Chipotle Mexican Grill (CMG) Steve Ells on Q2 2016 Results - Earnings Call Transcript

| About: Chipotle Mexican (CMG)

Chipotle Mexican Grill, Inc. (NYSE:CMG)

Q2 2016 Earnings Call

July 21, 2016 4:30 pm ET


Mark Alexee - Manager, Investor Relations

Steve Ells - Chairman & Co-Chief Executive Officer

Montgomery F. Moran - Co-Chief Executive Officer, Secretary & Director

Mark Shambura - Director of Brand Marketing, Chipotle Mexican Grill, Inc.

John R. Hartung - Chief Financial Officer

Curtis Evander Garner - Chief Information Officer


Brian Bittner - Oppenheimer & Co., Inc. (Broker)

Joseph Terrence Buckley - BofA Merrill Lynch

Jeffrey Bernstein - Barclays Capital, Inc.

Sara H. Senatore - Sanford C. Bernstein & Co. LLC

Nicole M. Miller Regan - Piper Jaffray & Co. (Broker)


Good day and welcome to the Chipotle Mexican Grill Second Quarter 2016 Earnings Conference Call. All participants are now in a listen-only mode. After the speakers' remarks, there will be a question-and-answer session. As a reminder, this conference is being recorded. Thank you.

I would now like to introduce Investor Relations Manager for Chipotle Mexican Grill, Mr. Mark Alexee. You may begin your conference, sir.

Mark Alexee - Manager, Investor Relations

Thank you and good afternoon, everyone, and welcome to our call today. By now you should have access to our earnings announcement released this afternoon for the second quarter of 2016. It may also be found on our website at in the Investor Relations section.

Before we begin our presentation, I will 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 about our business recovery, sales trends and potential to recover lost sales, funding of new restaurant growth, projections of the number of restaurants we intend to open, as well as statements about planned marketing programs, future restaurant margins, projected trends in food, labor, marketing, promo and G&A costs, and statements about 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-Q for a discussion of these risks.

I'd like to remind everyone that we have adopted a self-imposed quiet period, restricting communications with investors during that period. The 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 third quarter of 2016, it will begin September 1 and continue through our third quarter earnings release planned for October 25.

We will start today's call with some prepared remarks and then we'll take approximately 20 minutes of questions. On the call with us today are Steve Ells, our Chairman and Co-Chief Executive Officer; Monty Moran, Co-Chief Executive Officer; Mark Shambura, Director of Brand Marketing; and Jack Hartung, Chief Financial Officer; and Curt Garner, Chief Information Officer.

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

Steve Ells - Chairman & Co-Chief Executive Officer

Thank you, Mark, and good afternoon, everybody. Our sales recovery that began midway through the first quarter continued at a modest pace in the second quarter and we saw a return to profitability along with the opening of 58 new restaurants.

During the second quarter, we generated total revenue of $998 million. Our sales comp improved by 6% from the first quarter to a negative 23.6% for the quarter. As a result of promotional activities, we are seeing slightly better improvements in comparable traffic with customer traffic down 20% for the quarter. While we would like to see the sales recovery occurring more quickly we're optimistic our Chiptopia Summer Rewards Program, which launched on July 1, will encourage more guests to visit our restaurants and that this will help lead to a sustained higher sales recovery.

Though the program is just a few weeks old, we're already seeing approximately 30% of all transactions participating in Chiptopia. We are seeing further improvement in both comparable restaurant sales and transactions with comp sales down about 21% in July and traffic improving so that it is now down to a negative mid-teens for July so far.

Diluted earnings per share was $0.87 for the quarter, down from $4.45 earned in the second quarter of last year. While our unit economic model has been significantly affected by the sales hit, it continues to fully fund our current level of new restaurant growth.

Last week, Chipotle celebrated its 23rd anniversary. Throughout our history, we have been working hard to change the way people think about any fast food. And as we have grown into a national brand, we have cultivated and been supported by a very loyal customer base. As customers have fallen in love with Chipotle, they have also placed an extraordinary level of trust in us and have come to know that we will do the right thing when it comes to our food, our employees and our approach to running our business. Through the food safety events we faced last year, we lost some of that trust.

Our customers have come to expect a lot from us to prepare, cook and serve fresh delicious food while pushing the envelope to encourage farming and ranching practices that respect animals and the environment and the people who raise the ingredients we use. We're committed to exceeding our customers' expectations and restoring their confidence that we will deliver upon our promises.

While there are no quick solutions to restoring trust and bringing our sales back to previous levels, we're focused on a number of activities which will continue to emphasize driving traffic in the near term and increasing customer frequency. We will also focus on longer-term brand messaging and on advancing our Food With Integrity efforts, which have been key to building trust and loyalty with customers over the years. But the best thing that we can do in the near term is to encourage customers to come back into our restaurants and to ensure that our restaurant teams are delivering an extraordinary dining experience on each and every customer visit.

In the first half of the year, we have invested more heavily than ever in marketing and promotional activity and those investments are beginning to pay off. Since the CDC's investigation into Chipotle concluded in February, we have done a number of things. First, we launched our largest ever mobile offer and to our largest ever direct-mail program. Second, we introduced a new menu item, chorizo, and we expect to have it in all of our restaurants by the end of the year. Third, we created our first-ever customer rewards program, Chiptopia. And fourth, we launched a new animated short film in an effort to help customers appreciate what is unique about Chipotle. Collectively, these efforts, along with excellent operations are bringing customers back into our restaurants and our teams are working hard to provide an extraordinary experience in all of our restaurants every day.

