After three years of blistering growth, Chipotle Mexican Grill (NYSE:CMG) just reported another quarter that the market views as rather lackluster. As of this writing on Oct. 20, shares are down more than 7% in limited after-hours trading. The highlights:
- Revenue up 12.2% to $1.2 billion.
- Comps (same-restaurant sales) growth of 2.6%.
- Restaurant-level operating margin of 28.3%, a 50bps decline from last year.
- Earnings per share up 10.6% to $4.59; net income of $144.9 million.
Overall, the results aren't bad, per se, but Chipotle stock has traded at a pretty high premium in recent years, largely because it's been a premium growth company. Growth has indeed slowed, and there are certainly some short-term challenges that management needs to get ironed out, but it's not all bad news. Let's take a closer look.
What happened in the quarter?
In short, there were a few things that led to -- at least for Chipotle -- relatively lackluster sales and earnings growth.
- Price increases implemented in 2014 -- which led to an insane 19.8% comps growth in the year-ago quarter -- made for a very difficult comps quarter this go-around. However, management said that traffic was up 1.9% in the quarter, an improvement versus the second quarter.
- Higher labor costs, largely tied to expanding benefits and 5% higher average wages for hourly employees, were a primary driver in causing restaurant-level operating margins to fall 50 basis points to 28.3%.
- Earnings per share increased less than sales growth, primarily because of labor cost increases.
- Higher beef prices and the ongoing pork supply issue affected margins and comps. Beef costs have continued to increase, and the company is only just now implementing higher prices to address this matter. The company had carnitas in only about 60% of restaurants most of the third quarter. This situation limited sales and also kept management from raising beef item prices in locations that didn't have carnitas as an alternative.
- Even with higher beef prices and the lack of carnitas, food costs as a percentage of revenue came in at 33%, 130 basis points less than last year's quarter, a result of lower dairy and avocado prices so far this year.
Key things management said
Chipotle management made it clear that it's looking at multiple ways to fuel continued growth. In the short term, this effort will come from price increases on beef items, which management said would generate about 130 basis points of comps growth in Q4, as well as the full return of carnitas to all locations.
An analyst asked about the company's initiatives around technology on the earnings call, and CFO Jack Hartung replied:
Two-thirds of our business is eaten outside of our restaurants. But only 7% is ordered outside of our restaurants. There's a big gap between our customers who end up eating outside of our restaurants [and actually use mobile ordering]. So it kind of makes sense for us to provide a way that makes it convenient for them to order outside the restaurant.
Co-CEO Marty Moran talked at length about the company's focus on an additional order "make line" in the kitchen that's used for catering and to-go orders placed online and through the mobile app. He said these stations generate more than $500 per day on average already and that the company has made it a priority to increase the throughput and capacity of these stations. He also spoke about a new delivery partnership the company has established, focused especially in college markets. This strategy could be a key driver for the next wave of sales growth.
Looking ahead: Deceleration in comps doesn't have to mean slowed profit growth
Chipotle's growth the past two quarters was well below that of the past three years, but after averaging more than 8% annual comps growth over that period, it may be unreasonable to expect a return to those levels.
However, management made it clear that there are things happening that should help reignite some growth. In the short term, that includes the imminent return of carnitas to all locations, the price increase for beef items, and, in the long term, initiatives to grow delivery and take-out orders that utilize Web and mobile apps to place orders.
If the company can take advantage of these initiatives -- which should enhance operational leverage, driving more sales through essentially the same cost and labor structure as now -- then earnings growth has the potential to be strong for years to come. We didn't see that in the third quarter, but Chipotle's management has a history of executing. I wouldn't bet against this team.