Chipotle Mexican Grill, Inc.
Q4 2017 Earnings Call Transcript

Published: 7 Feb 2018

[Operator:]

Greetings, and welcome to Chipotle Fourth Quarter and Full Year 2017 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Mark Alexee, Investor Relations Manager. Please go ahead.

[Mark Alexee:]

Hello, everyone, and welcome to our call today. By now, you should have access to our earnings announcement released this afternoon for the fourth quarter and full-year 2017. It may also be found on our website at chipotle.com in the Investor Relations section. Before we begin our presentation, I'll remind everyone that parts of our discussion today will include forward-looking statements as defined in the securities laws. These forward-looking statements will include statements regarding our CEO search, initiatives to build sales, investments in restaurant upgrades, expected tax savings from tax law changes, sales trends and forecasts for future comparable restaurant sales, transactions and the impact of many price increases, expected new restaurant openings, estimates of future food, labor, occupancy, marketing, other operating, and general and administrative cost trends and expected margins, statements about plans for capital expenditures, returns on investment and stock repurchases, as well as other statements of our expectations and plans. These statements are based on information available to us today and we are not assuming any obligation to update them. Forward-looking statements are subject to risks and uncertainties that could cause our actual results to differ materially from the forward-looking statements. We refer you to the risk factors in our Annual Report on Form 10-K as updated in our subsequent Form 10-Qs for discussion of these risks. I'd also like to remind everyone that we have adopted a self-imposed quiet period, restricting communications with investors during that period. The quiet period will begin on the 16th day of the last month of each fiscal quarter and continues until the next earnings conference call. For the first quarter of 2018, it will begin March 16 and continue through our first quarter earnings release planned for April 24, 2018. We will start today's call with some brief prepared remarks and then open the line for questions. On the call with us today are Steve Ells, our Founder, Chairman, and Chief Executive Officer and Jack Hartung, Chief Financial Officer. Scott Boatwright, Chief Restaurant Officer; Mark Crumpacker, our Chief Marketing and Strategy Officer; Curt Garner, Chief Digital and Information Officer; and Laurie Schalow, Chief Communications Officer are also with us and available during the Q&A period. With that, I will now turn the call over to Steve.

[Steve Ells:]

Thanks, Mark, and good afternoon everyone. In 2018, Chipotle will celebrate its 25th anniversary. This is an ideal time to reflect on the things that have contributed to our success over the past 25 years, while at the same time, providing an update on the fundamental changes we are making across the business to enable us to get back on a strong growth trajectory and realize our vast potential. As I think back on the past 25 years, I'm extremely proud of the unique company we've created. Our success is based on our passion for serving great tasting wholesome food that's served in an interactive environment. It has been our vision, and the commitment of doing what is right for our guests, employees, suppliers, and farmers, the environment and animals well before these things were common in the world of fast food, all while delivering a superior economic model that has led to our success. When I started Chipotle, I wanted to show that just because food is served fast doesn't mean it has to be a typical fast food experience. It wasn't a commonly held view at the time, but it certainly has paid off. I continue to believe that this approach to serving nutritious, wholesome, and delicious food remains highly valued by our guests and can deliver strong returns to our shareholders. Now, after 25 years, we must navigate new challenges by continuing to evolve how we approach the business. Our results for the quarter clearly show that there is still work to be done to restore a strong growth and customer trust, and today, I want to discuss the progress we're making on a number of initiatives that will transform how we manage the company and that will provide a solid foundation for how we build the business going forward. Today, I want to talk about three key areas of focus

[John R. Hartung:]