The introduction of a new menu item such as chorizo is unusual for us. As you know, we have always maintained a very focused menu and rarely changed it. Instead, we focused on doing just a few things in our restaurants so that we can do them better than anybody else. But we have never ruled out additions or changes to the menu, and chorizo is one of the few changes that we have made to the menu in 23 years.

Our chorizo is made with a blend of responsibly-raised pork and chicken seasoned with paprika, toasted cumin and Chipotle peppers. We sear the chorizo in our restaurants to give it a perfect char and we believe it's a great addition to our menu. It gives customers another option and one that has been well received, accounting for approximately 6% to 7% of entrée sales in the restaurants where it's available.

During the quarter, we also resumed serving locally grown produce in all of our restaurants. Typically, our local program for produce runs the summer and early fall months, during the time that makes up the local growing season for much of the country. As we look to establish Chipotle as a leader in food safety, it's also important to us that we remain true to our commitment to serving Food With Integrity, including locally grown produce.

Through a partnership with PrimusLabs, funded by Chipotle, we are working with local growers to make certain that they can achieve our high standards for food safety and we are auditing any farms that we work with to be sure they are compliant with all of our rigorous safety standards. Initially, as we layer in new local produce suppliers that have met our new food safety standards, our local produce program will have fewer farm partners than it did in the past year but as we scale the program in the coming years, we'll have more local farms participating in the program than ever before.

We're also working hard to achieve our goal of eliminating the very last artificial additives from our tortillas. Tortillas are the only food item on Chipotle's menu that contain any additives, which include a minimal number of preservatives and dough conditioners. While we have made significant strides in reducing the number of additives in our tortillas to date, the goal is to achieve a simple recipe with only a few ingredients, much like tortillas made in the more traditional way that includes wheat flour, vegetable oil, water, salt and starter for the flour tortillas.

Finally, I'd like to address recent headlines surrounding Mark Crumpacker, our Chief Creative and Development Officer. We were surprised to learn of these personal issues and placed Mark on a leave of absence. We believe this will allow us to remain focused on our work and our efforts to serve great tasting food, to provide an extraordinary restaurant experience and to continue winning back our customers.

One of the cornerstones of our people culture is to build top-performing teams, Mark certainly had accomplished that in our development and marketing teams, and we have the utmost confidence in those teams and the people who lead them. And we know that they will do an excellent job running those departments. In Mark's absence, we have asked Mark Shambura, our Director of Brand Marketing, to lead our marketing team and Carolyn Anderson, Executive Director of Facilities, Construction and Design, to lead our development efforts. And we have asked Curt Garner, who joined us as CIO late last year to lead our e-commerce team.

Mark Shambura joined our marketing team in 2013 but his experience with Chipotle goes back further than that. Mark led our team at CAA Marketing from 2009 to 2011 working on some of the first innovative branded content programs including the animated short Back to the Start, and also worked on the development of our Cultivate Food, Music and Ideas festivals. In his role as Brand Director of Marketing, Mark already has been overseeing several critical marketing functions including all brand planning, content programs, digital – which includes web, mobile and social – and promotion and events.

Carolyn Anderson began working with Chipotle 20 years ago as an outside vendor in charge of facilities management. She joined us as National Facilities Manager in 2005 and was promoted to Facilities Director in 2008 where she was able to streamline our reinvest efforts to create programs to empower our restaurant managers to be better stewards of their restaurant, leading to substantially lower maintenance and repair costs.

Carolyn's leadership and the exceptional work she and her team were doing led to her promotion to Director of Facilities and Construction in 2012 and again in 2014 to a promotion to Executive Director of Facilities, Construction and Design. She has proven in building top-performing teams that have paved the way to redefine development's roles and responsibilities, and she has been critical to developing and executing our strategies surrounding sustainability, food safety and increasing our cash-on-cash returns for new restaurants.

Curt Garner has been involved with our e-commerce team since he came on board last November and has been extremely valuable as a member of the management team over just the past nine months. Curt oversees all of our information technology infrastructure and its impact on future sales channels. So shifting our entire pipeline out of store sales projects to Curt's guidance has been very natural fit.

We are confident in the current strategic direction of these teams and have full faith and confidence in Mark, Carolyn and Curt's abilities to deliver great results.

I'll now turn the call over to Monty.

Montgomery F. Moran - Co-Chief Executive Officer, Secretary & Director

Thank you, Steve. As we work to bring customers back to our restaurants and to reinforce Chipotle as an industry leader in food safety, it's never been more important to have top-performing teams in our restaurants and among our field leadership. It's the strength of our people culture and our teams that has allowed us to quickly implement many new programs in food safety as well as marketing.

To be sure that our restaurant teams are aligned around our current priorities and that their efforts are directed at the right things, we have realigned some of the success measures for restaurant managers and teams and we're tying incentives increasingly for our most urgent priorities of having an exceptional guest experience, as well as effective local store marketing.

We've also changed the prerequisite to becoming a restauranteur, placing a greater emphasis on measuring the guest experience, business fundamentals and food safety compliance. Historically, these measures have always been important but we are emphasizing them even more and providing additional tools and training to be sure our restaurants are exceptional in achieving these high standards. We've also changed how we calculate our manager bonuses to reward excellence in these metrics with the greatest emphasis on food safety.

This renewed focus on an excellent guest experience, local store marketing, food safety and business fundamentals will be the means by which restaurant managers are eligible to be interviewed for restauranteur. Once they meet these green fees, as we call them, they are interviewed as before to determine if they have a team of all top performers and power to achieve high standards. Historically, these fundamentals were always important to becoming a restauranteur but our audits for them have become more specific and rigorous, and our expectations for their achievement more stringent. The added focus we applied to that part of the process is already paying off in terms of generating sound business fundamentals in our restaurant and the improved food safety audits that we're seeing.

