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Chipotle's Turnaround Is Getting Expensive

By Timothy Green - Jun 20, 2017 at 2:30PM

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The second quarter will see a boost in advertising spending in an effort to drive sales, a trend that's unlikely to abate.

For fast-casual restaurant chain Chipotle Mexican Grill (CMG 3.06%), 2017 is a rebuilding year. Comparable sales crashed 20% in 2016, with customers fleeing after a disastrous string of food safety crises rocked the company. Hundreds of diners were sickened by E. coli, norovirus, and salmonella in various states across the country. Chipotle's profits tumbled 95%, and the stock was sent reeling.

Chipotle now faces the challenge of winning back customers. The company expects to grow comparable sales by a high single-digit percentage this year, guidance that it reiterated on June 20 in a filing with the SEC. It will take multiple years of strong growth for Chipotle to get back to where it was before the collapse, but this is a good start.

That SEC filing carried other news as well. Chipotle expects its marketing and promotion costs to rise by 20 to 30 basis points in the second quarter compared to the first quarter, reaching 3.6% to 3.7% of sales. I argued previously that Chipotle would likely need to ramp up marketing spending in order to drive sales, which could pinch margins. That scenario seems to be playing out.

A Chipotle burrito, with chips and guacamole.

Image source: Chipotle.

Losing customers is easy -- winning customers is hard

Historically, Chipotle hasn't been a big marketing spender. The company and its premise, offering meals with high-quality ingredients for relatively low prices, was enough to drive intense customer loyalty. Chipotle spent just $57.3 million on advertising and marketing in 2014, about 1.4% of revenue. Low marketing costs helped the company produce impressive high-double-digit operating margins.

But nothing does a better job killing customer loyalty for a restaurant chain than an outbreak of foodborne illness. Except multiple outbreaks of foodborne illnesses. Chipotle was forced to make significant changes. It launched its first loyalty program, ran promotions giving out free food, and took steps to reduce the chance that another outbreak occurs.

Sales in 2016 were down compared to 2014, but Chipotle spent a whopping $103 million on advertising and marketing, nearly double what it spent in 2014 and 5.1% of revenue. Chipotle expects this percentage to come down this year as it tries to bring its spending back to historical levels. The company warned that this plan may cause problems in its annual report:

In 2017 we expect to return marketing and promotional expense to levels closer to our historical practice as a percent of revenue, and doing so may adversely impact the number of customers visiting our restaurants. If so, we may be forced to engage in additional promotional activities, including further offers for free or discounted food, which may hamper our sales and profitability.

Chipotle launched a new advertising campaign in April, which will drive up advertising costs during the second quarter. The big question: Will the sales rebound Chipotle is seeing this year continue in 2018 and beyond without the heavy promotional activity that has helped bring customers back? Chipotle continues to open new restaurants at a quick pace, with plans to open 195 to 210 new locations this year, so total sales will continue to grow. And initiatives like online ordering are likely helping the cause. But comparable sales will need to keep growing at a mid-to-high single-digit pace for a few years for Chipotle to fully recover.

Chipotle stock is still shockingly expensive given the problems facing the company. Shares trade for nearly 30 times peak earnings from 2015, a level that will likely take quite a while to reclaim, and even longer if Chipotle is forced to ramp up advertising spending further to maintain its sales momentum. The market is pricing in a fairly optimistic scenario -- too optimistic if you ask me.

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