Thanks, Steve, and good afternoon, everyone. Last year held its full share of challenges, but we begin 2018 with optimism that the changes made so far and the changes and investments we'll make in 2018 will establish the foundation for a strong future. Our restaurant teams and field support teams are more committed than ever to delivering an excellent guest experience and will continue to emphasize the guest as we significantly increase our focus and investment on training. We've established incentives for our managers and field leaders to continue to elevate the guest experience and to build sales. Our second make-line sales including online, mobile and catering are the fastest growing parts of the business and we expect that growth to continue or even accelerate. We also plan to invest much more in our existing restaurants during 2018 and beyond to create a better dining environment, but ultimately to improve the overall experience and flow of our restaurants. I'll begin by reviewing results for the fourth quarter and full year, and then provide details related to our capital reinvesting plans and tax savings from the Tax Cuts and Jobs Act. For the fourth quarter, we reported $1.1 billion in sales on comp sales growth of 0.9%. Our reported comps include a 60-basis-point decrease as we lapped Chiptopia deferred revenue in Q4 of last year. If you recall, we recognized an additional 60-basis-point benefit in sales comp related to the deferred revenue in Q4 2016 and now that reduces our comp in the current period. We'll have a similar decrease in the first quarter of 2018 of about 50 basis points to our comp. Our restaurant level margins were 14.9% in the quarter, and we generated $1.55 in earnings per diluted share. Our EPS in the quarter benefited by about $0.21 related to the recent U.S. tax law changes. For the full year, we reported $4.5 billion of sales on a sales comp increase of 6.4%, which includes a 30-basis-point benefit related to Chiptopia. Restaurant level margins were 16.9%, and we generated diluted earnings per share of $6.17. The Q4 underlying comp of 1.5% before the 60-basis-point effect of Chiptopia was driven by a higher average check as we expanded our menu price increase to an additional 900 restaurants in November, bringing the total menu price impact during the quarter to about 240 basis points. Average check also benefited by about 200 basis points from queso. And queso continued to add about 200 basis points to the average check in January as guests are currently adding queso in a little more than 10% of our transactions. Paid traffic in the quarter was down about 3% due to the negative transaction trends that began in July of last year. January 2018 sales comp was 3.4%. We had one extra trading day in the month as we opened on New Year's Day for the first time. And that day contributed about 240 basis points and will account for just under 1% in the comp for the first quarter. Sales were diversely impacted during the first three weeks of January from the series of winter storms that impacted most of the country. As the weather has normalized over the past two weeks, our comps have been running in the 2.5% to the 3.5% range. First quarter comparisons will get tougher as we enter mid February and March, as warm weather last year caused our comps to surge, essentially bringing our normal seasonal spring sales bump earlier than normal. If our recent sales dollar trends continue through the first quarter, we would expect a comp of between 1% and 2% before the impact of Chiptopia. Our full year comp guidance for 2018 is in the low single digits with lower sales comps expected in the first half of the year due to the tougher comparison, then improving in the second half as comparisons ease. In addition to the menu price increase last November, we completed the final round of price increases in January in about 1,000 remaining restaurants or about 40% of our restaurants. The average price increase in these markets was about 5%, and we expect resistance of around 20% or less. We expect the average check will continue to benefit the comp by about 2% from guests adding queso through the first 8 months of 2018 until we lap the queso rollout in September. Of course, all this means we will likely continue to see negative transactions until we lap the beginning of the negative transaction trend which began in July. Food costs during the quarter were 34.2%, down from 35.3% in the prior year and down from 35% in Q3. The decrease from last year was driven by menu price increases, better management of paper and packaging inventories, and lower priced avocados. We expect relatively stable prices in 2018 including for avocados which along with the price increase should lower our food costs to the low to mid 33% range. California avocado growth should be on the upswing for their alternate-bearing crop this summer and we're fortunate that the recent wildfires in California are not expected to impact supply. Labor costs in the fourth quarter were 27.5%, flat with the prior year. Higher wage inflation of 5% was offset by a combination of factors including labor efficiencies due to fewer promotions, lower insurance and benefit costs, and slight leverage from pricing. Since early 2014, crew wages and benefits have increased by cumulative 29%, but we've only increased pricing by cumulative 12%. Our restaurant managers and crews are running some of the most efficient restaurant labor deployment we've seen in years. The labor pressures will continue at this level because of wage inflation, softer transaction trends and as we add our enhanced benefits that Steve discussed. Our labor as a percent of sales is typically flat from Q4 into Q1, although we anticipate it to increase slightly in Q1 related to regulatory minimum wage increases as of January 1 combined with the reinvestment into our employees funded by the tax savings. Occupancy costs for the fourth quarter were 7.6% of sales versus 7.4% last year. The higher occupancy costs were driven by inflation from renewals and slightly higher average rents from new restaurants. We anticipate new restaurant openings in 2018 to continue to have modestly higher average rents than existing restaurants due to refocusing our development pipeline with a heavier weighting toward proven markets. As a percentage of sales, occupancy for the full year should be about in line with 2017 in the low to mid-7% range as a percent of sales. Other operating costs were 15.8% of sales in the quarter, a decrease from 16.3% last year. Our marketing and promo costs were 3.8% of sales in the quarter, which is a decrease of about 100 basis points compared to last year. Our other operating costs also included 50 basis points of incremental cost related to maintenance and repairs. Maintenance and repairs is expected to remain at elevated levels during 2018, which I'll explain more fully in a few minutes. In 2018, we anticipate marketing and promo activity will be at or slightly above 3% of sales. Marketing and promo costs will be slighter higher in the second and third quarters with lower spending in Q1 and Q4. For the full year, we anticipate other operating costs to be about the same as last year as savings from the lower marketing and promo will be reinvested into existing restaurants with higher maintenance and repairs. With normal lower seasonal sales in the first quarter and the increased reinvestment in our restaurants, we would anticipate Q1 other operating expenses to be right around 15% of sales. So, overall in Q1, the restaurant level margins are typically similar to the fourth quarter with lower expected food and other operating costs and the full benefit of the price increase offset by higher maintenance and repairs investment and the investment