During the quarter, we made significant progress completing the implementation of an industry-leading traceability system which will be fully implemented in all of our restaurants by the end of this month. Already the traceability program has been rolled out in more than 1,900 restaurants. This has been a significant undertaking to put in place and we're very pleased to be so close to completion of this industry-leading food safety enhancement.

Prior to this year, we had traceability in place between our suppliers and our distribution centers, and from the distribution centers we could trace ingredients to our restaurants using ordering and distribution data. But the significance of this state-of-the-art traceability system is that we will have the ability to know exactly which supplier we got any particular food item from, as well as the lot number of all produce, meat, Sofritas, beans, salsas, dairy and tortillas that are received in our restaurant.

The system uses barcodes on every package to allow it to be traced from the supplier to restaurant the same way that overnight delivery services trace package shipments all over the world. This system is another significant way that Chipotle is becoming an industry leader in food safety because it gives us the ability to quickly investigate food quality issues in our supply chain or immediately remove food from our supply chain that we may find not up to our high standards.

This September we will host our biennial All Managers Conference. This year's conference will include restaurant managers, field leaders, operations leadership and select individuals from support departments. The content for this year's conference will be focused on helping our restaurant teams to create an excellent guest experience and teach them to more effectively market their individual restaurants. This conference is an excellent forum to reinvigorate our restaurant teams and ensure that they are totally focused on the things that will most powerfully allow Chipotle to achieve its goals.

On the development front, our openings continue to be on pace with our guidance for 2016. We have opened 116 restaurant so far this year, which is about half of our total planned openings of 220 to 235. We are pleased that we have a strong pipeline of real estate locations under consideration. But as I explained last quarter, we will continue to be judicious in evaluating those locations in light of the current operating environment with an eye towards delivering strong returns.

We've refocused our real estate team on assessing future openings with a more conservative lens that takes into account our current economic model, particularly given recent changes to our average unit volumes. We have also temporarily shifted markets into our developing markets category in order to direct our new store investments towards markets with the strongest track record of opening sales. This may slightly temper the number of openings in these markets in the near term as we look to rebuild our sales momentum and will help us ensure strong new store productivity.

The impact from this is primarily on where we open new stores with a minimal impact on the total opening. Because the real estate pipeline is inherently long term in nature, some of our efforts to reprioritize our market mix will not be realized until late in 2017. Of course, we will update you in the coming months as to how many restaurants we do expect to open in 2017.

We're also working to strengthen the returns in our new restaurants by optimizing our average investment cost. This year, we will realize some cost savings through a collaborative effort between our design and procurement function. In addition, our real estate team has been able to find an increasing number of great sites with strong landlord work letters, providing for landlords to invest more in our build-out costs. The benefit of these efforts translates to an average investment cost that is shaping up to be around $800,000 for 2016 in spite of increased market pressures on materials and labor.

The strength of our teams continues to be our key advantage. Top-performing teams allow us to take on new tasks more rapidly than others might be able to integrate and to create the great restaurant experiences that drive more traffic to our restaurants and delight our customers. We are confident that our teams will lead our recovery through this difficult time in our history such that we will emerge a stronger brand as a result of these challenging times and allow us to provide excellent value for our shareholders as well as the many additional stakeholders who benefit from our successful achievement of our vision.

I'll now turn the call to Mark.

Mark Shambura - Director of Brand Marketing, Chipotle Mexican Grill, Inc.

Thanks, Monty. Throughout the quarter, we continued to heighten our marketing initiatives to drive sales and increase positive perception of our brand. Through quantitative and qualitative research we've undertaken regarding purchasing habits, we have a better understanding of customers, their motivations and visitation patterns than we ever had before. We continue to increase promotional efforts more than we generally would because we think it's critical to reestablish contact and frequency among our guests so that they can recall how much they enjoy Chipotle.

In the last few months, we executed an integrated approach which included a number of different marketing activities. We launched our largest ever mobile and direct mail promotions, we introduced chorizo as a new menu item and we will have it in all of our restaurants before the end of the year. We developed and launched our first-ever customer rewards program, Chiptopia, and we'll be studying the initial three-month program to help us develop a more lasting rewards program.

We maintained a larger ongoing advertising presence than usual and we launched a new animated short film, A Love Story, to support Chiptopia which was aimed at reminding and inspiring our fans and attracting new customers. It's already been viewed in totality more than 17 million times with support from PR, paid digital and social media buy, along with placement on more than 10,000 movie screens. These marketing activities are an important part of our strategy to help drive our sales recovery and we are seeing encouraging results in the consumer research.

In a June 2 survey by YouGov, for example, consumer perception for Chipotle turned positive for the first time since November. While sentiment is not back to where it was prior to these issues, it shows movement in the right direction. This improving sentiment is also supported by our own ongoing brand health tracking study which shows consistent upward trends since mid-January's all-time lows. During the second quarter, we saw modest improvement in consideration and admiration across key customer segments. And with Millennials 18 to 34, the key customer group for us, we continue to see they have the most favorable opinion of Chipotle.

During the first quarter, new customer acquisition was down from the previous quarter but we saw improvement in this area in the second quarter and a trend in new customer acquisition which we can directly attribute to our aggressive promotional offers.

While we still have work to do to increase key brand metrics and traffic volumes, we have a very full slate of marketing programs planned for the remainder of the year that we believe will continue to support our recovery.

