Shares of Chipotle Mexican Grill (NYSE:CMG) continued their roller-coaster ride this week, plummeting 5.7% on Wednesday after the company's Q3 earnings and Q4 guidance didn't quite live up to expectations.
Investors were dismayed by Chipotle's slowing comparable restaurant sales growth. Comp sales momentum has steadily decelerated from a peak of 19.8% growth in Q3 2014 to just 2.6% growth last quarter. Some investors might have been willing to chalk up last quarter's slow growth to the incredibly tough comparison -- but then Chipotle indicated that comp sales growth could remain in the low single digits through 2016.
However, while comp sales growth is important for bolstering profitability in the long run, it's not Chipotle's only path to sales and earnings growth. Nowhere was this clearer than in Chipotle's Q3 earnings report.
Store growth accelerating
There are two ways for a restaurant chain like Chipotle to drive sales growth. The first is through comp sales growth: higher sales at each restaurant. The second is expansion: opening new restaurants.
While Chipotle's comp sales growth has slowed recently, the chain is expanding faster than ever. New restaurant openings have been running at the high end of the company's plans all year, and on Tuesday Chipotle revised its store growth guidance for 2015. It now expects to open 215 tp 225 restaurants this year, up from an original plan of 190 to 205.
This guidance implies that Chipotle will open 65 to 75 restaurants in Q4, ending the quarter with just about 2,000 restaurants. New restaurants continue to produce strong profitability out of the gate. As a result, Chipotle plans to open 220 to 235 restaurants in 2016. This will keep its restaurant count growing at a double-digit rate.
Store growth vs. comp sales growth
Chipotle's rapid expansion is now driving the bulk of its revenue growth. During the third quarter, Chipotle's revenue rose 12.2% year over year, even though comp sales rose just 2.6%.
There is one downside to growing through expansion rather than comp sales increases: Only comp sales growth can leverage the fixed costs associated with each store. But Chipotle still has stellar average unit volumes of $2.5 million and its restaurant-level operating margin remained strong at 28.3%. Over time, it should be able to improve those numbers -- but the upside for these figures in the next few years is relatively muted.
By contrast, Chipotle has enormous store growth potential. It is likely to at least double its namesake chain's U.S. footprint in the next decade. Other "growth seeds" such as new restaurant concepts and international expansion could also blossom into major growth drivers over time.
Expansion is working
As long as Chipotle's stellar unit-level operating economics remain intact, store growth will be very attractive, as demonstrated by the company's Q3 performance.
Pre-tax income rose 13.5% to $235 million last quarter, as a slight decline in Chipotle's restaurant-level operating margin, driven by higher wages and marketing costs, was offset by lower general and administrative expenses. EPS rose 10.6% year over year to $4.59, an all-time record.
All of these results are very solid considering that Chipotle continued to face a significant pork shortage last quarter, which probably dampened sales. Beef cost inflation also remained a headwind during Q3.
Both of these issues should be resolved soon. Chipotle has found new responsibly raised pork suppliers and ended last month with carnitas back on the menu in 90% of its restaurants (up from a low of 60%). Chipotle expects to have carnitas available chain-wide by the end of November. This should keep comp sales rising, if only at a low-single-digit rate.
Meanwhile, growing cattle herds are finally starting to reverse the multi-year surge of beef prices. Chipotle is also in the midst of raising its beef entree prices to catch up with the recent cost increases. This could drive a further decline in food costs as a percentage of revenue in 2016, keeping companywide margins steady or rising.
Chipotle's comp sales guidance for 2016 may prove to be conservative, but I don't anticipate a return to double-digit comp growth in the near future -- or perhaps ever. That's not necessary to justify Chipotle stock's valuation, though. Chipotle just needs to keep comp sales growing fast enough (perhaps 3%-5%) to maintain its impressive restaurant-level profitability. Steady expansion will do the rest.