in the special bonus for employees, Q1 margins should be in the 16% to 16.5% range. G&A costs for the full year 2017 were 6.6% of sales, or a total of $296 million. And this includes $30 million related to the data security incident from April 2017, $60 million in stock compensation, and $8 million in our employee bonus program. During 2017, our employee bonus program underperformed our targets. For the full year 2018, we anticipate G&A costs will be about $330 million, and this includes around $66 million for stock comp, $18 million for our employee bonus program, as we expect to return to paying bonuses at our target during 2018, $12 million for one-time executive retention bonuses and stock grants, and $12 million for our biennial all-manager conference. We expect underlying recurring G&A to grow by about $25 million after three years of flat G&A, despite the fact that we opened more than 650 restaurants during this time. The $25 million includes the formalized new training programs and the one-time special bonuses for staff related to the savings from tax rate reductions. We plan to invest a total of about $300 million in capital expenses in 2018, an increase from our 2017 investment of $217 million. For the first time ever, our capital investment into existing restaurants will outpace our investment in new restaurant openings. The total CapEx will be funded from our cash flow from operations and includes several components. First, in addition to normal ongoing upkeep of our restaurants, for which we would typically invest around $10,000 per restaurant, or around $24 million, we'll invest another $50 million to fund the new refresh and maintenance program that Steve introduced. This $50 million is a discrete one-time investment that will average about $20,000 per restaurant and it will allow us to fully assess the interiors of every single restaurant, improve efficiencies, ensure that the environments are warm and welcoming for our guests. This focus on improving our restaurants is also driving higher maintenance and repair expenses, which we expect will continue throughout 2018. In early tests, we have seen modest investments can have a significant influence on the atmosphere for our guests. In addition, we'll invest into new growth initiatives, including about $45 million to continue to retrofit our digitally-enhanced second make-lines into existing restaurants. Including new restaurants, the digitally-enhanced second make-line will be in about 1,000 restaurants by the end of the year. We'll also invest about $15 million to improve IT infrastructure, a portion of which will support and enhance our digital programs and digital experience. Our digital investments are targeted toward the fastest growing piece of our business, and will be accompanied by other digital-experience enhancements and focused marketing efforts to continue to encourage digital ordering. Beyond digital, we'll invest about $10 million in designing new prototype restaurants. The results from these prototypes will inform both new restaurant design and remodels of our older restaurants in 2019 and in 2020. We also plan to invest around $25 million into initiatives around optimizing our energy uses in our restaurants and introduce better equipment to cook our food, such as a new rice cooker to make our restaurants more efficient. And while we're investing more aggressively into our existing restaurants, our development pipeline remains healthy and we expect to build and open around 130 to 150 new restaurants during 2018. The majority of new restaurants will continue to be built in our proven markets where we've had a loyal and growing customer base. New restaurants opened during 2017 performed at about 75% of our average sales volumes and continue to provide a strong return during the first year of operations. Our net costs to build these restaurants will be slightly higher in 2018 as every site now incorporates the new digitally enabled second make-line. And finally we'll invest about $25 million into other general corporate initiatives which includes the consolidation of our two separate offices in Denver so that we can create a more efficient and more collaborative environment. Effective tax rate for the full year 2017 was 36.1%, compared with 40.8% in 2016, and for the quarter our tax rate was 28.8%. This lower quarterly tax rate resulted from remeasuring our deferred tax liability at the 21% corporate federal tax rate following the Tax Cuts and Jobs Act becoming law in late December. The full year rate is lower than 2016 due to the tax rate changes along with lower state tax rates. We expect the 2018 effective full year tax rate to be between 30% and 31%, with an underlying effective tax rate to be in the 27% to 28% range. There are a few moving pieces in this new rate. Relative to our normalized tax rate of about 39%, the last few years, our federal tax rate will decrease by 1,400 basis points as a result of the federal tax rate changes. But offsetting this decrease, our state taxes will be higher by about 100 basis points to 200 basis points due to the reduced benefit of deducting state taxes at the new lower federal tax rate. And under the new federal tax law we can no longer expense the full cost of our employee meals for tax purposes which is a substantial benefit that we offer our employees. That adds another 100 basis points to our tax rate. This underlying effective tax rate of 27% to 28% will then be impacted by prior and future stock based compensation plans. We currently have deferred tax assets related to outstanding non-vested stock award that contain market and performance conditions. If market conditions are not achieved, then we may not realize the benefit of these deferred tax assets which will result in a higher effective tax rate in future periods. Our current outstanding awards such as the 2015 and 2016 performance stock grant, there are estimates that these award either may not vest or may vest at lower realized values than originally anticipated. Under either scenario we would not benefit from the initial deferred tax asset which would negatively impact our effective tax rate by around 300 basis points to 400 basis points. Overall corporate tax law changes will result in tax savings of around $40 million to $50 million in 2018. We plan to invest more than one-third of these savings in our people with investments in special bonuses to our crew, managers and support staff, investment in employee training, and enhanced employee benefits. The remainder of the tax savings will help fund our investment to enhance existing restaurants. We continue to maintain a strong balance sheet, and we finished the year with $509 million in cash and investments and generated $467 million in cash from operations during 2017. During the fourth quarter, we repurchased $77 million of our stock at an average price of $297 per share and we repurchased $284 million in stock during the full year 2017. Even with our increased investment in existing restaurants in 2018, we still expect to opportunistically repurchase shares throughout the year, albeit at a lower level than last year. As should be expected, our outlook for 2018 does not include any potential strategic changes that may be driven by a new CEO. Despite a challenging year, we feel that we have a lot of momentum and energy throughout the company heading into 2018. We're more committed than ever to continue to perfect our dining experience and to build our sales. The investments that we're making in our people, into growing our digital and catering business, and investing in new innovation will not only help set up the foundation for a successful 2018, but also for the next 25 years. Thank you, and we'll now open the lines for questions.

