Chipotle: A Closer Look at CMG's 1Q Results

A former Wall Street analyst discloses the topics that equity analysts and hedge fund managers are currently talking about. 

I recently wrote about Chipotle's slow, gradual recovery after its numerous health scares. While I've thought about focusing most of my writing efforts on more in-depth, larger company updates, I do think Chipotle's situation warrants an update after the company reported its 1Q results on 4/25.

First and foremost, Chipotle's 1Q was better-than-expected on the two main metrics that matter - comps and restaurant-level margins. With national advertising just now turned on and digital performing strongly, the outlook now looks better than it did before the earnings report, and the stock is up ~3% on the day after.

With that said, the report was not enough to persuade bears to flip sides. Most of the discussion was focused on comps, which was distorted by several factors. And with some deeper digging, one could find enough wrinkles in the quarter to remain bearish on Chipotle's outlook. And that's why the stock has only had a modest gain despite such a strong quarter.  You need thesis-changing operational results to drive 10%+ moves, and this wasn't it. 

Into the details:


The Positives

- CMG's 17.8% comp was above consensus of 15.5% and importantly, was in-line to perhaps slightly above investors' expectations for the quarter (which had moved up recently ahead of the quarter results). 

Source: Company filings

Source: Company filings

- The company began its first national advertising campaign in April. The campaign is expected to increase awareness and drive more frequent visits from customers, and should provide a lift to comps. Early results suggest that it is proving effective in converting customers into more frequent visitors (with an 18% conversion rate from first visit to regular customer) and in improving customer sentiment

- Management noted that digital orders were up 53% as a result of their better pick up time technology and the second make line. Digital orders should continue to be a driver of sales as Chipotle more heavily advertises the feature and customer adoption picks up

- Restaurant-level margins improved ~1100 basis points to 17.7% vs. the consensus expectations of 16.9%. This was one of the first major sequential improvements towards the company's 2017 "stretch guidance" of 20% restaurant margins

Source: Company filings

Source: Company filings


The Negatives

Note: Much of this discussion centers on comparisons and 2-year calculations. See my prior post that explains these concepts in further detail.

- There were a number of adjustments and one-time factors that complicate the underlying growth at Chipotle. These adjustments include a leap year last year (which helps February comps last year and hurts February comps this year), an Easter shift (Easter was in April this year vs. March last year, which helps March comps but hurts April comps since Chipotle closes on the holiday), and bad weather in April (which hurts comps). Adjusting for these factors and finding the true underlying growth rate is difficult; while it doesn't necessarily help or hurt the reported numbers (since we don't know if they are boosted or hurt by them), it does increase the uncertainty around what is going on at Chipotle.

- When attempting to adjust for some of these factors, the underlying trends by month are stabilizing, but are not improving. Management gave monthly comps on the conference call where the figures they discussed showed that comparable store sales were decelerating. However, when accounting for more difficult comparisons (using a two-year geometric calculation, which analysts and Chipotle management use and cite during the calls), and adjusting for the Easter impact mentioned above, trends appear to have stabilized around -16%. The focus isn't on the -16% so much; what matters is the rate of improvement, which was flat. Investors expect to see a greater degree of sequential improvement this late into the recovery. Given that some of the adjustments are not an exact science, some investors even believe that the underlying 2-year comp worsened in March and April. 

Source: 1Q conference call

Source: 1Q conference call

- While advertising and digital are positive signs, they have not materially impacted the recovery in the past despite numerous attempts from senior management. That has proved true as well for the latest ad campaign which began in April, where underlying comps have not yet shown improvement (although it is admittedly early). Additionally, the advertising bump is expected to slow margin gains in the coming quarters.

- As management discussed on the conference call, labor costs could prove to be a bit more difficult to lever due to labor inflation and bonus payments for better-than-expected performance to managers.

- Management disclosed unauthorized payments on their network over the last month. While bullish analysts have pointed to the minimal expense that would likely be associated with correcting the issue, more bearish analysts believe that a breach could hurt comp trends as customers may think twice before going into a Chipotle.

- Chipotle noted that they would monitor the consumer reaction to the price increase that they implemented recently (5% price increase at 20% of the store base) for the rest of the year. While prudent, some investors hoped for the price increase to be rolled out to more stores, which may have helped comps and margins. Management noted that performance in the Northeast and West Coast remains particularly weak. Given that customers have not yet returned to stores to the same extent as other regions, management will be more careful in implementing price increases.


The Conclusion: Monitor Upcoming Comp Trends

Ultimately, Chipotle's results were better-than-expected on both comps and restaurant-level margins. Both of these results should drive upward estimate revisions for 2Q and for the full year. However, there were enough issues with the underlying rate of improvement on a monthly basis for the bears to latch onto, as Chipotle will need to show continued improvement to reach its "stretch guidance" targets for the year and to reach pre-health-issue peaks.