Chipotle Mexican Grill, Inc. Q3 2008 Earnings Call Transcript

 |  About: Chipotle Mexican Grill, Inc. (CMG)
by: SA Transcripts


Good day and welcome to the Chipotle Mexican Grill third quarter 2008 earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Chris Arnold, Investor Relations for Chipotle Mexican Grill. Please go ahead.

Chris Arnold

[Break in audio] for our third quarter ended September 30, 2008. It may also be found on our website at in the Investor Relations section.

Before we being our presentation I will remind everyone that parts of our discussion today will include forward-looking statements within the meaning of the securities laws. These forward-looking statements will include projections of our restaurant comp sales trends, the number restaurants we intend to open, food costs and other expense items, pricing plans, margins and other statements of our expectations and plans. These forward-looking statements are based 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 for 2007 as updated in our subsequent 10Qs for discussion of the risks that could impact our future operating results and financial condition.

I want to remind everyone that we've adopted a self-imposed quiet period restricting communications with investors during sensitive periods. This quiet period begins on the first day of the last month of each fiscal quarter and continues until the next earnings conference call. For the fourth quarter it will begin December 1 and continue until our fourth quarter release in February.

On the call with us today are Steve Ells, our Founder, Chairman and Chief Executive Officer, Monty Moran, our President and Chief Operating Officer, and John R. Hartung, our Chief Financial Officer. After the comments, we will open the call for questions.

With that out of the way, I'd like to turn the call over to Steve.

Steve Ells

Thanks, Chris. The third quarter was challenging for us. Like many other restaurant companies, we grappled with the nation's economic crisis, rising food, energy and transportation costs, and weakening consumer confidence. And even though we have a lot of very loyal customers in our customer base, we're certainly not immune to these conditions. During the quarter, same-store sales growth continued to decelerate, prompting us to lower our comp estimates for 2008.

In spite of the challenges, our same-store sales remained positive at 3.1% on price increases of about 4%. In the third quarter our revenues increased by 18.9% over third quarter 2007 to $340 million, contributing to diluted earnings per share of $0.59, a decrease of 4.8% from the third quarter of 2007.

While top line pressure as well as increased commodity costs certainly had an effect on our performance during the period, we believe that remaining focused on our long-term vision to change the way the world thinks about and eats fast food is still the right course for us, and I am pleased to report that Chipotle has never been further along with regard to this strategy.

During the quarter we continued to make progress in our effort to serve food made with the very best ingredients. In addition to serving more naturally raised meat than any other restaurant company, including 100% of our pork and chicken and more than 60% of our beef.

We made considerable progress toward our commitment to serve produce from local farms. In fact, as we outlined in the second quarter, we're now serving produce from local farms in all of our restaurants when it's seasonally available. Our initial commitment is to purchase at least 25% of at least one produce item from these farms, and if there are opportunities to purchase more than 25% or more than one item, we'll do that. All of this produce is coming from farms that are within about 200 miles of our restaurants, which is a sharp contrast to most produce in this country, which is typically transported about 1500 miles from the farm to it is served.

This locally sourced produce makes sense for the environment thanks to less fuel used for transportation of produce. In addition, it supports small farmers, which we believe will resonate with our customers and serve to differentiate Chipotle from our competitors. And so far, we have seen no added costs, as the efficiencies from lower transportation costs have offset the reduced economies of scale from smaller farms.

While we believe that these decisions build trust among our customers in the long run, we also recognize the need to take a hard look at our business and to be sure we're connecting with our customers in meaningful ways and offering alternatives that remain responsive to their preferences. We want to be sure that our strategies are appropriate in light of short-term pressures without sacrificing our long-term vision.

To that end, we continue to focus our attention on retooling our marketing effort, and we are developing a more thoughtful marketing direction and strategy. Over the years we have relied primarily on word of mouth and local store marketing efforts to create awareness of Chipotle. And this approach has worked well in helping people discover Chipotle as we have enjoyed 10 consecutive years of double-digit same-store sales growth through 2007.

But while our food and people strategies have evolved as we have grown, our marketing strategies have not. Sure, many people are now aware of Chipotle, but our marketing can go beyond just creating awareness, building a deeper bond and a deeper sense of loyalty with our customers. We also should expect that effective marketing can move beyond creating awareness and entice customers who have heard of us but never tried us. And actually research tells us there may be a lot of them.

Part of this effort includes our current search for a new advertising agency to help develop great creative and support our marketing vision and strategy. That process is moving forward, and we are meeting with several agencies over the next few days. And we are in the process of completing a research project aimed at helping us better understand who our customers are, what motivates them, what we can do better to respond to their needs, and to help us determine the best strategic platform to help us communicate with new and existing customers.

We are moving aggressively but thoughtfully so that we can make sure we make the right decision, and I'm confident. I'm as confident as ever that we're on the right track.

The macro operating environment will likely remain difficult in the coming year, but we also believe that the strong loyalty we have built with our customers will continue to help us during these difficult times and that we will emerge even stronger when the economy improves. We know that taking a disciplined approach to our business, remaining true to our long-term vision and expanding our efforts to understand and connect with our customers remain the best way for us to grow our business and provide shareholder value in the long run.

As we discussed during our last call, we opened our first restaurant in Toronto, Canada in August. The opening was extremely successful and the initial response from customers has been exceptional. As expected, most of the customers have never been to a Chipotle and their reaction was very similar to how customers in the U.S. responded when they first tried Chipotle, with comments like it's the best-tasting burrito they've ever had and that they were impressed with the quality of the food and the great service.