[Operator:]

At this time we will be conducting a question and answer session. Our first question is with John Glass from Morgan Stanley. Please proceed with your question.

[John Glass:]

Thanks very much. First just on top line drivers, if you could comment about in 2018 how you're viewing either product development differently or approaching marketing differently. Does queso give you more confidence, for example, in more new product introductions in 2018 to drive traffic? And when you think about marketing, the same question. Your approach has been non-traditional in the past. Does that approach continue to work or do you think that this is the time to pivot to maybe a more traditional marketing message to get traffic going again?

[Mark Crumpacker:]

Thanks, John. So we've learned a lot over the last year as we've pivoted toward more traditional marketing using television in particular. So this year, we're going to do a number of things. Our marketing plan will consist as it traditionally has of three big components over the year, three big advertising components. So in the spring, we will launch another advertising campaign. This time though it'll be using addressable TV rather than broadcast TV, which is a learning that we took away from fall, where a lot of that TV we're reaching lapsed customers who aren't the best target for us. So we're really focusing in more with this addressable TV on the new and current customers that we have. And then in the summer, we'll head into our 25th anniversary marketing campaign which is largely targeted toward existing customers although certainly it will reach new as well. And then in the fall, there will be another large advertising campaign which again is likely to include television. So the pivot I think toward more traditional advertising will continue, the one that we started last year. That's not to say that we won't do more non-traditional things, as we always have. The notable difference I think for this year will be in the addition of a much more robust CRM platform and the inclusion of a loyalty program which we should see in the second half of the year. So that'll give us – the combination of this more strategic approach to advertising, particularly the use of this addressable TV, along with a more robust CRM platform should allow us to reach the right customers more effectively. So I think it is overall a pivot to slightly more traditional, if you will, advertising, but we're doing it in a very targeted way.

[John Glass:]

And, Jack, if I could just sneak in one follow-up. You gave a number of detailed items around cost items individually. Could you just, if you were to hit your low single-digit comp guidance for the year in 2018, where do you think store margins land on a basis of what you just described?