The first phase of our recovery plan, which began in February and which we are just coming out of, focused on winning back our customers. Based on the data we have, we believe that the majority of our most loyal customers have returned but many of them are not coming as frequently as they used to.

The second phase of our recovery plan, which we are in the early stages of now, continues our win back strategy but adds a focus on increasing frequency and attracting new customers. Programs such as Chiptopia Summer Rewards and Love Story are aimed at helping us achieve these objectives.

Just three weeks after launching the Chiptopia program, we have more than 3.6 million participants and are seeing approximately 30% of all transactions participating in Chiptopia. This is a significant start to the program and we anticipate our participant levels to continue to increase over the coming weeks. Most importantly, we are seeing growth in the number of guests that are visiting Chipotle at a run rate of more than 24 visits per year, our most frequent customer tier. These increased visits have helped the top line and have grown our traffic comp by about 5 points from June. It's still very early to draw conclusions on the long-term sustainability of these trends but every incremental visit from a customer provides an opportunity for us to further restore trust.

All of these programs are helping to change the conversation about Chipotle. Q2 social sentiment is at 93% of the level it was pre-crisis and the response to our Love Story film has been extremely well received: 80% of consumer conversation is positive. Overall, our marketing awareness is at its highest since Q1 2015.

Lastly, according to a survey by Ace Metrix, A Love Story is the highest scoring QSR ad they've ever tested, delivering strong results on breakthrough, which means high attention and likeability relevant to other measures, as well as change, meaning viewers feel strongly that the brand is moving in a new direction. The survey indicates that the film delivered strongly not only with our brand loyalists but also with lapsed customers and brand considerers.

For the remainder of the year, our marketing programs will continue at a robust pace. Among the programs you can expect to see in the coming months are ongoing emphasis on advertising and digital content to highlight our commitment to using high-quality ingredients and preparing food using classic cooking techniques just as we have always done without cutting corners, and new content demonstrating how Chipotle has become a leader in food safety; targeted promotion inviting groups like students and families; the national rollout of chorizo by the end of the year; our annual Burrito Halloween promotion which will have a charitable component with our Cultivate Foundation; a holiday promotion and a gift card incentive program, continued improvements to our mobile and e-commerce programs and continued emphasis on restaurant level marketing, which allows our restaurant managers to delight customers on a very local and individual basis.

We are encouraged by the progress we are making to improve sentiment about our brand and drive traffic to our restaurants. While we recognize that there is a lot more work to be done to restore confidence, we believe we have the right programs and the right teams in place to improve in these areas.

I will now turn the call over to Jack.

John R. Hartung - Chief Financial Officer

Thanks, Mark. The sales comp in the second quarter showed modest improvement from the trends we reported in April when we reported that comps were running in the negative 26% range. We'd like to see the sales recovery happen more quickly but we are as committed as ever to do all we can to reengage with our customers to restore their trust in Chipotle and reestablish customer frequency.

The first half of 2016 has been focused on establishing and executing industry-leading food safety practices along with aggressive offers to invite our customers to return to Chipotle. As we begin the second half of 2016, we are optimistic about engaging our customers at a deeper level, going beyond basic, broad-based free food offers with things like Chiptopia, with branding efforts that are uniquely Chipotle such as the Love Story video, rolling out chorizo, and continuing to show leadership in food quality by removing the few remaining artificial ingredients from our food.

Although it's very early, we're optimistic about the customer engagement with Chiptopia so far. Over 3.6 million actual or digital cards have been issued and, as Steve mentioned, nearly 30% of all transactions are engaged in Chiptopia. Sales comps over the past two weeks have improved to down 20% to 21%, in that range, but importantly transactions have improved from down 20% in June to down 15% during the first half of July, an improvement of 500 basis points.

Our main objective with Chiptopia is to reward and incentivize our loyal customers who have decreased their frequencies since late last year and to restore their visit frequency back to their previous levels. Our research has shown that most of our loyal customers have returned to Chipotle but not at the same frequency, so Chiptopia is targeted at those customers, and the early frequency results are very encouraging. In fact, since Chiptopia began July 1, we've seen a 90% increase in the number of customers who visit 2.5 times or more each week compared to June. We've seen a 200% increase in the number of customers coming in from 2 times to 2.5 times per week compared to June. And we've seen a 140% increase in the number of customers who visit between 1 time and 2 times each week compared to June.

So we're off to a great start with Chiptopia so far. We'll continue to engage and encourage our customers to visit often during entire the three-month program and when our restaurant teams delights them with delicious food and great service we have a great shot at maintaining or even improving these reestablished higher frequency levels.

The average check has declined slightly during July by nearly 3% versus June as many customers have already redeemed their free chips and guac for registering in Chiptopia or they've redeemed their free burritos for earning frequency status. Some customers are spending a little less on extras. There's only a $6 minimum purchase price in Chiptopia and we're also seeing a slightly smaller group size.

One important note in the accounting for Chiptopia, although the program is intended to last for three months ending September 30, there will be rewards available to be redeemed in the fourth quarter or beyond. Therefore, at the end of the third quarter, GAAP accounting requires that we defer a portion of the revenue from the third quarter into the fourth quarter or later when the awards are ultimately redeemed or the awards expire. It's not possible to project what that deferral might look like right now but we'll fully explain the impact during our third quarter earnings call.

