Now that fast-casual eatery Chipotle Mexican Grill (NYSE:CMG) has reopened 43 restaurants it temporarily shuttered in Seattle and Portland while dealing with E. coli contamination linked to 11 of its locations,investors can turn their attention back to a longer-term problem: Is Chipotle finding itself a victim of its own success?
In its third-quarter 2015 earnings released late last month, the company reported revenue which rose at a healthy pace of 12.2% to $1.2 billion. Yet comparable restaurant sales increased only 2.6%.
Of course, shareholders should have been expecting a low-single-digit comps increase. Chipotle was up against an extremely difficult comparison from the prior year, in which comps leaped 19.8%. And management had already set a comps outlook in July for the entire year that targeted the low to mid-single digits.
But the realization that comparable sales, after expanding only 4.3% last quarter, are truly slowing down, is perhaps causing longtime adherents to question if the stock can maintain its traditionally steep ascent.
Chipotle's growth engine was on the mind of both analysts and management during the company's third-quarter earnings call. Let's review the thematic ideas management presented to demonstrate how the company might regain some of that lost revenue velocity.
Embracing activity outside the store
"But one way we think about the business is, about two-thirds of our business is eaten outside of a restaurant, but only 7% of our business is ordered outside of a restaurant."
-- CFO John Hartung
This quote refers to a growing realization among Chipotle's executives that revenue from off-premises consumption, primarily in delivery, catering, and store take-out, should be embraced. If two-thirds of customers eat-off site, yet 93% of customers order inside a restaurant, then there is probably a potential for increased sales simply by making it easier for the majority of Chipotle's customers to purchase their food off-premises as well.
During the call, co-CEO Montgomery Moran pointed out that nearly all Chipotle restaurants house a second "make line" to service take-out orders. Moran disclosed that Chipotle is now averaging sales per restaurant of $500 a day on the second make line. In some high-volume restaurants, average sales are many times higher, turning these lines into "virtually a second restaurant within the restaurant."
Responding to consumption patterns outside store walls is a strategy that one of Chipotle's peers, Panera Bread Company (NASDAQ:PNRA) is throwing significant resources behind. Like Chipotle, Panera experienced a period of slowing comps after years of fast growth. During the past several quarters, Panera's management has invested in its technology and distribution infrastructure to increase alternative revenue versus the dining-in experience.
CEO Ron Shaich summarized the initiative (and related huge market potential), on Panera's most recent earnings call, as an initiative "to create roadways for growth into several $1 billion-plus adjacent businesses, including large order delivery, which we call catering, small order delivery, which we call delivery, and consumer products, which we call Panera at Home." At this juncture, it seems wise for Chipotle to follow its worthy competitor and experiment with some of these "adjacent businesses."
Refocusing on throughput
"And then I think sometimes when things aren't moving -- when the growth isn't quite as rapid, people get a little less excited about pushing throughput."
-- co-CEO Montgomery Moran
As is true with almost every Chipotle earnings call, management devoted much discussion to throughput -- that is, the rate of sales in a given time period. Moran singled out a slight decline in lunch peak hour throughput during the quarter as one area for improvement.
The quote above is perhaps the most tangible illustration of why Chipotle stands at a revenue growth crossroads. The company has for many years been able to increase sales merely by increasing its rate of throughput. That's because customers are reliably found extending out the door during peak hours in high-volume locations. Figure out how to move the line faster, and you've just increased sales.
However, there's perhaps a future in store for Chipotle in which novelty wears off, and lunch and dinner lines aren't quite as long. In this future, meeting demand during a peak hour will mean that no potential customer turns away, but in this scenario, sales will eventually flatten.
Until that time, at which other revenue strategies should have theoretically taken over the burden of growth, management is absolutely correct to stress the importance of extremely efficient service at each daypart -- even if some of the excitement of the service challenge is fading for employees.
Is a new comps cycle beginning?
"We deliberately spend less on our marketing so that we can afford these higher-quality ingredients. And that's essentially ... the main marketing benefit to our customers. And so we find different ways to tell that story, entertaining ways to do it, but we have recently shifted our focus more to telling the basic story about where our ingredients come from and how they're made."
Moran is alluding to a phenomenon unique to Chipotle, in that comparable sales seem to crest and sink in three-year cycles. Specifically, Moran refers to management's assessment that the current low-comps environment may mark the beginning of a new three-year cycle. Company leadership has a firm idea of how to lift comps through the cycle, and it doesn't involve turning on an indiscriminate spigot of advertising dollars.
Instead, co-CEOs Moran and Steve Ells, as well as CFO Hartung, passionately believe that spreading Chipotle's brand message, as opposed to traditional marketing spends, drives increased revenue. During the call, management offered that there are still numerous parts of the country where Chipotle doesn't have much of a presence. By this logic, simply expanding awareness in new metropolitan areas could ignite a new three-year wave of comps increases.
Of course, since that call, Chipotle has faced a challenge to its brand integrity from the E. coli contamination that has vividly occupied headlines for the last three weeks. If the chain incurs any additional missteps like this, it may be forced to spend more on advertising than executives would like, simply to reinforce the perception that Chipotle's food is safe to consume.
We won't rush our R&D projects
"I hate to put a timeline on it. We are accelerating to a certain degree, but I assume what you mean is to really ramp it up aggressively. They're still in the nurturing phase; it's still in the brand-building phase."
Could you guess which initiative CFO Hartung is referring to? The quote is part of the response Hartung gave to an analyst who asked if, with $1.6 billion in cash, Chipotle would accelerate expansion of its Pizzeria Locale and ShopHouse SouthEast Asian Kitchen concepts.
As of the end of the third quarter, there were more than 1,900 Chipotle locations, including 11 in the U.K. But the company has opened only 11 ShopHouse and three Pizzeria Locale stores. If it desired, management could ramp up the development of these concepts, which share extremely similar operating characteristics to Chipotle Mexican Grill locations, albeit under different culinary themes.
Instead, the company is choosing to test-market the concepts extensively, work on their branding, and improve return on investment before scaling up. It's a determined and principled way to ensure that these additions to the Chipotle banner will be able to approach the company's high restaurant contribution margins of 28%, and average revenue per restaurant of $2.5 million.
The approach springs from the same thinking that informs Chipotle's narrative-based marketing approach. Despite potential investor impatience, this executive team is willing to remain at a growth crossroads for now. It will stick to its proven formulas, in the belief that the next cycle of growth could be as strong as the one that now appears to be ending.