Chipotle Mexican Grill (NYSE:CMG) shares initially spiked after the company's second quarter earnings call, as the company reported $2.32 in earnings per share, beating analysts' expectations by $0.14.
But the bottom-line beat took attention away from the company struggling sales -- its top-line came in below expectations, and given the recent norovirus outbreak in Virginia, the sales disappointment is likely to continue in the coming quarters.
Revenues in the second quarter fell short of estimates by $20 million, with the EPS beat occurring due to cost-cutting and efficiency. While cost-cutting is commendable, it won't get the company all the way back to where it was prior to 2015's E. coli episode.
Moreover, though the second quarter's same restaurant sales increase of 8.1% seems impressive on the surface, it only brought the two-year "stack" (or, comps relative to two years ago) to negative 17.5%, or only 82.5% of 2015 volumes.
Management also added that the first two weeks of July sales were in line with that figure. That seems to indicate the recovery was stalling even before the norovirus outbreak, especially since the company also raised prices in almost 500 restaurants last quarter.
Even more concerning is that the recent norovirus outbreak and video of rodents in a Dallas restaurant could hurt sales even more. Since the incidents were recent, the company had only one week of data following them. That week, same restaurant sales fell 5.5% from where they were running in the weeks prior. That meant restaurant volumes had fallen back roughly to last year's levels (as CFO Jack Hartung said it would take a 5.6% positive comp over Q3 2016 to hold current sales levels).
Deleverage is brutal
While a 5.5% comp decline may not seem disastrous, it could theoretically erase most of Chipotle's profits. That's because every Chipotle restaurant has to leverage fixed costs such as rent, energy, and labor, and the overall company has to leverage its corporate overhead with profitable restaurants. The math works like this:
In the third quarter of 2016, restaurant margins were 12.5%, and net income margin was almost non-existent at 0.8%. Excluding the impairment related to the closing of Shophouse, net margin would have been roughly 1.4% .
Contrast this with the recent quarter, when same restaurant sales were a mere 5.5% higher: Restaurant margins were 33% higher at 18.9%, and net income margins were over 67% higher at 5.7%. Therefore, a 5.5% drop in same restaurant sales could cause restaurant margins to fall by one-third, and overall profits to fall by two-thirds.
Adding insult to injury, the company is currently enduring its worst three-year stretch of labor inflation in its history, as well as spiking avocado prices. Without a meaningful increase in same restaurant sales, there will be little in the way of an earnings recovery, even if the company continues to open new locations.
In order to reignite earnings growth, the company will not only have to overcome the effects of the norovirus outbreak, but also get new or lapsed customers to return to 2015 volumes.
While that may seem like a Herculean task, all hope is not lost. On the recent earnings call, Chief Marketing Officer Mark Crumpacker said the company's study of "lapsed defectors" revealed the two biggest reasons former Chipotle loyalists stopped frequenting the restaurant were 1) boredom and 2) no queso.
The coming rollout of queso, as well as the other new menu items, could address the two main "defector" complaints in one shot. Chipotle is planning on rolling out queso in 350 restaurants in the near future, or about 15% of the footprint, along with an accompanying marketing campaign.
The company also reassured investors by reiterating its full-year guidance of high single-digit comps, though management admitted that number factored in a gradual recovery from the outbreaks, an uplift from queso, and a price increase later in the year. That's a lot that has to go right.
At this time, investors are left in limbo, having to gauge the cross-currents of new menu items running into the hangover of the norovirus and bad press events. Though the stock hovers near multi-year lows, it's too soon to tell if the company can regain the momentum it had earlier in the year, and it probably won't be apparent for the next couple of quarters.