Our entire company is eager to see the sales recovery happen even faster in all restaurants and all markets throughout the country. Many of you on the call today probably feel the same way. While we'd certainly like to be further along, there are signs that the recovery is well on its way and continues to march along. The company-wide July sales comp of down approximately 20% along with the July TC comp down about 15% has come a long way from the low point in January when sales were down 36% and TCs were down 34%. July so far represents a recovery versus a low point in January of 42% on lost sales, meaning that we've recovered 42% of lost sales from January, and we've recovered 53% of the transactions that we lost in January. So, most of our markets across country are further along than this in the recovery. For example in Middle America, the Mid-Atlantic, the Southeast and the Southwest, which combined account for nearly two-thirds of our comp restaurants, the comp sales are down about 18% and the comp TCs are down 13% in July. This represents a recovery rate versus January of 46% on sales and nearly 60% on TCs. Our best market in the country is in Ohio where comp sales are down just 12% and TCs are down just 6% in July.

We still have a ways to go but we're making progress. Unfortunately, the recovery is not as far along in the Northeast and on the West Coast where comp sales are still down around 26% and comp TCs are down around 21% in July. Of course, these are the areas closest to the events of last year and so the recovery is just not as far along as it is in the rest of the country. In fact, sales recovery for the Northeast and the West Coast combined is only 35% and TC recovery is about 45% when comparing July to the January lows.

We returned to profitability during the quarter with EPS of $0.87 per share. Of course, fully restoring our earnings power is highly dependent on the pace and the magnitude of the sales recovery, which remains a top priority for us.

Running through the P&L for the quarter, we reported $998 million in sales, a decrease of 17% versus the second quarter 2015. We generated restaurant level operating margin of 15.5% in the quarter, which is down from the second quarter 2015 but up sequentially from the first quarter of 2016.

During the second quarter, sales deleverage contributed about 800 basis points of pressure compared with Q2 of 2015. Food costs were 34.2% in the quarter, up 110 basis points from the prior year. Underlying inflation was minimal during the quarter as increased supplier costs for our new preparation of tomatoes, lettuce and steak along with food waste more than offset last year's small increased menu prices and lower stock pricing for paper and beef.

Food waste added about 70 basis points as we are still inefficient with some of the new procedures and we're still navigating through ordering and prepping the right amount of food at the right time, especially surrounding promotions. Looking at the rest of the year, we anticipate food costs will remain at right about the same level as any efficiencies we achieve are likely to be offset by higher avocado pricing in Q3.

Labor expenses during the quarter were 27.7% of sales compared to 22.6% during the second quarter of 2015. Nearly all of this drop or about 450 basis points is due to sales deleverage. The remaining increase is due to labor inflation offset by better labor scheduling this year versus Q2 of last year. In Q2 of last year, we had a system reporting issue which led to elevated labor scheduling. Our underlying labor inflation is running at about 6% while hourly wage inflation is closer to 9%.

Occupancy costs were 7.2% of sales, higher as a percent of sales by 180 basis points, all of it related to sales deleverage. Other operating costs were 15.2%, up from 10.9% during the second quarter of 2015 driven by deleverage and higher marketing and promo activity. Marketing costs during the quarter were 2.7% of sales and promo activity added 1.6% of sales for a total of 4.3% combined compared to 2.3% last year. Our investment in marketing and promo will remain at elevated levels as we continue to aggressively engage with our customers to regain their trust and loyalty.

G&A expenses were $70.8 million in the quarter, which was virtually identical to last year's expenses of $70.2 million. A few months ago, we made the decision to temporarily hold off on hiring any new G&A head count in an effort to manage our support costs during challenging times. Instead, we've narrowed the focus of all of our support teams to only those efforts which will lead to safer food, a better restaurant experience for our guests or increase sales. Our teams have stepped up to the challenge and are supporting a greater number of restaurants without adding resources and are focusing the vast majority of their efforts on those three things: food safety, the guest experience and sales building.

Of course, we continue to hire at the restaurant level to support our new restaurants and ensure every restaurant is fully staffed and ready to delight our customers when they visit. As a percentage of sales, G&A expenses increased 120 basis points to 7.1% of sales due entirely to sales deleverage. Underlying G&A for the next two quarters will remain at about this level but the third quarter will include the incremental cost of All Manager Conference, which is expected to be around $10 million.

Our pre-tax income was $41.7 million and our tax rate during the quarter was 38.6%. For the full year 2016, we also estimate our effective tax rate will be about 38.6% compared to 38.2% in 2015, a slightly higher tax rate as a results of higher state taxes.

During the second quarter and through yesterday, we repurchased $117 million of CMG shares at an average price of $438. We generated cash from operations of $118 million during the quarter and we continue to maintain more than $600 million in cash and investment. As we work to restore customer trust and restore our earnings capability, we still have the ability to fund our growth and buyback our stock optimistically. As of today, we have $123 million remaining on our current share repurchase authorization.

These are challenging times, the most challenging we've ever faced. Our company is committed to restoring customer trust. recovering customer visits and restoring our economic model to its full potential, which we believe will position us to add significant shareholder value for a very long time.

Thank you for your time today and we'll be happy to open the lines for the questions you may have.

Question-and-Answer Session


And we'll take our first question from Brian Bittner with Oppenheimer and Company.

Brian Bittner - Oppenheimer & Co., Inc. (Broker)

Thanks. Good afternoon, everybody. I just want to better understand the strategy of your new loyalty program, Chiptopia, because with the comps still down over 20%, I guess the impact to the overall trend of the business does seem pretty muted despite all the data that you talked about including 30% of transactions using it. Can you just comment on the reasoning behind why the strong data isn't necessarily having a bigger impact on the recovery? And secondarily, what's the plan when summer is over regarding loyalty? Are you going to maybe switch to something that's aimed less at those that have already come back and maybe more at regaining those that you've lost? Thanks.