We also saw a good number of customers who have visited Chipotle in the U.S., and they have been anxiously waiting for us to come to Toronto. These Chipotle fans were the ones in line with their friends, proudly telling them all about the great burritos they discovered when visiting the U.S.

The restaurant opened with a phenomenonal management team and crew, led by one of our existing restaurateurs from Texas, [Damon Biggins]. Damon and the management team, along with key support from area managers and managers from our central region, worked hard over the past several months to hire and train a great crew that not only have made us proud by creating a strong first impression in Toronto but will also be our future leaders there.

While most of our attention remains focused on building the brand in the business in the U.S., we're excited about the great start in Toronto and look forward to bringing the Chipotle experience to more Canadians as we change the way Canadians and the world thinks about and eats fast food.

I'll now turn the call over to Monty.

Monty Moran

Thanks Steve. As Steve said, these tough economic times make it harder for customers to afford to eat out, even though Chipotle provides a great value for each dollar spent. We know that some of our customers are forced to visit us a little less frequently than they were a year ago.

While these trends continue, we know that it's more important than ever to be at the very top of our game, and we believe that the people culture we're building - a culture that appeals only to the highest performers - will help us continue to strengthen our operations.

The centerpiece of our people culture is our Restaurateur Program, and the success of this program makes it clear to us that our investment in these top-performing managers is paying off.

As a reminder, our Restaurateurs are our top performers in every way. They run terrific restaurants with better-tasting food and a superior customer experience. They're excellent in hiring crew and developing the crew to become our future Managers. They run great restaurants with lower turnover, lower food costs, and higher margins. Restaurateurs set the standard for every other manager for how a great restaurant should run, and every single Manager we have aspires to become a Restaurateur someday.

For this reason our officer team spends a significant amount of time visiting with new Restaurateur candidates to be sure that the people that reach this elite position embody the culture that we're trying to build. We visit potential Restaurateurs along with our Regional Directors and Operational Directors to be sure that everyone is on the same page in setting very high expectations for the taste, appearance and quality of the food, for our top-notch customer service, the cleanliness of our restaurants, and the internal development of our crew, the Managers.

As we expand the Restaurateur Program, we will continue to turn good restaurants into great restaurants across the country while strengthening our bench of future restaurant Managers.

To further support this special culture, in the third quarter we held our first-ever all-Manager conference, bringing all 800 of our Managers and all of our field leadership together in one place. Our primary purpose was to empower them and to ensure that they have all of the tools, training and authority that they need to build a team of high performers in each of their restaurants, a team that will treasure each customer and ensure that each customer has a great experience every time they visit.

Our Managers learned how to better interview and select top candidates, how to better develop them, and how to identify and remove low performers. Our Managers also learned how to introduce and educate new employees about food with integrity, about their career potential at Chipotle, and the importance of delivering an outstanding experience to every customer. Every new hire at Chipotle now goes through this orientation before they ever serve their first customer.

The energy during this conference was amazing. Our people came to the conference motivated, but they left the conference truly inspired and incredibly proud to be a part of Chipotle. They left the conference eager to get back to their restaurant so that they could share their enthusiasm with their people and continue to work to create a team of all high performers.

We continue to see this enthusiasm in our ongoing market visits. Morale in our restaurants is outstanding. Our Managers are proud of the high-performing teams that they are creating and the people that they're developing. They're proud of the food they serve and food with integrity. They're proud of the great service that they're delivering, and they're proud to be part of a growing and successful company.

We believe this pride and enthusiasm of our managers and crew is an important competitive advantage for us. It translates into a better customer experience and ultimately into more customer loyalty.

Building stronger teams in our restaurants has also allowed us to work toward building a stronger and more efficient mid-management structure in the field. Our mid-management leaders are able to oversee more restaurants now because Restaurateurs need less oversight. In 2003 our Area Managers oversaw an average of 5.7 restaurants. Today they oversee an average of 9.7 restaurants.

We are now also taking a very different approach in how we develop our people in the mid-management roles. In the past we would pull one of our best Managers out of their restaurant and ask them to oversee six or more stores all at once. Unfortunately many of them would struggle or fail in taking such a large step.

Our new approach is that the best Restaurateurs will have the opportunity to mentor and oversee a nearby restaurant while continuing to run their own restaurant. Once they're successful with a second store, they will be awarded a third and begin to mentor the Manager in that one as well. They'll continue to add additional restaurants one at a time as they prove themselves successful with each.

As they successfully develop several Restaurateurs themselves and as they gradually oversee more restaurants, they will have the opportunity to become a Team Leader. This newly created position recognizes and rewards those Restaurateurs and Area Managers who are most successful at developing strong teams and who have a proven track record of developing Restaurateurs and who can oversee a patch of 12 or more restaurants. It's our hope that soon all of our remaining Area Managers and many top-notch Restaurateurs will ascend to this new role of Team Leader.

But our constant efforts to improve are not limited to the changes in our restaurants. We have always taken a practical and disciplined approach to managing G&A, including finding opportunities to streamline our corporate departments, eliminate unnecessary positions, and carefully reviewing our corporate G&A to maximize every dollar we spend. This disciplined approach has allowed us to grow rapidly while reducing G&A as a percentage of revenue from over 8% in January of 2006 at the time of our IPO to about 6.6% today.

And while we have full respect for the challenges of the current economic situation, we're also aware that we were in a better position than most to weather the storm well. Our same-store sales growth has remained positive in 2008 even as we have seen an economic crisis that is unprecedented in most of our lifetimes. We are well capitalized, with more than $200 million in cash and no debt. We are able to finance our current and foreseeable future growth from internally generated cash flow, and our restaurant-level economics are still among the best in the restaurant industry.