[John R. Hartung:]

Yeah, John, I think, we'll be in the – probably in the upper teens, maybe in the 17.5% to 18%, 18.5% range, something like that. A couple percent margin means that we would delever on the labor line with labor inflation running in the mid-single digits, and with only running a 2%, even though that's driven by price, that means we're still running negative transactions. And so I think it would be in that – probably constrained in that 17.5% to 18%, maybe as high as 18.5% if we really get cooperation from commodities. We've also got some of the one-time things I mentioned as well, like the bonus that we're going to pay for tax savings. And then the additional M&R, maintenance and repair, that we're going to, in addition to extra capital, we're really going to place a heavy focus on making sure our restaurants look, feel, and are a wonderful environment for our customers. So I think that's about where you can expect margins to hit for the year, John.

[John Glass:]

Got it. Thank you very much.

[Operator:]

Our next question is from Nicole Miller from Piper Jaffray. Please proceed with your question.

[Nicole M. Miller Regan:]

Thank you. Good afternoon. I just have two quick questions. The first one, on point number 2 on innovations around digital and catering, how does loyalty fit into the mix there? And when might you be willing to launch a loyalty program?

[Mark Crumpacker:]

Well, as I just said, we expect to launch a loyalty program which is part of a larger CRM effort in the second half of the year. So the program is being designed as we speak. And so loyalty is a subset of the larger CRM effort, which will be an important part of all of our digital marketing, as well as catering, as marketing catering, obviously as those are things that we market to people who we know as existing customers. So they're very much linked.

[Nicole M. Miller Regan:]

And will you be – you'll get the customer data so that you can reach out to them. And is this a surprise and delight or points or dollar based program?

[Steve Ells:]

Well, yeah, I mean, absolutely. I mean, knowing the customer and having that one to one relationship with them is the central focus of it. The actual structure of the program is not something that we're talking about today, but absolutely everything is on the table with regard to that.

[Nicole M. Miller Regan:]

Okay, and then just a second question in regards to the 130 to 150 new stores. To figure out how to model those, any sequence you would offer quarterly? And then are these new stores in new markets? Are they in existing markets? And is there any international growth to speak of?

[Steve Ells:]

Yeah, Nicole, they should be reasonably even-filled throughout the year. You know, timelines always change throughout the year, but there's nothing out of the ordinary in terms of the way that they fall in through the quarters. And most of them will be in proven markets. We still will seed a few here and there in some of the newer markets, but most of them, way over – way more than 80% should be in our proven and established markets, which gives us greater confidence that they should open and generate an attractive return right out of the box.

[Mark Crumpacker:]

And none planned in international.

[Steve Ells:]

And nothing planned in international right now, Nicole.

[Nicole M. Miller Regan:]

Thank you.

[Steve Ells:]

Thanks, Nicole.

[Operator:]

Our next question is with David Tarantino with Robert Baird. Please proceed with your question.

[David E. Tarantino:]

A couple questions on the traffic trends. First, Jack, on the quarter-to-date commentary, I think you sort of pointed to an underlying trend of around 2.5% to 3.5%. Could you just confirm the level of pricing that you have in that equation so that we can get to kind of an underlying traffic number? I believe you might be running 5% pricing or higher plus queso.

[John R. Hartung:]

Yeah, it's right at 5%, David. There were some markets that had extremely high local costs, especially labor, so, market-by-market you would see some markets that were a little above 5%, but the overall weighted average across the country is running about 5%. We typically model in about a 20% resistance, so that 5% converts to about 4%. We might see less resistance than that, so, I would expect the comp to benefit somewhere between 4% and 5%. And then we're running 2% added to the check because of queso, so when we're running a 3%, for example, 3% positive comp, if you assume 4% from pricing and a couple percent from queso, you could back into a negative transaction of somewhere in the 3% range.

[David E. Tarantino:]

Got it. And then your guidance for the year seems to assume that doesn't get a whole lot better, despite everything you're doing. Is that correct? If you look at sort of the seasonally adjusted traffic trends, are you assuming much improvement? Or are you just assuming that the year-over-year number gets better when you cycle the stepdown you saw in the second half of the year?

[John R. Hartung:]

Well, yeah, there's a couple things, David. One, we do assume the back half of the year, the underlying trends do get better because comparisons get better. When we compare against July, we're comparing against the beginning of the negative transaction, so we do think the transactions get better. But we have a couple things also that roll off. We have some pricing that rolls off in April. We will compare against queso launch in September and it will compare against the pricing in November, as well. Of course, we hope that we will build even more momentum, so we're not being overly bullish with our guidance. We're working on a number of things from an ops standpoint, from a digital standpoint, Mark mentioned loyalty, so we're hoping that we can spark a more positive transaction trend, but based on how tough it's been the last couple years to get that momentum going, we think this is the right level of guidance.