John R. Hartung - Chief Financial Officer

Yeah, the program has only been around for less than three weeks and the first week had a holiday weekend which we saw some pretty choppy enrollment during that time with the 4th of July being closed and the buildup to the 4th of July, it's just not a regular transaction or sales builder for us. Since then, we've seen a very regular engagement. We've seen a very regular ramp-up of people that are participating in the program. We have significant – every single day, we have over 100,000 people that are added to the program. The majority of them are registered in the program. And we've seen significant repeat visits. We've seen like 28% of the people that are enrolled, they're engaged in Chiptopia, have come back a second time. So we're seeing saying exactly the results we had hoped that our already loyal customers who had reduced their visits after the results of – or after the events of last year are coming in more often.

We're hopeful that will happen is as we get into the end of this month – and, by the way, there's an incentive for people to come back more often as the months close because each month account towards earning the big end-of-program awards. And so achieving a level in July is the starting point, then it starts over. Basically, now you need to achieve that same level in August and then September. So it's very, very early and so we're optimistic that we got a 500 basis point impact in effectively less than three weeks.

In terms of what's going forward, after this, we're going to watch this very closely, we're going to learn from it. We're going to find out what works, what doesn't work both for our customers and for our teams in the restaurants. And we anticipate we will have another program. We just don't know yet whether it will be another temporary program, will it be a permanent program? But it's very, very likely that we'll have something to follow on when Chiptopia ends at the end of September.

Brian Bittner - Oppenheimer & Co., Inc. (Broker)

Okay. Thanks, Jack.

John R. Hartung - Chief Financial Officer

Thanks, Brian.


We'll take our next question from Joe Buckley with Bank of America.

Joseph Terrence Buckley - BofA Merrill Lynch

Thank you. I guess, a couple of questions on Chiptopia as well. The improvement in July, you gave us sequential improvement in June, is some of that showing the benefit from the year-over-year comparison? If so, how much? And the GAAP widening between transactions and same-store sales, should we read into that the cost of Chiptopia is going to be rather high? And the last one on Chiptopia, and the last one, as you roll it out, are there learnings about the technology framework within the company? And do you have a sense that you have to invest more heavily in technology either on the expense side or CapEx side over the next couple of years?

John R. Hartung - Chief Financial Officer

Okay. Joe, I'll take a shot at these. The first question was about the comparison. The comparison is not easier in July. In fact, if anything, the comparison is tougher in July. So we feel good about the 500 basis points of improvement so far.

In terms of the average check, it's only down less than 3% in July. We had a gap even before July started, Joe, and a lot of that was due to lower group size. It's also due to the fact that we've had promos throughout the last few months as we tried to earn customers back. With the less than 3% that we're seeing in July so far, right about half of that is due to the retention of awards, that was part of the program.

We were prepared to offer compelling incentives to get people signed up, and so all you have to do is come in, get a card. You don't even have to register yet and you'll free chips and guac. A lot of those have been redeemed already. The fact that there's a lot of redemption of burritos already means that our customers are marching through the levels. They're already earning Mild status. A bunch of them have earned Medium status. And believe it or not, within the 12 or 13 days, we have thousands of people that had earned the Hot status, which means they came 11 times already and you can't come more than twice in a day. So you have to come basically 11 days and people had already been part of the program within the first 12 or 13 days that we were open. So, the redemption of awards we totally expected that.

The other thing we did on purpose, we had a pretty low threshold where if you came in and spent $6, which basically means come in and get a burrito, you'll be part of the program. Again, Joe, our objective was to get as many visits as possible, the idea there being, once we get people in the restaurants and if we can delight them with a terrific experience we have a shot at keeping them. And so we didn't want set a high threshold and so that has contributed to folks participating without all the add-ons, without the drinks and things like that.

So the average check, we are ready for that and we think gaining the customer visit is most important and we'll work on the average check later. And then, in terms of technology, I don't know if Curt is on the phone. I think the question, Joe, was have we learned something about technology and do we have to make significant investments in technology going forward with our customer?

Curtis Evander Garner - Chief Information Officer

Hi, Joe. This is Curt. Chipotle has got some great technology assets already in place with the mobile app that's very popular in the marketplace and in-store technology that's very capable. I think – and certainly we're committed to continuing to innovate and build upon those experiences and reduce friction in the customer experience with them. I think the great opportunity that we have going forward as we look at investment is capitalizing upon these programs to understand the incredible amount of data that we now have available to us as our customers engage in programs like Chiptopia. We're already starting to see some significant insights and learnings from that data and I think there's an opportunity for us to continue to do more in that space around personalization and other ordering capabilities that will, again, remove friction for our customers.

Joseph Terrence Buckley - BofA Merrill Lynch

Thank you.


We'll take our next question from Jeffrey Bernstein with Barclays.

Jeffrey Bernstein - Barclays Capital, Inc.

Great. Thank you very much. Just two related questions on the comp. One, in terms of the recovery, you mentioned a couple times that maybe the pace was slower than you had initially expected. I'm just wondering what you believe the greatest impediment or frustration is with the survey work you've done or learnings or whatnot, and whether or not you feel confident in that full recovery or whether that just seems harder to see at this time? And the second one was just how would you define success with the comp? I'm just wondering going from here, it seems like you are down 21% in July. What's the pace of expected improvement in 3Q? How do you think about the 4Q comparison? I'm just trying to define what success might be. Thanks.

