Chipotle 4Q 2017 Update
My thoughts on Chipotle’s fourth quarter
Chipotle reported 4Q results last week. 2018 guidance for low single-digit same-store sales growth and 17.5%-18.0% restaurant margins is modestly disappointing.
Management is stepping up capex this year for store refreshes, store remodels, IT investments, new store prototypes, and more efficient equipment.
My view is that management is finally providing conservative guidance after a couple years of overpromising and underdelivering.
My new lowered base case assumes 2-3% comps indefinitely, restaurant margins plateau at 20%, and new store openings remain at 140 per year until saturation at 4,250 stores. This scenario suggests CMG is worth $300 per share.
With the stock around $250 per share, there appears to be limited downside from here.
The fourth-quarter was not wildly different than expectations. Comps were +0.9% but were +1.5% excluding the 60 bps benefit from deferred revenue in 4Q 2016. Comps benefited from price increases and the queso rollout, but were hurt by -3% traffic, a weak trend that began in July after a norovirus incident at one Virginia restaurant. Restaurant-level margin of 14.9% was up 140 bps from 4Q 2016.
Second make-line sales were +33% in the quarter. The second make-line is the line in the back of the restaurant that is used to make digital/online orders and catering orders. Digital sales are now up to 8.6% of sales. Mobile ordering was up over 50%. Catering sales were +20% and is now 1% of sales. Catering delivery is now available at 40% of restaurants now, and that should grow this year. These are solid trends because digital and second-make line sales free up congestion on the main line, allowing for more people to join shorter lines. Companies like Panera and Starbucks are light years ahead of Chipotle with digital ordering, so this is a big opportunity for Chipotle over the next few years.
2018 same-store sales guidance of low single-digits is below what I would hope they achieve this year. It seems like management is finally toning down expectations after a couple years of expressing optimism that a recovery would soon take hold. One analyst asked why guidance for 2018 seems to assume things don't get much better despite all the initiatives they are doing. CFO Jack Hartung responded that same-store sales should improve in the second-half of the year, but "we're not being overly bullish with our guidance," and that management is "hoping that we can spark a more positive transaction trend, but based on how tough it's been the last couple of years, to get that momentum going, we think this is the right level of guidance." In other words, we've overpromised and underdelivered in the recent past; we're now trying not to overpromise. I think that is a better approach because it is more likely to set the company up to beat expectations.
Capex is stepping up to $300 million this year. That includes growth capex for 130-150 new restaurants, as well as a slew of other projects. Maintenance capex will step up to around $74 million this year, due to deferred maintenance. Retrofitting more digitally-enabled second make-lines will cost about $45 million. Improving IT infrastructure for mobile initiatives will cost $15 million. Interestingly, they are spending about $10 million to develop new store prototypes that will improve digital ordering flow. Another $25 million will be spent on more energy efficient restaurants, including equipment. Investors are right to question whether many of these non-growth investments will generate attractive returns for the company. Major store remodels at other restaurant chains like Wendy's over the last several years have caused meaningful lifts to same-store sales growth, but it is too soon to tell whether the changes Chipotle is making will cause a similar improvement.
It sounds like the company is aggressively testing new menu items, including nachos and quesadillas. The challenge with these items has always been that they take longer to prepare than burritos and bowls and therefore slow down throughput. (You can actually order quesadillas now off-menu, and they are the best food they serve, in my opinion). The new store prototypes are being designed to allow for some of these more complex items to be prepared in an efficient way. I think quesadillas on the menu could give the company a nice lift.
Management also mentioned a permanent loyalty program is in the works for the second half of this year. The company had been reluctant to roll one out in the past because business was so good that it didn't need a loyalty program. But the disappointing pace of the recovery over the last couple years has apparently changed their perspective. Starbucks and Panera do very well with their loyalty programs, so that has the potential to improve comps starting later this year.
The company's tax rate for 2018 should be 30-31% and then should drop to 27-28% in 2019 and beyond, although there could be some variability related to stock-compensation tax issues. This is a bit higher than the 25% I had assumed, but still a huge benefit. In 2018, Chipotle is reinvesting about 1/3 of the $40-$50 million tax savings into bonuses for its workers (like many companies have been announcing). The remainder should more or less drop to the bottom line, although you could also say it is being reinvested in the stepped up capex program.
There is no new news on the CEO search. Given Steve Ells will remain Chairman and has obviously strong views on the direction of the company, I wonder whether the best restaurant executives would want to run Chipotle with Ells looking over their shoulder. He insists he will give the new CEO autonomy, but at the same time says the new CEO would not tweak with the company's mission around "Food with Integrity." So there are some sacred cows. It will be interesting to see who they announce as the new CEO.
Scenario Analysis and Valuation Update