And as we look to 2009, we intend to capitalize on our strength by increasing the number of new restaurant openings, by developing great Managers and future leaders from within, and by making our marketing more relevant and strategic.

Before I turn the call over to Jack, I'd like to speak to the subject of price increases. We have resisted an across-the-board price increase so far this year, largely because we know that the economy is already causing so many people to make difficult choices about how and where they spend their money. However, in light of food costs that have continued to rise further and more rapidly than we expected, we will be raising menu prices, which Jack will speak to in just a minute.

While we know it may be a difficult time for our customers to pay higher prices, we remain committed to using only the very best ingredients and we'll adjust prices strategically considering competition, transaction trends, market demographics and other factors, while still offering food that is much higher quality.

We strongly believe that this focus on approving service and the strength of our restaurant operations, combined with our commitment to serving better food from the very best quality ingredients we can find, will not only help us through these challenging times, but position us for continued success when the economy improves.

With that, I'll now turn the call over to Jack.

John R. Hartung

Thanks, Monty. The third quarter of 2008 included a host of macroeconomic challenges, including gas reaching $4 a gallon, the continued meltdown of the financial sector, and the lowest levels of consumer confidence we have seen in quite some time. While we have held up since the economy started to soften about a year ago, the severity of the current environment has made it clear we're not immune.

While we continue to deliver the very best customer dining experience we can, as our restaurants Managers and crew work hard to treasure and delight each and every customer, our customers are faced with the challenge of prioritizing how to spend their hard-earned dollars. Though we continue to believe we have extremely loyal customers - perhaps among the most loyal in the restaurant industry - unfortunately this current economic downturn has caused even some of our most loyal customers to visit Chipotle less often. This, along with continued food inflation, has made the third quarter especially challenging.

During the third quarter of 2008 we increased revenue by 18.8% over the prior year to $340.2 million. Year-to-date, revenue increased 23.9% to $986.6 million. These increases were driven by new restaurants, a 3.1% increase in comps during the quarter, and a 6.6% comp increase for the year.

For the quarter the comp increase was driven by the menu price increase impact of around 4%. During the quarter we did not take any additional menu price increases, so the entire 4% menu price increase was a rollover from increases in prior quarters.

While sales held up well in July, they decelerated in August to the low single digits and have continued at that level into September and into October so far. For the full year we continue to expect comps within our previous guidance of mid to low single-digits.

Food, beverage and packaging costs were 33% in the third quarter, up 90 basis points from 32.1% in the third quarter of '07. And year-to-date we're up 60 basis points to 32.5% over the prior year, increases primarily due to avocados, chicken and cheese, with avocados increasing more than expected in the quarter as the supply of California avocados ran out sooner than usual.

Our annual pricing agreements for rice, corn and soy have recently been renewed at levels significantly higher than last year, which will cause our food costs to creep toward 34% in the fourth quarter before any menu price increases. As we look ahead to 2009 we expect continued food inflation as our pricing agreements for [inaudible] and cheese expire and from continued price [inaudible] from our naturally raised meats.

We hope the recent pullback in commodities, including corn and crude oil, will hold and reduce food inflation in 2009. At the current level, we would expect food inflation in the mid single-digits next year. The 33% food cost in the third quarter creeping toward 34% in the fourth quarter and mid single-digit inflation in 2009 would cause food costs to hit the 35% to 36% range in 2009 if we didn't increase menu prices. This trend is what led us to communicate in our pre-release last month that we will pursue a national menu price increase.

As you know, our menu pricing strategy is typically centered around holding off on increasing prices until we have the opportunity to bring additional food with integrity to individual markets, but that sometimes resulted in not increasing prices in some markets for two or even three years. Mild food inflation, combined with our ability to drive efficiencies from our very high comps, allowed us to increase margins without raising prices. Clearly, this is a different environment both in terms of food inflation and comps.

We remain as committed as ever to our vision to change the way the world thinks about and eats fast food, and central to this vision is our effort to constantly enhance the quality of our food, even in the face of current food inflation trends and even though we already have the highest food quality of anyone in or even near our category. And we want to remain as affordable as possible.

So with that in mind, we have planned a fourth quarter incremental price increase of about 6%, which began rolling out to individual markets last week and will continue through the end of the fourth quarter. The overall effective price increase in the fourth quarter, including the rollover of increases in previous quarters, is expected to be about 6% to 7%. This incremental price increase is not intended and will not fully offset food inflation I just talked about in Q3, Q4 and into 2009. In fact, a 6% incremental price increase, when fully in effect, will only cover about 200 basis points in higher food costs.

This price increase was designed to preserve attractive restaurant-level returns, which supports our continued investment in new restaurants. As a perspective, this increase can cover some of the food inflation, including inflation expected in 2009, and help offset the deleveraging in other areas of the P&L from the current soft transaction trends.

And it can result in restaurant-level margins in the 19% to 20% range. Though these margins are lower than our margins in recent history, margins of about 19% to 20% are still among the highest in the industry and allow us to expect restaurant-level returns in the 30% to 35% range or higher for our new openings within a few years.

And while we expect over time we can return to margins in the 22% range or higher and [inaudible] level returns in the 40% range or higher, we need to be patient during this difficult environment. And we certainly don't want to be overly aggressive in trying to retain those margins and returns at the expense of charging much higher prices to our customers. After the price increase, our menu prices will generally be comparable to competitors, even though our food quality and the value we offer to customers will be much greater.