[David E. Tarantino:]

Makes sense. And then one more if Scott Boatwright is available to answer. There's a comment about guest satisfaction scores and a new system that you're using to measure those and some early signs being good on your progress there. So, I was just wondering if Scott could comment on sort of where you think you are today on those metrics and where you think you need to be to drive much better traffic trends. Thanks.

[Scott Boatwright:]

Hi, David, Scott here. Thanks for the question. We are using Medallia as our partner in the space. And we have just really started garnering the level of survey volume necessary for statistical relevance probably over the course of the last four to five months, and we have seen pretty significant growth in overall satisfaction since September of last year with a steady increase. And February is still ahead of January, although not fully baked, but feel really good about our current trends. I feel like we are really regaining consumer confidence all across the country by some of the steps that we took later in last year to really shore-up some of our operational deficiencies, and we'll see that to continue to improve. I am encouraged by the trend at this point. But to the last part of your question, I think to be best-in-class, we probably need to continue to improve probably another 600 basis points, 700 basis points from where we sit today.

[David E. Tarantino:]

Thank you.

[Operator:]

Our next question is with Sharon Zackfia with William Blair. Please proceed with your question.

[Sharon Zackfia:]

Good afternoon. A few questions. I just want to clarify, Jack, on that 1% to 2% comp for the first quarter, are you including the New Year's Day benefit in that?

[John R. Hartung:]

I am, Sharon, yeah.

[Sharon Zackfia:]

Okay.

[John R. Hartung:]

The New Year's Day overall for the quarter will give us about 1%. So that does imply that we're looking about just – on top of that a 1% positive, net 1% to 2% range. And the reason is just that our sales really surged significantly in the middle of February, and we're about to go up against those numbers. So, if we're lucky, we'll get mild weather again, but again, if we had kind of normal winter weather compared to how warm it was last year, 1% to 2% is about where we expect the quarter to fall.

[Sharon Zackfia:]

Okay. And then I guess a question on the CEO search. I think, Steve, you mentioned being a purpose-driven company, and clearly, the culture has been one of the key hallmarks over time of Chipotle. As you look for that new CEO, is that purpose-driven dynamic? Is that a guardrail on that search? Or would somebody coming in kind of have free reign to take Chipotle in the direction he or she thinks it should go?

[Steve Ells:]

Sure, Sharon. You know, it's a delicate balance bringing in a new CEO. Of course, you've heard of examples where new CEOs have come in but have not really been allowed to act as a CEO, and I fully intend to have the new CEO be in charge. It's been great spending time with a number of candidates, and one thing has been consistent though, and that is how strongly Chipotle has impressed these folks, and it's based in the purpose. So many of the candidates come from the restaurant industry and have been – either have led them or been a key player in these brands. And while they've enjoyed a lot of success in their companies, they've never had the kind of purpose that we've had at Chipotle, which is I think very, very exciting to all of them. I think it's not lost on them that you can really have both. You can have a purpose and you can have a product that's very, very popular with consumers, and you can have a great economic model. And for 25 years we never compromised on that. We had it all. And we need to get back on track and build momentum again, and all of the new CEOs realize that. I don't think you're going to see a situation where someone says "To hell with food with integrity. We're going to buy cheap commodity meat now and really turn this thing around." I just don't worry that that kind of a thing would happen.

[Sharon Zackfia:]

Okay. Thank you. That's helpful.

[Operator:]

Our next question is with Sara Senatore with AB (44

[Unknown Speaker:]

Hi. Thanks. One question and one follow-up, please. So, the question is on the CapEx and some of the investment in the existing stores. I think the comment was that you're seeing some real benefits in terms of customer experience. But is that translating into same-store sales lifts? I think a lot of times in the industry we see lifts in the kind of mid-single digit range when there are some upgrades to the stores. So, just trying to get a sense if that guest experience improvement that you're seeing is actually also translating into top line. And then I do have a question on margins.

