Mark Alexee - Chipotle Mexican Grill, Inc. Steve Ells - Chipotle Mexican Grill, Inc. Mark Crumpacker - Chipotle Mexican Grill, Inc. Curtis Evander Garner - Chipotle Mexican Grill, Inc. John R. Hartung - Chipotle Mexican Grill, Inc. Scott Boatwright - Chipotle Mexican Grill, Inc..

Jason West - Credit Suisse Securities (USA) LLC Nicole Miller Regan - Piper Jaffray Andrew Charles - Cowen & Co. LLC David E. Tarantino - Robert W. Baird & Co., Inc. (Broker) Will Slabaugh - Stephens, Inc. David Palmer - RBC Capital Markets LLC John Glass - Morgan Stanley & Co. LLC.

Greetings, and welcome to Chipotle Mexican Grill, Inc. Second Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Mark Alexee, Investor Relations Manager for Chipotle Mexican Grill, Inc. Thank you, Mr. Alexee. You may begin..

Hello, 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 2017. It may also be found on our website at chipotle.com 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 estimates of future food, labor, occupancy, marketing and G&A cost trends, statements regarding sales trends, description for the impacts of new technologies on our business, projections of effective tax rates for 2017, and statements about possible price increases, stock repurchases, and our ability to create shareholder value, 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 on our subsequent Form 10-Qs for a discussion of these risks. I'd also like to remind everyone that we have adopted a self-imposed quiet period, restricting communications with investors during that period.

The quiet period for Q3 will begin on the 16th day of the last month of each fiscal quarter and continues until the next earnings conference call. For the third quarter of 2017, it will begin September 16 and continue through our third quarter earnings release planned for October 24, 2017.

We will start today's call with prepared remarks and then open the line for questions. On the call with us today are Steve Ells, our Chairman and Chief Executive Officer; Mark Crumpacker, our Chief Marketing and Development Officer; Curt Garner, our Chief Digital and information Officer, and Jack Hartung, Chief Financial Officer.

We also have Scott Boatwright, our Chief Restaurant Officer and Jim Marsden, our Executive Director of Food Safety available for questions. With that, I will now turn the call over to Steve..

Thanks, Mark, and good afternoon, everyone. Thanks for joining us. When I opened the first Chipotle restaurant 24 years ago, I set out to prove that food served fast doesn't have to be a typical fast food experience. I spent hours preparing the freshest ingredients using the classic cooking techniques I had perfected as a chef.

When it came time for service, I was able to serve the food I had prepared incredibly fast in a format that allowed my customers to get exactly what they wanted. Fast forward 24 years and Chipotle is still fundamentally the same experience I created in that very first restaurant, but much within the company has changed.

As we grew, we had the opportunity to work with our farmers, ranchers, and suppliers to change the way our ingredients are produced. I'm proud of the positive influence we've had on the development of a more sustainable food system in our country.

I remain true to my original vision for Chipotle, and am more committed than ever to be a champion for positive change in making real food accessible to more people than ever before. But as we've grown, we have also encountered our share of adversity.

Our unprecedented success leading up to 2015 has masked operational weakness in some key areas of our business.

The food safety incidents of 2015 revealed that our food safety program needed to be more robust and it became clear that we were focused too much on building cultures that didn't drive the results we were expecting, and too little on the operations fundamentals required to deliver an exceptional guest experience.

Upon returning to the position of sole CEO at Chipotle late last year, I committed to fulfilling the promise of dramatically improving the guest experience and making Chipotle the safest place to eat. I'd like to discuss our progress toward each of these goals now.

With regard to food safety, we have formed an independent food advisory council comprised of the nation's leading food safety experts to oversee and advise us on our food safety practices. Additionally, I directed our Head of Food Safety, Dr. Jim Marsden, to develop the most comprehensive food safety program in the industry.

Jim has implemented a robust food safety program, which includes the implementation of a HACCP food safety program in all of our restaurants.

HACCP stands for hazard analysis and critical control point, and we're the only major restaurant company to have such a program; the implementation of a third-party food safety auditing system, all managers earn a rigorous food safety certification; the installation of advanced ventilation purification systems in our restaurants; and the implementation of a rapid deployment team, including food safety experts and nurses in the event that any food safety incident does occur.

All of this creates one of the most advanced food safety programs anywhere. However, no matter how advanced our systems are, it is not possible to completely eliminate all risk, and unfortunately, we had a norovirus incident in one of our restaurants in Virginia last week.

Norovirus is a common and highly contagious illness affecting nearly 20 million Americans each year and is unrelated to our food supply chain. It's commonly spread within closed environments like cruise ships, schools, and restaurants.

We're disappointed that we failed to prevent it from affecting our customers and employees in our Virginia restaurant. We deeply regret that anyone became ill and I'd like to apologize to those who were affected. We quickly reached out to our employees and customers to provide assistance, and to ensure their well-being.

Our safety systems are designed to provide very fast detection and rigorous procedures to quickly remedy the situation. In this case, we were able to quickly detect the problem, proactively alert the Health Department and close and sanitize the restaurant. We have isolated the failure that occurred.

It was a failure in one restaurant to comply with our procedures used to prevent norovirus. We know that our procedures work when executed properly, but compliance in each restaurant is essential.

In order to reduce the risk of this happening again, we are undertaking an additional comprehensive communication and training effort to ensure that every manager and every field leader understands and execute these norovirus prevention procedures, and that they understand that compliance with our procedures is non-negotiable and a condition of their employment.

