not tragic) earnings miss and low restaurant-level operating margins, offset by the nice December and January comps.
1000 Days of Ratios Analysis
I start with a data base of the last 1000 days of trading history (about four years). For each day, I calculate the Price/Earnings, Price/Sales, and Price/Free Cash Flow ratios based on the trailing twelve-month (TTM) data that was known on that date. I sort the data on each of the metrics to see where the current ratio stands compared to the data base’s history. Finally, to identify prices that might be considered a bargain, I find the ratio value for each metric where the ratio is “cheaper” only 25% of the time.
Current Price to Earnings Ratio: 436.62 (worst 1% – range is 24.11x to 436.62x)
Current Price to Sales Ratio: 3.03 (best 9% – range is 2.78x to 5.94x)
Current Price to Free Cash Flow Ratio: 130.79 (worst 1% – range is 28.55x to 130.79x)
25% P/E cut-off ratio is 39.82x. TTM earnings per share are $0.93. P/E-based target is $36.85.
25% P/Sales cut-off ratio is 3.35x. TTM sales per share are $129.35. P/Sales-based target is $446.09.
25% P/FCF cut-off ratio is 40.74x. TTM FCF per share is $3.65. P/FCF-based target is $125.87.
Target Price: $202.94 (based on averaging the three 25% cut-off targets)
Please do NOT rely on this analysis at present. It works best for companies that are in a steady state, not in the throes of change, as Chipotle is today. As always, do your own due diligence. Tom Engle (TMF1000) has suggested applying a target PE ratio using “normalized” earnings for Chipotle, but that approach demands that you take a very long-term view (as he does). You should go to his CMG page posts to get his full thoughts on this point. I’ll point out that – pre-crisis – the TTM earnings were $16.76, TTM revenue per share was $144.96, and TTM FCF per share was $14.16. Just because they’re “pre-crisis” doesn’t necessarily make them “normalized”, though.
Financials
Food Inflation and Price Increase Philosophy
CFO Hartung said during the Q&A, “… we’ve been absorbing … inflation. We’ve not had a price increase in three years. We’re not planning any specific price increase right now. But at some point over time, we’ll need to pass on some of the higher costs. But we believe we’ll be able to do that.” I think that CFO Hartung must mean an across-the-board price hike, as I recall that there were selective price hikes within the last eighteen months associated with regions with high wage and occupancy costs, as well as price increases on beef products.
In answering a later question on the topic, CFO Hartung indicated that price increases, when they eventually occur, would likely be selectively tested in regions where Chipotle’s recovery has been strong (or where the effects of the crisis were minimal), where they felt their operations were strong, and where competitors’ prices offered them the opportunity to raise theirs. “If that goes well, we’ll consider what we do from there. But no specific plans right now to do anything with price.”
Average Restaurant Sales
This metric has declined for the fifth quarter in a row. With comps turning positive, I’d expect the number to rise from this quarter’s $1.868 million. This is down about 26% from the 3Q15 peak of $2.532 million. Conversely, it would take a 34% increase to return to $2.5 million in average restaurant sales. CFO Hartung believes that restaurant-level operating margins could return to the high 20% range should that kind of volume be achieved.
Stock Repurchases
Diluted share count continues to decline, although the rate of decline seems to be slowing. This quarter’s average diluted share count id down to 29.0 million from last quarter’s 29.17 million. Chipotle purchased $67 million worth of shares at an average price of $392 this quarter.
Cash, Cash Equivalents, and Investments
Cash, short-term investments, and long-term investments declined a little from $610 million last quarter to $543 million at the end of this quarter. The company remains debt free. CFO Hartung has said in the past that he wants a buffer of $500 million in cash and investments.
$100 Million in Efficiencies
My best guess is that I will drop this subject heading after this report. Management offered no commentary about this initiative. Former co-CEO Monty Moran had introduced it last quarter, and it isn’t clear to me that the management team continues to embrace this goal. The biggest cost savings announced – perhaps ironically – is that the All Managers Conference will not be held this year. That will probably save somewhere between $10-15 million. I say “ironically” because this conference was a team-building and communication initiative introduced by former co-CEO Moran.