[Scott Boatwright:]

Hi, Sara, this is Scott Boatwright. It's a fantastic question. Once I joined the brand back last summer, I spent a great deal of time in our restaurants really from coast to coast and recognized there was a great deal of deferred maintenance across the country that needed to be addressed to ensure that we are best on block in each of the trade areas in which we operate. Unfortunately, Sara, those changes don't really alter the facade or the exterior of the Chipotle restaurants we've been talking about. So it wouldn't garner additional traffic, but I do feel, as a great number of our guests dine in that changing the experience for those folks will, although a slow build, will contribute to the overall sales performance here in 2018.

[Unknown Speaker:]

Great. Thank you. And then just on the margins, Jack, if you could talk a little bit about I think a year ago or what have you, we talked about 20% restaurant margins at $2 million AUVs, and now it sounds like maybe you're looking for 18% restaurant margins at roughly that number or even a little bit higher. Granted that you're reinvesting some of the tax savings as is the rest of the industry. But I guess is that 20% number off the table? And a related question, do you rethink how you approach pricing given that the nature of your pricing has meant that you've really lagged the cost inflation by quite a bit?

[John R. Hartung:]

Yeah. It's a good question. And let me try to answer it this way. Let me go back to Q2 of last year when our margin was at right around 19%, 18.9% or 19%, and then let's talk about what we can expect in the second quarter of this year, and that might be the best kind of way to show kind of before and after because second quarter of last year was right before we had the July where we started the negative transaction slide. So I would expect, Karen, that we'd have about the same margin in the second quarter of 2018.

[Unknown Speaker:]

Sara.

[John R. Hartung:]

I'm sorry, Sara. That we'd have about the same margin in the second quarter of 2018, about 19%, but there's a lot of pushes and pulls. First of all, we're having a net inflection point of about 500 to 600 basis points since the transaction trend last year. We were running positive 3% and then we switched to a negative 3%. So that 500 to 600 basis point, that impacts the margin by negative about 1.6%. The ongoing labor inflation that we've seen is about 1.2%, 1.3% or so. And that's running about a 5% margin on top of our 26% labor. The menu price increases is helping us by 300 or so basis points. And so the menu price increase essentially offsets the deleverage from the comp and then the labor inflation. And then we have pushes in terms of this year we're expecting lower marketing and promo but a little bit higher maintenance and repairs. The maintenance and repairs we think is going to be a this year item, not a forever item, but still. So you've got all these pushes and pulls, and so while our model still has the ability at higher volumes, if we can get transaction momentum growing, we can lever the model. We've seen us do that year after year after year. But this negative transaction hit is taking hits into the margin and then menu price increase, which adds 300 basis points to the model, is eaten all up by the delever and then by the inflation. And so the important thing for us is to hopefully get some of these things that we're focused on to start transaction momentum, start positive transaction. And then in terms of menu price, we certainly are open to the idea instead of waiting three years and raising prices to perhaps, especially that labor inflation is an every year thing at this level, perhaps we take a smaller increase every year, just kind of hold on to our margins in terms of regular ongoing inflation. So I hope that helps in terms of comparing the quarters year to year because it really is a dramatic different picture since the transactions turned negative.

[Unknown Speaker:]

Thank you. That's helpful.

[Operator:]

Our next question is with Jason West with Credit Suisse. Please proceed with your question. Jason West - Credit Suisse Securities (USA) LLC Yeah, thanks. I'm just trying to understand the level of investments that you guys need to make in the stores. You talked about some refresh of equipment and the ambiance, lighting and things like that. But then you also touched on a more significant prototype change with maybe things like mobile ordering pickup stations and things like that. So what is the plan there in terms of – I know this year, it sounds like more of a refresh plan, but then is it more of a full remodel in the future or are you doing both at the same time? Can you talk about that a bit?

[Steve Ells:]

Yeah, it's actually both at the same time. It's really low-hanging fruit to change light bulbs and to freshen with new deep thirds on the service line, the new stainless steel pans that aren't bent, things like this that really cause customers to notice that there's something different. It's shinier, it's brighter, it's cleaner. And we're going to continue to find those kinds of opportunities. Right now, we have engaged with three different architectural firms to create the next version of the Chipotle experience, and we've deliberately asked them to remodel existing restaurants so that this new experience can be applied to existing restaurants as well as brand new restaurants. And we'll start to see some of those come online shortly. We've got three of them now mocked up as models in full-scale cardboard models in a warehouse, and we've walked through them and kicked the tires and really felt what that experience is going to be like. It's really exciting. It combines the traditional Chipotle experience along with things like digital pickup, whether it's in-store digital or out of store digital, and grab and go. And it also allows for potential new menu items. So really exciting stuff and really preparing ourselves for the next 25 years.