Though we've seen little or no resistance to menu price increases in the past, we recognize that this environment is much more challenging and we hope our customers will understand and respond favorably.

Labor costs were 26.3% of revenue in the third quarter of 2008, which was flat compared to the same quarter last year. Despite decelerating comps, a slight deleveraging in management and crew labor was offset by better workers comp experience for the quarter. Year-to-date we saw 30 basis points of labor leverage and as we've lapped our labor matrix early this year, we continue to expect no labor leverage the remainder of the year.

Occupancy costs for the quarter were $24.5 million or 7.2% of revenue, up from 6.9% last year. And year-to-date occupancy costs are up 20 basis points to 7.1%. As we discussed on the last call, occupancy costs as a percent of revenue were up primarily due to the opening of proportionately more restaurants in more expensive, densely populated areas such as Boston, New York, Philly and Florida.

Other operating costs for the quarter were 12.2% of revenue, up from 11.6% in the third quarter of '07. Year-to-date these costs are 12.4% of revenue, up from 12.1% in 2007. While other operating is down 40 basis points from last quarter, driven by reduced marketing and promotional expenses, it is up over last year due to increased utility and higher maintenance and repair costs.

Our G&A expenses were $22.6 million for the quarter or 6.6% of revenue, down 10 basis points from the same quarter last year. The expenses for our first-ever all Managers conference held in August that we discussed in the last call were offset by a reduction in our 2008 bonus accrual. For the year, our G&A is at $64.9 million or 6.6% of sales, down slightly from the same period last year. We continue to expect slight to no G&A leverage for the full year.

For the quarter, income from operations was $31.1 million, which is down 1.1% from the prior year, and year-to-date income from operations was $96.2 million, up 19.1% from last year.

We ended the quarter with a cash balance of $212 million. With the onset of the financial crisis and a lack of confidence in traditional liquid bank-held investments, we became increasingly more conservative with investing our cash, investing much of it in U.S. Treasuries to ensure capital preservation. Combined with lower interest rates in general compared to last year, interest income for the quarter declined 30 basis points to $931,000. For the year interest income is $3.2 million, also down 30 basis points from the same period last year.

Part of this capital preservation strategy entails us moving away from tax-exempt securities and, as a result, our effective tax rate increased to 39% for the quarter. The tax rate impact in the fourth quarter will remain dependent on the stability of the financial sector and our confidence in investing in tax-exempt securities.

For the quarter we opened 20 new restaurants, which included our Toronto opening. With the 20 new openings for the quarter, as of September 30 we now serve customers in 798 restaurants.

Given our strong real estate pipeline and cash flow position, we remain confident in our guidance of 130 to 140 new restaurants for 2008.

Our shares outstanding as of quarter end decreased to 33.17 million as a result of the impact of the lower average share price on stock options included in the fully diluted shares calculation.

Despite difficult credit markets and a challenging economy, Chipotle's strong balance sheet and operating cash flow allow us to act opportunistically. We will allocate up to $100 million or roughly half of our existing cash balance to repurchase these shares under a 10b5-1 open market purchase plan.

Additionally, due to our strong restaurant-level returns, we will invest in opening 135 to 145 new restaurants next year, funded by operating cash flow. And frankly, we have a top performing development team with the capacity to open even more new restaurants next year, but we have begun to see a slowdown in new developments which we expect will reduce or delay some [some of our inventory] for 2009 opening.

Now that we're past the second anniversary of our separation from McDonald's, we are assessing the possibility of collapsing our dual class structure. It's important to understand that we face significant and complex hurdles which we may not be able to overcome. In order to take any action to modify the separate classes, we have to receive an opinion of counsel acceptable to McDonald's or work with McDonald's to receive a ruling from the IRS that a collapse of the twoclass structure won't compromise the tax-free nature of the split-off from McDonald's and its shareholders.

We can't make any guarantee that either of these routes will be available to us. And if we took any action in violation of these requirements, and even if we do meet these requirements and the transaction is subsequently deemed taxable to McDonald's shareholders, we could face liability to McDonald's that we estimate could be as high as $400 million to $500 million. So obviously we need to honor our contractual obligations and not make any decisions on the dual class structure that could adversely affect our shareholders.

So the best we can do at this time is to assure you we'll pursue this as far as we can on behalf of our shareholders and we'll make any announcements as soon as we can.

We've typically ended our calls with comments about our long-term growth expectations, which we state as targeting a growth rate of at least 25%. We still believe we have the ability to grow at this rate in the long term, but we don't expect to be able to achieve that growth rate while the economy and the consumer are under so much pressure. As we gain more clarity and visibility around the financial markets, the economy and the impact on our business, we will have a greater confidence as to when we can return to that rate of growth.

In the meantime, we'll continue to focus on our vision and continuing to grow the Chipotle brand and the business in a strategic manner. Thanks for your time today. We'd be happy to answer your questions. Operator, please open the line.

Questions-and-Answer Session


(Operator Instructions) Your first question comes from David Tarantino - Robert W. Baird & Co., Inc.

David Tarantino - Robert W. Baird & Co., Inc.

Just a clarification question on the mention of the trends to date in Q4. Jack, did you indicate that comps were still positive?

John R. Hartung

Comps are still positive, David, and they're in the very low single-digit range. If you think in terms of the third quarter, we had comps overall of 3.1% and that was made up of a pretty healthy July. We held up well in July. And we had our second quarter call at the end of July and didn't have any idea that this trend was about to happen.