People
Former Co-CEO Moran
There was absolutely no mention of former co-CEO Moran. Not in the press release nor in the prepared remarks. No thanking him for years of service. Zilch. Nada. Analysts took the hint and didn’t mention his name either. While I’ve insinuated in prior posts that perhaps his model of what makes an individual Chipotle restaurant great weren’t as properly-focused as they could have been, I have mixed feelings about his departure. He’s very bright, driven, charismatic, and articulate. His focus on throughput was a key enabler of Chipotle’s unit economic model, which to my mind is what makes Chipotle an interesting investment. In many ways, his presence allowed CEO Ells to concentrate on the food, which is probably where CEO Ells shines the brightest. It also took pressure off CEO Ells’ public-speaking skills (not such a strong point). Sadly, it seems that CEO Ells let former co-CEO Moran operate a little too independently, and failed to recognize that Mr. Moran was too focused on “people” and “throughput” and not enough focused on “restaurant”. Appropriately or not, former co-CEO Moran will take the fall for Chipotle’s crisis. I don’t find him solely culpable, but I recognize that this is the way things can work in large organizations, especially when an activist shareholder starts stirring the pot. That said, as a shareholder, I’m happy to no longer be underwriting former co-CEO Moran’s compensation package.
Morale
Asking a CEO of a company – any company – to opine on morale is likely to produce a positive answer. Better to go to a variety of stores and observe the front line. In any case, here is CEO Steve Ells’ commentary on company morale: “… I think our folks appreciate that we’ve simplified it. I think that in our past, the tools that we had were sometimes more complicated than actually running a good restaurant. So we’ve really allowed now our folks – with great training, with a clear path to restaurateur, we’ve really allowed them to thrive. And so we’re starting to see a great morale.” [By the way, Seeking Alpha misattributes this quote to Chief Information Officer (CIO) Curt Garner. Trust me; it was CEO Ells.]
Food
There really wasn’t anything mentioned during the conference call that appropriately fit under this heading. No illnesses, thankfully. No new safety protocols. No mention of how chorizo is doing or how the testing of desserts is going. That seems odd for a restaurant, but I guess there are bigger concerns at present.
I’ve seen/heard of recent articles claiming that a tariff on imports of avocados from Mexico will hurt Chipotle. Of course, any cost increase “hurts”, but this is largely a canard and probably politically-motivated. The story gains plausibility because Chipotle laid partial blame on 3Q16 results to the high cost of avocados. CFO Hartung noted last quarter that a $10 increase in the price of avocados affects Chipotle’s earnings by $0.17 per share. During the first half of 2016, the average cost of a case of avocados was $30. A temporary shortage spiked the price close to $80, but prices have since subsided. A 20% tariff on $30 cases of avocados would nick Chipotle’s earnings by only ten cents. That may be noticeable while Chipotle is running close to breakeven, but it is not significant if you look at Chipotle’s historical earnings power. I don’t want to start a political discussion and I am not arguing for or against tariffs. I am trying to quantify the effect of avocado tariffs on Chipotle’s bottom line and make it clear that I don’t believe Chipotle’s investment thesis hinges on the presence or absence of avocado tariffs, despite the assertions of certain authors.
Real Estate
New Restaurants
Chipotle opened 72 new restaurants – one of their most prolific quarters ever – bringing the total to 2,250 stores, and increasing the 2016 total to 240 net openings, above the 220-235 guidance. Mr. Crumpacker, who now seems to be in charge of real estate, indicated two changes. First, new stores will be introduced to the community with marketing, citing improvement in their reception when this occurs. Second, in markets that are considered “developing” (Chipotle is not new to the market, but it’s not firmly established yet either), Chipotle will only open “Tier 1” locations.
Growth Seeds
There was no mention of any of Chipotle’s growth seeds, either in the press release or during the conference call. However, I was able to gather information from Chipotle’s web site, and there have been some changes.
In Europe, a sixth Chipotle Mexican Grill location has opened in Paris. There are still six locations in London and one in Frankfurt.
The ShopHouse count is unchanged at 15: five in Southern California, four in Maryland, four in Washington DC, and two in Chicago. This assumes the ShopHouse web site is accurate and up-to-date – an assumption that is not supported by the 2016 copyright on the bottom of each web page. That said, the Chipotle web site does still have a link on its home page to the ShopHouse web site.
The Pizzeria Locale count stands at seven: three in and around Kansas City, two in Denver, and two in Cincinnati.