[Operator:]

Our next question is with Karen Holthouse with Goldman Sachs. Please proceed with your question.

[Karen Holthouse:]

Hi. Another question on the CapEx (52

[John R. Hartung:]

Yeah, I think on a theoretical basis, it could lead to that, but I don't think it's a matter of access to capital because we've got enough access to capital through our operations and through our balance sheet to do the remodels, to do the repairs that Steve talked about, the bringing our restaurants up to standard, and we can accelerate growth. I think the biggest driver right now is we want to give our ops teams a chance to really get on solid footing. The things that Scott has put into place have really just started to take hold. We're going to put a huge emphasis on training, a refocus on training so that we can have confidence that all of our teams, all of our managers, all of our crews will know what our standards are, they can execute the standards and they'll deliver an excellent guest experience including great throughput. We haven't had a great throughput year in the last few years, and that takes a lot of training. So I think the new store growth, reaccelerating that is going to be much more about how we feel about the ops teams and are they on solid footing, are our training programs, are they really taking hold. And then I think we'll redeploy capital into the new stores. So I wouldn't say just because capital frees up that that automatically would move into a new store. And we're not commenting specifically on 2019 right now. I think it'd be prudent for us to get through at least half if not three quarters of 2018, and then we'll assess at that time and talk about what 2019 and beyond looks like for growth.

[Karen Holthouse:]

Great. Thank you.

[Operator:]

Our final question is with Jeffrey Bernstein from Barclays. Please proceed with your question.

[Jeffrey Bernstein:]

Great. Thank you. Steve, I believe it was last quarter you talked about the NEXT Team whether it was for menu innovation or new segments and what not. And I know you talked about how queso was I guess their first foray. So I'm just wondering with greater time now under your belt as you think about that NEXT Team, what's the early evolution or thoughts around I think you mentioned new segments or new day parts? How would you prioritize the different opportunities that perhaps they're coming up with as you think about the next many years. And I know you just mentioned kind of new menu items, so what do you think kind of the genesis of what's the outcome of that NEXT Team in terms of over the next year or so?

[Steve Ells:]

Sure, I think the NEXT Team's biggest opportunity is to always look at our core menu and make sure that we're cooking better food, we're sourcing better food, we have better ingredients, we're improving our preparation techniques, our cooking techniques, our serving techniques. It's what drove our business for the first couple of decades, taking a core group of menu items and continually improving them, not only through food with integrity but through better restaurant execution. So that's a priority. But additionally, they need to work on new menu items and they have a whole host of menu items. New menu items at a place like Chipotle is tricky though. It's tricky not only because we've had the same menu for basically 25 years, but because of the linear format, it's not like you can put a whole new thing up on the menu board like at a typical fast-food place. Ingredients sort of become part of the overall offering, so it's a tricky proposition. But it's something that we're working really hard on. There are exciting new offerings that are around things like salads and different kinds of grains and also exploration of traditional things and these are things that customers are asking for, things like nachos and quesadillas. And so, how to integrate those into our service format so that we can maintain throughput and sort of the level of execution that we've relied on in the past is tricky. So, that's something that they're focusing on also.

[Jeffrey Bernstein:]

Got it. And then, Jack, I just want to clarify. I think you said more than one-third of the tax savings you're going to reinvest. It sounds like a lot of it is more one-time in nature versus ongoing, but did you say something about the remaining two-thirds? I thought you said maybe you'd be reinvesting that, as well, or should we assume that the remainder gets returned to shareholders?

[John R. Hartung:]

Well, in essence, what we did say is that that will help us fund the increase in CapEx, but we'll continue, Jeff, we'll continue to generate more than enough capital from operations to support our CapEx. We still have a strong balance sheet, so you can expect us to continue to return cash to shareholder. Not necessarily an incremental amount. I think the incremental amount that we're getting from taxes is going to be funneled into the extra CapEx and into our existing restaurants. We still have room that we can return some of our capital to shareholders, as well, through buybacks.

[Jeffrey Bernstein:]

Thank you.

[John R. Hartung:]

Thanks, Jeff.

[Operator:]

This concludes our question-and-answer session. I would now like to turn the call over back to Mark Alexee for closing remarks.

[Mark Alexee:]

Great. Thanks, everyone, for joining us today. We look forward to sharing our Q1 results with you, which again is planned for Tuesday, April 24. Thanks.

[Operator:]

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.