And so we saw the trend decline in August to low single-digits and we saw basically that new level continue into September and into October. So to hit the average of 3.1% for the quarter knowing July was pretty healthy will give you an idea that we were in the pretty low single-digits but still positive, David, on a sales basis.

David Tarantino - Robert W. Baird & Co., Inc.

In terms of all the commentary on margins, which was helpful, what type of traffic assumption is embedded in that commentary, Jack? Is it in line with what you've seen recently or worse than what you've seen recently?

John R. Hartung

It's generally in line, David. And because this is a new environment in terms of our customers accepting price increases, I would assume and we have assumed pretty conservative assumptions on what kind of resistance we would see. Our history has shown that we see little or no resistance, but this is a different environment so we remain relatively conservative on how our customer is going to absorb this increase.


Your next question comes from Jeff Farmer - Jefferies & Co.

Jeff Farmer - Jefferies & Co.

Jack, can you just remind me how your approaching cost pricing structure works with your suppliers? And I guess more specifically, is there a historical relationship we can look at between your actual protein costs and movements in things like corn and soy?

John R. Hartung

Yes, Jeff. You can think of our relationship with our suppliers as generally being on a spot market basis. We do have pricing relationships that may go for as long as a quarter, but it's generally not locked. There isn't, like the feed costs, for example, locked. We are working with our suppliers and we've got many smaller suppliers to try to do that, to try to work with them so they can lock the cost of their feed and so that we can have more stability.

Generally, Jeff, we will see the cost of our naturally raised meats move with the cost of feed. So as corn moves up and down, it will move. It just doesn't move as abruptly. So when the feed moves up, our costs do move up, but not as abruptly as the commodity market. And the same thing in terms of when it moves down.

And there's one fundamental difference that we see with, for example, the cost of our naturally raised chicken compared to commodity. There's some unnatural situations in the commodity chicken environment where chicken prices have been coming down, commodity chicken prices have been coming down, yet chicken suppliers are losing money, going bankrupt, and it's not a sustainable model.

Our model's more sustainable, where our suppliers need to make money. And so to the extent that the feed cost is going up or to the extent that feed cost remains high, even though it's pulled back, our prices have not come down, our naturally raised chicken price did not come down really anywhere close to what the commodity chicken has. Ours have really held up.

Jeff Farmer - Jefferies & Co.

Just as a follow up to that, the natural question is: Have you seen any of your network of suppliers be pressured or get to a bankruptcy point?

John R. Hartung

No, we've not seen any indication of that kind of pressure.

Jeff Farmer - Jefferies & Co.

And then just one quick clarification. You said 19% to 20% restaurant-level margins in '09, and that includes the benefit of 6% pricing, right?

John R. Hartung

It does.


Your next question comes from John Glass - Morgan Stanley.

John Glass - Morgan Stanley

First, Jack, just as a follow up on your comments about the 25% earnings growth long-term, is it possible or is it even probable you won't see any earnings growth next year, just given your comments about restaurant-level margins?

John R. Hartung

Well, I think in this environment, John, I think you have to consider anything as possible. But I think if you go through your model and you take the kind of margins we're talking about, the kind of openings we're talking about, and the kind of comps we're talking about, and with some slight G&A leverage, I think you'll see that we should have the ability to grow our earnings. I just don't think it's possible for us to, with confidence, say that we can get to that 25%, at least not until there's more clarity and visibility with the economy.

John Glass - Morgan Stanley

And does that include the buyback you announced tonight or that would be on top of that benefit?

John R. Hartung

Well, I mean, roughly it includes it, John. But that's contingent upon, we're going to do open market purchases, there's a limit to how much we can buy. And as you know, there aren't that many shares that are being traded, so it will take time. So it's in there, but it's just a matter of your assumption in terms of how quickly we're going to be able to buy the shares back.

John Glass - Morgan Stanley

And then as a practical matter, why does it matter that you collapse the shares rather than just buy Bs back since it's economically more beneficial to buy the Bs. Why even consider the risk of collapsing the shares?

John R. Hartung

Well, it doesn't help us run our business at all, but we have many shareholders  in fact, most of our largest shareholders - have a significant ownership in the Bs, and so we owe it to them, John. And we think we can do this in a nondistracting way. We can have attorneys look into it. And we won't do it if there's a risk. You know, we have to do it with pretty much 100% certainty that we won't trigger this tax problem.

If we're able to do that, it's a benefit to our B shareholders, it removes a potential distraction as some of our shareholders are concerned and sometimes confused because none of us really understand why there's the gap in the Bs, and frankly all of our shareholders benefit because if the Bs do convert to As, we have much more liquidity and I think that's probably better for all of our shareholders.


And our next question is from Jeffrey Bernstein - Barclays Capital.

Jeffrey Bernstein - Barclays Capital

A couple of questions, the first one related to unit openings. I am just wondering with the targets you put out for next year, whether you contemplated more or less? I know you made a comment with regard to a slowdown in development that was going to impact your growth. I’m wondering if you can give some details on the new construction environment, the terms you’re seeing and how you arrived at the number you did?

John R. Hartung

Jeff, our inventory building through the first half of the year was going great and we were on target to really shoot for a greater opening number than the 135 to 145, but over the last couple of months, we’ve really started to see that new developments are slow to come out of the ground. We’ve had a couple that look like they’re still real deals, but they’re not going to get done in 2009. The developer, either because of financing problems or just a little bit of a hesitancy, some of those deals are going to be pushed off.