There is now a link to the TastyMade web site on the Chipotle home page. TastyMade still has just one location, in Lancaster OH. Last quarter I mistakenly located it in Lancaster PA, and I regret any confusion I may have created.
Marketing and Technology
Promotions
CFO Hartung declared, “… we’ve weaned ourselves off of promo.” This is actually kind of impressive, if you look at the December and January traffic increases and realize that almost everyone was paying full price!
Mobile and Online Ordering
CEO Ells commented, “We’ have redesigned and simplified our online ordering site, enabled online payment for catering and integrated with several well-known third-party providers for delivery.” “Smarter pickup times” has been rolled out to roughly half the restaurants and should be completely rolled out shortly. Initial results indicate customer wait times have been reduced by half. The second make-line is critical to this effort, and it has been streamlined. Promotion of online ordering has started in restaurants where “smarter pickup times” is available.
Chipotle on TV
Chipotle is experimenting with television advertising. Mr. Crumpacker described mixed results from a one month trial in three test markets. Last quarter, I credited management for “broadening the playbook”. Upon further reflection – and especially in light of the mixed results – I wonder if this is a bad idea. I think that part of Chipotle’s cachet is that they became popular largely through word-of-mouth advertising. In an era when everyone everywhere is inundated with advertising incessantly, how cool is it that Chipotle grew mostly through word-of-mouth? Will their presence on TV negate some or all of that cachet? It is tough to know. Chipotle may be too large at this point for the coolness of word-of-mouth to still matter.
Other Random Musings
How Realistic Are 20% Restaurant-Level Operating Margins?
I’m not particularly skilled at creating models for the companies I cover, and I’m sure my analyses reflect that (hopefully there are other strengths to offset that weakness). That said, I went through a rudimentary modeling effort for 2017 quarterly earnings to see what restaurant-level operating margins would fall out of that effort. I modeled revenues as growing by 17%, which reflects 9% growth in restaurant count and 8% growth in customer spend (based on high-single-digit comparable restaurant margins). I modeled food cost growth at 15% because CFO Hartung mentioned initiatives to minimize waste and negotiate with suppliers, and he targeted food costs as a percentage of revenue a little above 34%. I grew labor costs by 13% to account for new hires to support new stores, and for 4-5% wage inflation. I modeled occupancy growth at 9% - just accounting for new stores. Finally, I let “other” grow by the full 17%, matching revenue growth. I was tempted to cut a percent or two from “other”, but I know that marketing spend will be elevated. The result? 2017 restaurant-level operating margins are likely to run about 16%, maybe a bit less. I think it probably takes heroic efforts to get them close to 20% by year-end. Or a price increase. Or comps that wildly exceed guidance.
Cover Story in this Week’s Barron’s
I subscribe to Barron’s and usually – but not always – respect the content they present. To my mind, this week’s cover story is a hit piece that barely clings to the edge of respectable financial journalism. If you want to read it, use your favorite search engine to find “Chipotle: Can it be Fixed?”
Criminal Investigation
No news; I just want to keep the topic on our radar.
Closing Thoughts
In my introduction, I mentioned that results were a mixed bag of encouraging and disheartening. I think I am most disheartened by the current dynamics of restaurant-level operating margins. With food and labor costs high as a percentage of revenue, and an increasing propensity to spend on marketing, I don’t envision margins reaching 20% without a price increase or a real surge in traffic. What encourages me the most are the strong December and January comps, especially January’s. CFO Hartung took pains to point out that it is difficult to ascertain trends from January, as weather can be an important factor. However, if Chipotle can maintain double-digit comps into the warmer months, then the leverage inherent in Chipotle’s unit economic model will come into play and make the results I modeled seem far too low.
I have to admit that Chipotle’s slow recovery has tempered my bullishness and made me wonder whether the size of my personal holding (it’s a top-ten holding for me) aligns well with my current level of conviction regarding the company’s long-term prospects. Perhaps I am just not patient enough. There is a lot of leverage in Chipotle’s unit economic model, but they’ll need to bring traffic in the door for the leverage to succeed. That’s why those post-crisis comps are so encouraging.
Fool on!
Thanks and best wishes,
TMFDatabaseBob (long: CMG)
See my holdings here: http://my.fool.com/profile/TMFDatabasebob/info.aspx
Peace on Earth