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Why Chipotle's Q3 Earnings Freaked Out Investors

By John Maxfield – Oct 26, 2016 at 2:14PM

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The headline earnings figures were horrible, but there's reason for investors to be optimistic.

Image source: Wikimedia Commons.

If it wasn't clear in after-hours trading Tuesday evening, it's certainly clear on Wednesday that investors were none too pleased with Chipotle Mexican Grill's (CMG -0.75%) third-quarter earnings. Halfway through Wednesday's trading session, shares of the burrito chain are down more than 8%.

The headline numbers were dismal

The headline figure says it all: Chipotle's profit of $7.8 million last quarter represented a 95% drop compared to the same period last year. The company is still reeling from a series of foodborne illness outbreaks that struck its restaurants over the past 12 months.

Most of the underlying metrics that contribute to Chipotle's earnings were similarly dismal:

  • Revenue was down 14.8% compared to the year-ago quarter.
  • Same-store sales were off 21.9%, despite aggressive marketing aimed at bringing customers back into its locations.
  • Restaurant-level operating margin was only 12.5%, less than half of last year's 27.9%.
  • And Chipotle doubled its marketing and promotional costs as a percentage of revenue.

While these are unfortunate, however, the most concerning thing discerning investors picked up from Chipotle's conference call with analysts was the fact that it's moving away from its singular focus on serving simple, high-quality food. To this end, here's the first question its executives were asked on the call:

One of the hallmarks of the Chipotle business is how simple you have kept the operations and how focused you have been on delivering high quality. And now, we are hearing that you're going to shift the focus a bit toward menu innovation and perhaps traditional marketing tactics or strategies. So just wondering why you think that shift is needed now versus, perhaps, just going back to basics on focusing on delivering the high-quality experience.

What David Tarantino of Robert W. Baird & Company is referring to are a series of changes that are in the works at Chipotle:

  • It's experimenting with desserts.
  • It's rolling out television advertisements for the first time.
  • It's mining customer data to figure out how to recapture lost business.
  • It's launching a new online ordering experience, designed to make ordering and paying for food on a mobile device easier and faster.
  • It hired an executive to lead a charge into Europe.
  • And it's investing in new equipment in it locations to speed up throughput in its stores.

Prior to the foodborne illness outbreaks that first struck last year, Chipotle was able to grow sales by focusing on its core model of serving fresh, responsibly sourced foods. These changes thus smack of an element of desperation.

Additionally, as I noted earlier today, Chipotle announced that it is stepping away from its Asian-themed concept, ShopHouse. After five years and the opening of 15 locations, Chipotle's co-CEO Steve Ells said that it "has not demonstrated the ability to support an attractive unit economic model." The company will thus "pursue strategic alternatives" to offload it.

All is not lost

After reading all of that, you'd be excused for concluding that Chipotle is a goner. And, indeed, the substantial drop in Chipotle's share price today seems to confirm that.

But it's important to put all of this into context. In the first case, Chipotle isn't the first restaurant to run into trouble following a foodborne illness outbreak. McDonald's and Yum! Brands' KFC ran into similar problems at their locations in China in 2014 and 2015 after an undercover report showed that one of the suppliers was providing tainted meat. And a serious E. coli outbreak at Jack in the Box in the early 1990s infected more than 700 people. Yet, all of these companies' stocks went on to produce substantial gains for investors in the following years.

In Chipotle's case, there's definitive evidence that it's putting its scandal behind it. Same-store sales are slowly but steadily improving. They were down 36.4% in January of this year. But by September, they were off 20.1%. You can see the upward trend in the graph below:

Data source: Chipotle Mexican Grill. Chart by author.

On top of this, Chipotle issued what I consider to be positive guidance for the future. It expects same-store sales to be down in the "low single digits" for the fourth quarter of this year. And it expects the figure to improve to the "high single digits" next year, as it will then be comping against quarters impacted by the outbreaks.

Moreover, Chipotle is continuing to buy back stock, taking advantage of the roughly 50% drop in its share price since its peak in 2015. After repurchasing over $1 billion worth of common stock over the past year, reducing its outstanding share count by 6.5%, it added another $100 million to its buyback authorization.

And the burrito chain isn't throttling its expansion efforts. New restaurant openings for 2016 are at or above the high end of its previously disclosed range of 220 to 235. And it expects to open between 195 and 210 restaurants next year.

In short, while there's no getting around the fact that Chipotle had yet another dismal quarter in the three months ended Sept. 30, enterprising investors like myself will see the sharp decline in its share price as an opportunity to be greedy when others are fearful.

John Maxfield owns shares of Chipotle Mexican Grill. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. 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.

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