So really, I would say most, if not all, of the fact that we’re opening fewer than we’re capable of opening, is because of outside forces, because of the economics.

We also are starting to see a little bit of room to negotiate some of these deals to get some better terms, including some better financial terms. It’s not always the case and we are dealing with a new development. The landlord, the developer needs to attract certain rents so he can justify really starting the building in the first place. Those are much, much tougher to find some negotiating room and to improve the terms. But in general we’re starting to see some relaxing of the terms. We’re fortunate that we’re one of the few companies out there that are still growing.

Jeffrey Bernstein - Barclays Capital

On the pricing, I think you said the pricing for the fourth quarter is going to be in the 6% to 7% range based on when you are implementing the 6% increase. I’m just wondering when you lap the prior 4%? As we look to early ‘09, are we just looking at the 6% or is it going to fall off over time?

John R. Hartung

Yes, it’ll fall off over time and probably the best way to think about it is of the 6% to 7% that we expect to see in the fourth quarter, roughly half of that is rollover from previous quarters and roughly half of that is incremental in the quarter. As we get into January we have basically in that same kind of 6% to 7%, maybe 8% range for a while and then gradually the prior quarter stuff is going to fall off. Then about three or four months into 2009 you’ve basically got the 6% that I talked about as the incremental.

Jeffrey Bernstein - Barclays Capital

On the commodities, I think you said mid single-digit inflation in the third quarter. I know you said a lot of it is on spot market, but if things remained where they are right now, what your expectation is for inflation in the fourth quarter? Then bigger picture, what it looks like for ‘09 at this point in terms of an inflation basket?

John R. Hartung

Just to clarify, in the third quarter we talked about our food costs were 33%. I don’t know that I quoted what inflation was, I haven’t really calculated that. We see our food costs in the fourth quarter moving up toward 34%. That’s mainly the three items that we’ve been talking about on a few calls now because of rice, corn for the salsas and soy oil.

We see food costs in the fourth quarter approaching 34%. That would imply about a 3% bump from the third quarter. Then into 2009 we see another mid single-digit kind of inflation in 2009 and that’s where we talked about the fact that our food costs without an incremental menu price increase would be approaching that 35% to 36% range.

Jeffrey Bernstein - Barclays Capital

In terms of the average check, I’m wondering if you have any fear of pushback on traffic with aggressive pricing? I know you held off on taking pricing for as long as you could, but whether or not there are any test markets or anything you can look back on to give comfort that you’re not going to see further traffic fall-off with more aggressive pricing pushing people and the average check?

Steve Ells

Despite the fact that we haven’t raised prices for quite a long time, I should say in our average store, our average store has not experienced a price increase in 20 months. With that in mind – what was my point? When we made those price increase we did not notice any resistance. We noticed no fall off in traffic whatsoever, but the reason Jack made the comment that we’re more cautious now is just because in light of this environment and this economy, we’re not going to go ahead and predict that we will have absolutely no resistance again. So we’re a little more careful to predict that.

But a key part of our philosophy is to make our food accessible so we’ve always taken a hard look before raising prices. We’ve continually lagged behind the CPI in doing so. In fact, even during this time of high food inflation we’ve had very few price increases.

We are committed to making these much higher quality ingredients available and accessible to everybody and to continue to make our food affordable. That’s the reason for increasing prices at this time. We do not predict that there will be no resistance, but we’ve got confidence that our customers understand that we haven’t raised prices and we’ve been very hesitant to do so; that they understand that our ingredients are better; that they’re very loyal and they’ll understand our doing this. So we are cautiously optimistic that this will be well received.

Jeffrey Bernstein - Barclays Capital

Great. Thank you for the color.


Our next question is from Steven Rees - JP Morgan.

Steven Rees - JP Morgan

I just wanted to explore the comp deceleration a bit. If you think about some of your older, more mature markets versus some of your newer units in newer markets that maybe opened up two or three years ago, have you seen any difference between the same-store sales performance in these two different markets or are they all sort of slowing down altogether?

Steve Ells

Steve, we have seen a difference really in all layers of opening, and you’ve heard us talk about it before. If you go back and look at the layers of opening, typically our newest restaurants have the highest comps. The next layer of openings has lower comps and the older you go, the lower the comps. But even in this environment of low, single-digit comps our oldest stores -- those that are five-years-old and older -- are right about at flat from a sales standpoint. Now that doesn’t mean that they’re on average negative from a transaction standpoint, but they’re relatively close to flat when our comps are in a very low single-digit range.

Our newest openings, those openings from the last few years, they’re still a healthy, positive comp. They used to be healthy well into double-digits; they’re not into double-digits anymore but they are well into the single-digits. So they still have that stair step as you go to the older openings, but every single layer of openings, including our oldest, including our newest, have moved down.

Steven Rees - JP Morgan

Historically you talked about where the new store volumes have been coming in. Has there been any change there in the more recent openings?

John R. Hartung

Steve, I would expect the same kind of mix as we’ve talked about on the last few calls. That is about one in three of our openings will be in what we described as new or newer markets; we expect that to really continue for the rest of this year and into 2009 based on the inventory we’ve built so far.

Steven Rees - JP Morgan

Steve, you talked about exploring new marketing strategies in ‘09 and it sounds like you want to be more explicit with the message in your creative to drive traffic. Can you give us some more color on the types of things you’re looking at? If you think you’re going to break from traditional print and billboard media?