John R. Hartung - Chief Financial Officer

Jeff, success to us is getting all the sales back. The timeframe, we can't predict what that is. We're frustrated that we're further along but there's never been a case like this. Any of the case studies that we looked at in the past just didn't have the amount of publicity and didn't have things like what happened in March where nothing happened and yet there was a news story about somebody – or that some of our crew that didn't work because they were ill, didn't show up to work, no customers got sick, and yet that turned into a news story. So it's been frustrating that there have been things beyond our control where things had worked perfectly well and we followed all our protocols, and yet that still caused our recovery to see a setback. So it's been challenging and frustrating but our objective is to fully win all of our customers back. How long it will take, we just don't know.

In terms of some of the things we've learned on why it's been slower, we know that we have to build our customer trust back. A lot of the research has told us that customers are looking for more information. They're looking for a longer time period where nothing happens. And so, so far, so good in that. Mark had mentioned this. I don't know if you picked up on it, that he and the team are starting to put together a strategy where we will communicate what we've done in a compelling way. It's not something that we're excited to talk about in terms of food safety but we're doing some amazing things. We're talking to some of the best experts or the best experts in the country and so we are doing things that are industry-leading and we are going to find a way to share that with customers so that they will – we can rebuild their trust back that it's okay to come back to Chipotle.

We're also going to continue to introduce things that make Chipotle special. And I don't know, Mark, if you want to talk more about that where we're going to talk about Food With Integrity, we're going to talk about what we're doing with ingredients and talk about the things that people have come to love about Chipotle.

Mark Shambura - Director of Brand Marketing, Chipotle Mexican Grill, Inc.

I think in addition to the content and communication specific to food safety, you're starting to see us get back into a pattern of the marketing that we used to do with A Love Story. We're adding new news with chorizo. We're adding new news with Chiptopia and trying to reclaim our voice with the Love Story film and begin to get back into a rhythm of new programs and new news that reminds our fans of the Chipotle they know and love, and introduce Chipotle brand to new people with efforts like A Love Story.

Steve Ells - Chairman & Co-Chief Executive Officer

Thanks, Jeff, for the question.


We'll go next to Sara Senatore with Bernstein.

Sara H. Senatore - Sanford C. Bernstein & Co. LLC

Thank you. Two questions, if I may. One about the product and one about margin. First, on the product, obviously with all the changes you've made about in your supply chain, there's always some debate about whether people like it as much, whether the food just tastes as good as it did before you made some of these adjustments. The social media coverage varies on what people are saying. So I wanted to see if you had a view on that, whether that's played any role, a change in pace or perceptions on customers' traffic? That's one.

And then the second question I had was for Jack about margins. I'm trying to reconcile what we're seeing in your margin structure now versus historically, which is to say I think you suggested at the current run rate roughly $2 million AUV, restaurant margins are kind of where they are in the mid-teens. If I go back to 2011 when your volumes were around $2 million, your restaurant margins were 26%. So I understand that there's been inflation and you clearly have some food costs associated with it, but I'm just trying to understand where that – if there's any way to bridge that roughly 1,000 basis point gap between what your margins have looked like at these volumes in the past and what you're guiding to now?

Steve Ells - Chairman & Co-Chief Executive Officer

Sure. Sara, I'll start with the food and the taste of the food. So during the time of the incident last fall, we didn't know the cause and so we looked at every single ingredient that we were bringing into our restaurants. And working with a number of food safety experts, tried to understand what the risk of those items were. The individual items coming in and I'll just give you an example that I think illustrates sort of how things happen.

Take bell peppers, for instance. One of our experts said that it would be helpful if we could test the bell peppers before we bring them into the restaurant. Well the way to test them though is to slice them up in a central kitchen and then wash them, test them and then package them. That turned out to degrade the flavor. It does not taste as good as when our crews would expertly chop using a cutting board and a knife right there in front of the customer and then sautéing. But in order to make sure that we had the highest food safety, we went right to the central kitchen. And we did this with a couple of other items also. And I fear that we probably did negatively impact the flavor and I think maybe some customers noticed that also.

We have reversed that though with bell peppers and other items because we have developed with our in-house food safety expert, Jim Marsden, a number of interventions that we put in place from the farm all the way through the distribution system and into the restaurants. And so, with peppers, for instance, we now have our crews blanche the peppers in boiling water which would completely eliminate any pathogen that might be on the surface because blanching doesn't actually cook the pepper because it's for such a short period of time, but it's plenty of time to kill any pathogen that may be on the surface. Our crew then goes with the old process of with a knife and a cutting board chopping right in front of the customer and then sautéing as usual.

We did the same thing with lettuce. We put a number of interventions in place so we brought chopping lettuce back into the restaurant. And so we've returned, I think, our food to taste levels that were where we were before the crisis. But we're going beyond that and we're going beyond that in the elimination of preservatives and dough conditioners in our tortilla. If you look at the ingredients at Chipotle overall, it's a really, really clean ingredient list. And what do I mean by that? It doesn't have the kinds of things that are very hard to pronounce: preservatives and fillers and artificial flavors and artificial colors, all these kinds of things.

So once, in the fall, our tortillas are rid of the preservatives, we will be in an extraordinary position to tell people, our customers, about our very, very clean ingredient labels and be proud to display them. And I think that's not something typical fast food can do. So again, we're not only bringing the great taste that we had pre-crisis but we're continuing to push Food With Integrity in ways that are going to set industry standards.

Sara H. Senatore - Sanford C. Bernstein & Co. LLC

And your customers, when you survey them, they recognize this and they kind of agree with your take on it?

Mark Shambura - Director of Brand Marketing, Chipotle Mexican Grill, Inc.

They do. And in fact, Sara, our complaints amongst customers have actually gone down in terms of food complaints. So we feel very, very strongly about the quality of our food, the taste of our food and the customers' perception and satisfaction with the quality and taste.

Sara H. Senatore - Sanford C. Bernstein & Co. LLC

Thank you.

