Is Chipotle's Turnaround for Real?

Chipotle Mexican Grill (CMG 1.07%) shareholders received a huge 24.4% bump in the shares the day after its recent earnings report, showing the market's optimism for a turnaround under new CEO Brian Niccol. In the first quarter, Chipotle posted revenue of $1.15 billion, which met analyst expectations, but earnings per share of $2.13 handily beat expectations of $1.57.

After such a huge rise in the stock after its earnings report, it is worth digging into the details to see if there is anything in the business fundamentals or guidance that would justify such an elevation, or if the fast-casual restaurant chain's long-awaited turnaround may finally be upon us.

In this case, although the headline numbers outperformed Wall Street's expectation and were presented by an enthusiastic new CEO, the underlying trends in Chipotle's sales and cost structure are not as encouraging. Let's examine why Chipotle's turnaround is currently more of a hope than a reality.

Can Chipotle's new CEO reinvigorate growth?

"Stacked" comparable sales

First, the good news. For those who haven't been following Chipotle closely over the past few years, the company suffered from the fallout of an E. coli outbreak in the fourth quarter of 2015. Ever since, the restaurant chain has failed to regain the customer traffic it had prior to that outbreak.

One way to track unit traffic is by comparing same-store sales over the past three years, then multiplying each year's number, to get a sense of the average store's revenue compares with pre-crisis levels. The E. coli incident happened in the fourth quarter of 2015, we now have a three-year "stack" for the fourth quarter 2015 through 2017, and first quarter 2016 through 2018.

This quarter did show some improvement, with overall sames store sales coming in 15.4% below 2015 levels as opposed to the negative 17.5% figure in the fourth quarter:

Data source: Chipotle earnings releases. Calculations and table by author.

However, much of this improvement came from price increases of roughly 5% across the menu. When viewed through that lens, comparable store sales of 2.2% indicates that traffic actually declined in the most recent quarter. So, while positive comps are a plus, it doesn't exactly scream out, "recovery."

Costs rising

Making things harder, the company not only needs to get back to its level of pre-crisis average unit sales, it actually has to do better. That's because Chipotle has experienced wage inflation, just like everyone else in the industry. This quarter, wages increased 5%, higher than same store sales, causing labor costs to increase to 27.8% of sales, up 90 basis points from last year.

Chipotle management expects that ratio to worsen, too. On the most recent earnings call, CFO Jack Hartung said, "we expect labor for the full year to approach 28% as crew and manager merit increases combined with general wage pressures continue to outpace the comp."

With labor costs surging more than sales, one might wonder how Chipotle beat earnings estimates in the quarter. The answer is that the company under-spent on marketing, which only made up 1.8% of sales, down 150 basis points (or, nearly cut in half) from the same figure last year. But that trend likely won't last, because the company plans to increase marketing expenses to 3% of sales for all of 2018.

Betting dollars on Niccol

These numbers don't paint a great picture, so why are shares up? It likely has more to do with the optimistic tone struck by Niccol, who previously led a turnaround at Taco Bell and replaced Chipotle founder Steve Ells in the first quarter. At Taco Bell, Niccol introduced new creative products such as the Doritos Locos taco and chicken fries, and backed it up with a savvy marketing campaigns while changing the company slogan to, "Live Mas."

Judging by the rise in Chipotle's stock, the market clearly liked what it heard from Niccol, and thinks he can do the same at Chipotle; however, on the call he didn't reveal much in the way of a revolutionary plan. Niccol's points included: 

1. Doubling down on restaurant fundamentals. 
2. Increasing marketing to focus on the "cravability" of the food.
3. Potentially expanding hours beyond its current 10:30 a.m. to 10 p.m. range. (Fourth meal, anyone??)
4. Reviewing some 100 stores that are cash flow negative, and considering shutting some down.

This all seems well and good, and I'm sure there will be more ideas coming, but really, how different is this from what Ells had been trying for the last few years? The truth is, not much.  

For instance, last year Ells renewed the company's focus on the fundamentals of running great restaurants, and hired a Chief Restaurant Officer in Scott Boatwright from Arby's. The company also opened its NEXT Kitchen in downtown New York to test menu innovations, but when the company unveiled its queso last summer, it garnered criticsim from many. 

So, apparently when Ells wants to introduce new ideas and double-down on fundamentals, he's a man out of ideas, but when Niccol does it, Wall Street deems it a brilliant turnaround strategy! 

Not biting the burrito

Don't get me wrong, I love Chipotle's food and "Food with Integrity," mantra and the company may have been overly punished for the food safety sins of the past. However, investors should use caution. Trading at 36 times forward earnings, the stock seems to be pricing in a recovery that hasn't happened yet probably won't happen this year either.