Steve Ells

I wouldn’t necessarily look at it that way. We haven’t decided the tactics of what kind of media we would be using. Traditionally though, our message has been generally around brand building and focusing specifically on local store marketing and just introducing awareness of the Chipotle brand. We now know that people are very aware of Chipotle; now we’re specifically going to build a stronger relationship with our customers by talking to them about what differentiates us from the competition and other fast food.

Specifically, why the quality of our food is better and why the taste of our food is better. We want this to be able to show increases in transactions directly. So it’s going to be a much more aggressive way of talking to our customers specifically about why we’re better. We’ve always been a little bit hesitant to do that and we think that now is the time to share how special the Chipotle story is.


Our next question is from Jeff Omohundro - Wachovia.

Jeff Omohundro - Wachovia

As a follow up to that question that was just asked, it sounds like that’s a further evolution of brand awareness. I’m just wondering if there’s going to be more explicit efforts to drive existing customer frequency and how you might weigh that versus driving a new user trial?

Steve Ells

I think it will do both and how that breaks down, I’m not sure. I think it’s too early to be able to make those kinds of predictions. But again, our initial marketing was more of an awareness building and we noticed that we have great awareness. Now we want to specifically drive people in in two ways, to your point: new customers and by strengthening the bond with our existing customers and get them to come in more often.

We can do this, we think, by taking an approach that lets them know why we’re different. Specifically, that we are buying better quality ingredients, sustainably raised ingredients and there are many different reasons that these ingredients are good. We’ll show the direct link between that and creating better-tasting food.

Jeff Omohundro - Wachovia

How soon do you think you’ll be able to share with us your thoughts in terms of the spend rate either in a dollar amount or as a percentage of sales to support these new efforts?

John R. Hartung

We don’t anticipate increasing the percentage that we’re going to be spending on marketing but instead, the monies that we spend will be very focused on specifically creating marketing that will drive people in by doing two things: creating the stronger bond with existing customers, and bringing in new customers who may have been aware of Chipotle but haven’t had a reason to actually try it.

Jeff Omohundro - Wachovia

Given this challenging macro environment and considering the 135 to 145 unit development target contemplated for 2009, I’m just wondering in the event that the environment continues to be challenging or perhaps worse, just how locked in are you on those targets and do you have the flexibility to maybe push some out into 2010 if that seemed prudent?

Steve Ells

Based on what we know today we don’t see that being necessary, but I get the nature of your question. You know, there’s inventory that we built and that we’ve committed to and we have broken ground already; obviously, those are committed to. I would say for roughly half of next year it’s fully committed, we’ve got a signed lease. We’ve done the due diligence, we’re ready to go on those things.

In the second half of the year not only could we, if we chose to maybe get out of a deal -- that’s possible, but we don’t anticipate doing that -- but as I mentioned before, it’s possible the developers that we are counting on to deliver space to us in the second half of next year that we might get opened, that they may not be able to do so or they may not get the financing so they just slow their whole development.

Just as another point of reference, we’ve already, through three quarters, generated $150 million of cash this year. We generate a lot of cash, a lot more cash than our EPS suggests because of things like the deferred rent that you’re able to look at in our 10-K when you look at the statement of cash flow. Stock option expense is not cash-generating. When you look at our statement of cash, we generate a lot of cash notwithstanding the EPS that we are reporting. We fully expect with that opening total to more than fund those and have cash left over.


Your next question comes from Jason West - Deutsche Bank.

Jason West - Deutsche Bank

I believe you guys mentioned that the food margin would be in the 35% to 36% range in ‘09 without pricing, but can you tell us roughly what it might look like if you include the pricing that you’re going to take?

John R. Hartung

That 6% incremental that we’re talking about will cover about 200 basis points of food costs. So if you take the 35% to 36% range, assuming all our projections are correct and knock 200 basis points off of that, that’s about what the price increases will do. So it would be in the 33% to 34% range.

Jason West - Deutsche Bank

A bigger picture question on the margins, you guys do run restaurant margins at the high end of the industry, even though you’re a fairly young company. What is the reasoning? Why do you think this model should continue to support those margins over the long term in a pretty competitive market? Would you weigh that versus holding on to market share and traffic, maybe take some off of the premium margins that you have today?

John R. Hartung

Here’s the way I would answer why this model works and why we’re able to enjoy the margins we are. We have driven a large part of that margin, or a big part of that margin. It’s a very focused model: we have not changed the menu, we have not thrown gimmicks at our operating teams and so we’ve been able to run extraordinarily efficient labor, extraordinarily efficient food costs. We can manage our food costs.

This is all while we’re preparing all this great food. Our crews come in and our managers come in very early in the morning to prepare all this food, and yet because we’re so focused we can be very, very, very efficient. We have not been funding these attractive margins by really high menu prices. In fact, we are funding basically the ability to go out buy this very expensive, very high quality food and basically charge about the same price as other competitors within this category.

So if you look at other fast casual providers, look at their menu prices versus us -- and this is even after the menu price increase that I’m talking about -- we are on par with them. Yet if you look at our food costs, our food costs are much, much higher. Our food quality is much, much greater than any of those competitors.

So we’re offering our customers a much better value by buying this high quality, premium food and charging the same prices. We’ve earned these high margins by basically starting with and then protecting a very efficient unit economic model.


Your next question comes from Sharon Zackfia - William Blair.

Sharon Zackfia - William Blair

Jack, it looks like your new unit productivity came in actually in line with what you’ve been saying for so long after having beaten out as a percent of comp sales, I think forever. I’m just wondering, have you seen that stabilize? Has it continued to run at that 85% of comp sales as we got into September and October?