John R. Hartung - Chief Financial Officer

Sara, on the margins, if you look at our 15.5% today and what's different then, it would've been a few years ago – and listen, I don't have the details of 2011, but I do know the pieces. There's about 300 basis points and, call it, 350 basis points are so, between 325 basis points, 350 basis points of what I would call nonrecurring expenses. Two hundred of that is in our marketing and promo. We're intentionally overspending on that line item and it's way above historic norms. There's another probably 125 basis points to 150 basis points or so of inefficiencies. We're wasting a lot of food. We're not very efficient with labor. And part of it is because we are taking on a lot of new procedures and that's been inefficient. We're being inefficient in terms of dealing with the promotions and we're tending to overstaff rather than understaffed. So that's in that 325 basis points to 350 basis points.

Food costs, I believe back then was probably in the 31% range or so, maybe even below that. There was a time when our food costs was in the 30% range. And so without the details in front of me, I'm guessing that was probably 300 basis points or so difference in food costs. And what's happened there is we just haven't raised prices very much over the years. Our model a year ago so it could handle a 34% food cost. With the deleveraging effects and all the efficiencies, the 34% food cost is a lot more painful today.

We also have labor inflation that has crept in since then, and I'm just guessing that's probably at least another 200 to 300 basis points. The labor inflation especially in the last year has been significant. We had intended to pass on the wage rates that we were seeing because of local pressures, because of raises in minimum wages, some of them very significant at $10, $12, $13, and we haven't really raised prices. We haven't passed on the cost of those higher wages. Probably a couple hundred basis points there.

We do have recurring food safety costs that you heard me talk about. We talked about that being in the maybe 200 basis point range. I think it's going to be better than that. I would say that's probably going to end up in the 100 to 150 basis point. Right now we've got about 150 in there. And so that's the only thing that's really what I said is an absolute permanent. So if you add these things up together, you're probably in that 1,000, 1,100 basis points or. So those are the items. We're very aware of the items.

We believe the most important thing we could do, we've lost 800 points because of deleverage. That's most of our focus this year, of course food safety first. Now, secondly is to recover our customers and we're doing that through offers, through Chiptopia, through branding, and then our focus, as Monty mentioned, is making sure that our customers have a wonderful experience when they come back because if we get our sales back, we get 800 basis points of margin. These other items though, we think we can chip away at these other items as well but we don't want to go after them aggressively until we've recovered as many or all of our customers. And once we've done that, then we know that we can make a lot of progress on these other margin items as well.

Sara H. Senatore - Sanford C. Bernstein & Co. LLC

Thank you.


We'll take our next question from Nicole Miller with Piper Jaffray.

Nicole M. Miller Regan - Piper Jaffray & Co. (Broker)

Thank you. Good afternoon. What data are you collecting through the loyalty program? And what do you intend to do with it? And a follow-up, how is the turnover at the store level? And as you realign the incentives, is it changing? Or do you expect it to change? Thanks.

Steve Ells - Chairman & Co-Chief Executive Officer

Nicole, I think I'll take a shot of that and I don't know if Mark wants to add onto it. The single biggest thing we're doing is we can now match up specific customer behavior using credit card data and people's enrollment in Chiptopia and we've been able to go back, so far, we've gone back to June but we're going to go back to even a year ago before all these events happened to see the loyalty of our customers. We've got lots of outside data showing us what's happened to the loyalty of our customers.

So we're going to be able to do a better job of seeing those customers that were once loyal a year ago, they were coming twice a week or three times or four times a week and have dropped their visits now to once or twice a week, we're going to be able to see whether Chiptopia is bringing them back up to the two or three or four times a week that they visit. We've done that so far just going from June to July and we're very encouraged and I shared that data with you. We also now have greater engagement with a lot of the customers where we can actually reach out and market to them. And so we have a communication link that we have with our customers as well. And then, Mark, I don't know is there any other customer data that you...?

Mark Shambura - Director of Brand Marketing, Chipotle Mexican Grill, Inc.

I would focus mostly on – we used the data and the regression analysis to really hyper-target those who had descended in their frequency or those who had lapsed to make sure we could invite all of those people into the program. And now, we can match up those who are now in the program to determine what their return frequency level is and utilize all of that data we're mining there to help influence the evergreen loyalty program we are currently evaluating in the months to come.

Steve Ells - Chairman & Co-Chief Executive Officer

And then the other question was on turnover. Monty, I don't know if you wanted to comment on turnover?

Montgomery F. Moran - Co-Chief Executive Officer, Secretary & Director

Yeah. Our turnover is going various directions for different positions. The crew turnover right now is fairly high. It's in the 130%-plus range and our kitchen manager turnover has sneaked up a little bit, whereas the manager – or the general manager turnover has gone down quite a lot. And we've really targeted general manager turnover in particular. In an effort to try to reduce general manager turnover, we are making certain to communicate and understand exactly the reason for every single person turning over. And in fact, you need officer approval for a general manager to turnover at Chipotle because we want to have that intimate of an understanding as to why they turnover. So that system has really worked.

But we also implemented a similar program where any manager turnover is something that has to be approved by our team director, team directors in the company. And so we anticipate that we'll continue to work on that. We'll get a better understanding as to why some of the turnover is happening and continue to work on reducing turnover.

Nicole M. Miller Regan - Piper Jaffray & Co. (Broker)

Thank you.

Montgomery F. Moran - Co-Chief Executive Officer, Secretary & Director

Thanks, Nicole.


And that does conclude our question-and-answer session and brings us to the end of the conference. We appreciate your participation. You may now disconnect.

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