John R. Hartung

Well it’s not in the 85%, Sharon. It’s more in that below 80%, 75% to 80% or so that we talked about on the last two calls. From a dollar standpoint, I’ve been talking about on average it’s between a $1.35 million and $1.4 million on average and it’s staying right within that range. So you’re right to observe that the openings are still holding, hanging right in there.

We’re delighted by that because that, along with the expectations of these margins in the 19% to 20% range in spite of food inflation and with the menu price increase, allows us to invest more in capital in opening up the next round of openings.

Sharon Zackfia - William Blair

Secondarily, now that you’re projecting, if you add up all the components, slightly slower sales growth in 2009, how should we think about the dollar growth in your G&A? Is that going to settle more in the mid-teens going forward? I know you’re expecting leverage but I’m trying to figure out what the right dollar run rate is at this point for your company.

John R. Hartung

I haven’t thought about it that way, Sharon. What I would do -- and I know you can back into the number -- is I would expect that we could hopefully see some slight G&A leverage. We saw extraordinary leverage the year we went public and last year we saw some nice leverage as well. You won’t see that again but we do hope that we’ll see maybe 10, maybe 20 slight G&A leverage in that kind of range.

Now of course it depends on a lot of factors. It depends on what our sales really do, what happens with the economy. It depends on wage inflation and things like that, but we’ve always managed our business in a disciplined way. We don’t feel like we have to all of a sudden become disciplined because the economy is tough. It’s just who we are and what we do.

I think we can inch out a little bit more G&A leverage into next year and hopefully each year. But it will be inching it out rather than taking big bites of G&A leverage.

Sharon Zackfia - William Blair

Lastly just to clarify, if comps so far in October are running in the very low single-digit range, should we expect it to be a little bit better for the full quarter as you take the price?

John R. Hartung

It all depends on how well our customers can endure the price increase. We’re remaining cautious and we’re assuming our customers are going to struggle with this a little bit. Yet the facts that we have on our side is typically our customers have generally not resisted. Offsetting that though, this is a tougher environment. This is the toughest environment we’ve ever taken a price increase in and so we’re being very cautious about that, Sharon. We’re assuming that it will stay in that same very low single-digit comp level even with the price increase, but that remains to be seen.

We took the first price increases; in fact, we saw your note on it last Friday. This is really just days into it.


We have time for two more callers. Our next question is from David Tarantino - Robert W. Baird.

David Tarantino - Robert W. Baird

A follow-up, Jack, on a couple of line items. Pre-opening costs looked a little high relative to the number of units that were opened in the quarter. I was wondering if you could help us understand what’s going on there? Maybe it was the entry into Toronto? Was there something else going on there?

John R. Hartung

It wasn’t really Toronto much at all, David. The way I looked at it is, look at the pre-opening costs more on a year-to-date basis because we only opened 20 restaurants during the quarter, but we have a lot in the pipeline. To meet our range of 130 to 140 we’re going to have more openings in the fourth quarter and we’ve got a bunch keyed up for the first quarter of next year as well. So pre-opening costs, we’re starting to incur those on the stores that have not yet opened.

Now if you look at it on a year-to-date basis, it’s in the $94,000 per store range. That’s a little higher than we’ve typically seen, we’ve typically seen more in the $80,000 range. But when you look at the $94,000 two-thirds of that is non-cash. So we’re not really spending more cash on these openings, but because of the straight line rent calculation, because of some of these higher occupancy cost markets we are going into, we have to book a journal entry that’s recorded to the pre-opening expense, but two-thirds of that number is non-cash, it’s non-economic. It’s another reason why we’re able to generate as much cash as we are, despite the [inaudible] that we report.

David Tarantino - Robert W. Baird

The other line item, asset disposal loss, it looked like that was up $1 million sequentially. Was there something going on there that made that high or is that the run rate that you would expect going forward?

John R. Hartung

It’s really more that we’ve just been a little bit more aggressive throughout the year in taking a look at our older stores and upgrading, doing some remodels in those stores and so write-offs have been up just a little bit. Denver is one of the markets in particular that we’ve really taken a look at. It’s by far our oldest market and some of the stores are starting to look tired. So we’ve done some things to spruce it up. We’ve got a new, great looking counter that displays our food in a much better way. Our food just looks better with greater visibility with this new counter.

So we made some investments in some of our older restaurants and that means we’ve had to write-off some of the older assets. I would expect that was a little bit of a bump up and we should probably retreat back to a normal run rate like you’ve seen in the past.


Our last question comes from Nicole Miller Regan - Piper Jaffray.

Nicole Miller Regan - Piper Jaffray

I might have missed it, Jack, but what was the cash balance at quarter end?

John R. Hartung

$212 million.

Nicole Miller Regan - Piper Jaffray

And CapEx for ‘09, is it the same as ‘08?

John R. Hartung

We haven’t communicated that but it will be in the same ballpark, Nicole, because our openings are going to be about in the same ballpark as well.

Nicole Miller Regan - Piper Jaffray

I might have missed this as well, but why are you buying back only the B shares?

John R. Hartung

Because they’re on sale.

Nicole Miller Regan - Piper Jaffray

Okay. That’s all I had.

John R. Hartung

Every time we buy one of those we’re buying 10 votes, so clearly it’s just economical. We can buy a lot more shares with our $100 million by buying the Bs than we could if we bought the As.


I would like to turn the call back to Chris Arnold for closing comments.

Chris Arnold

Thank you all for your time today and we’ll look forward to speaking with you next quarter. Thanks everyone.

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