We will continue to build a culture of compliance in our operations through relentlessly training and enforcing adherence to our policies. Beyond my commitment to continued improvements in food safety, I also promised to dramatically improve the customer experience in our restaurants.

Core to this was focusing our teams on delivering an excellent guest experience. This included a new measurement and bonus system that rewards our managers and teams on a handful of easy to understand metrics, the majority of which are customer satisfaction oriented.

We have increased the number of restaurants meeting our high operational standards, and have reduced general manager turnover. We have also recently implemented a new guest satisfaction survey, and are intensely focused on steadily improving our scores. During the quarter, we hired Scott Boatwright as our first ever Chief Restaurant Officer.

Scott comes to us from Arby's, where he was responsible for the success of nearly 2,000 franchised and company owned restaurants. Scott has a very strong vision for creating a compelling guest experience and he's already demonstrated that his expertise will dramatically improve operations inside our restaurants.

All our field leaders now report directly up to Scott and we are confident that we will continue to see strengthened operations in our restaurants under his leadership.

In addition to strengthening our leadership team and simplifying our restaurant operations, we are now executing with more discipline against a clear set of strategic priorities, which is enabling our teams to pursue innovation projects in a more effective manner.

As you are likely aware, we opened the Chipotle Next Kitchen in New York City earlier this month. The Next Kitchen is a Chipotle restaurant where we explore changes to our menu. The Next Kitchen is primarily intended to test the operational impact of potential new menu items.

This includes how they'll be prepped, cooked, presented, and served, in addition to the operational implications of the training required for proper execution.

While the restaurant is not intended to definitively determine customer acceptance of new menu items, it's open to the public so that we can interact with the customers, while they order and enjoy the new menu items.

Once the new items have been evaluated in the Next Kitchen, they may be put into wider consumer testing in various markets to determine customer acceptance.

The Next Kitchen is currently serving queso, frozen margaritas, new salad greens served with an avocado citrus dressing, and buñuelos, our crispy cinnamon dessert with a Chipotle infused chocolate dipping sauce. I work closely with the menu development team to create the recipes.

Each item is delicious and it complements our current Chipotle offerings nicely. I believe they all have the potential to earn a place on our menu, and because of the early operational success we found with our queso offering, we'll expand the test to two markets in August in order to evaluate its customer acceptance.

As you know, one of the hallmarks of Chipotle's success over the years has been our focused menu and our commitment to doing just a few things so that we can do them exceptionally well.

As part of our larger customer experience strategy work, we're exploring innovations that will appeal to our guests, while being mindful to avoid adding unnecessary complexity to our restaurant operations. Of our last 24 years, there's no doubt the last two have been extremely challenging. But we are emerging as a stronger company.

We've built stronger teams, refined our strategy, enhanced our technology, advanced our food with integrity offerings, and are carefully evolving our customer experience with changes to our menu and to our environments.

We are doing all this with the aim of creating loyal customers by delivering a compelling dining experience and ensuring that real food, raised with respect, is accessible to more and more people, ultimately creating greater shareholder value. I'll now turn the call over to Mark..

Thanks, Steve. Our marketing efforts have always included a combination of brand-building efforts and transaction-driving promotions and advertising. The brand-building programs target existing customers and are designed to strengthen brand loyalty. The advertising campaigns cast a wider net and target current lapsed and new customers.

For the last year, we have increased all of our marketing activities, first with increased promotional activity, and then with increased advertising. While this increased marketing activity has been effective, it's clear that winning back occasions lost to competitors is going to be an ongoing challenge.

The solution to winning back customers is not simply to spend more on advertising or tweaks to the creative approach. To win new customers, attract lapsed customers and increase the frequency of our existing customers, we need to evolve the Chipotle experience and create more compelling reasons for customers to visit.

There's tremendous demand for something new from Chipotle, and we are actively working to add excitement to our menu and our environments and to add new ways to order from Chipotle, all while staying true to the core promise of our brand.

To accomplish this, we took a comprehensive look at our overall customer experience with an eye toward the future. We carefully examined all the different ways our customers order from Chipotle today, and how that might change in the future. We looked at what our customers order and how single orders, group orders, and family orders differ.

We looked at how customers might like to access Chipotle, including in-store physical and digital ordering, out of store digital ordering, dining in, in-store pickup, in-vehicle pickup, and delivery.

And we took a close look at the different ways people might like to access Chipotle, including smaller catering formats, family meals, and-grab-and-go options, and, of course, we looked at the menu itself with an eye toward appealing to new customers or to create new options to encourage existing customers to visit more often.

From this strategy, we have begun to enhance the Chipotle experience in areas with the most potential. An obvious example of this is the Next Kitchen in New York, where we are experimenting with four new menu items.

But other examples include the new digitally-enhanced second make line, where digital orders are fulfilled, which is currently active in 25 New York restaurants. And it includes changes to the design of our existing and new restaurants to optimize them for digital orders, new types of ordering formats, and new menu items.

This includes the first ever Chipotle vehicular pickup window that will be opening at an Ohio restaurant this fall. These changes, and especially the changes to our menu, also enhance the effectiveness of our marketing efforts.

We know that many of our lapsed customers are waiting for a reason to return to Chipotle and new menu items are an ideal way to spark the necessary interest. New menu items are also ideally suited to advertising, especially the 15-second television spots that make up the majority of our television ad buying.

Along those lines, I'd like to share with you the details for expanding the test of queso that Steve mentioned. Now that we have successfully completed the operational test in New York, we will be rolling out queso to more than 350 restaurants across markets within Central and Southern California and Colorado, beginning on August 1.

We will measure customer acceptance of queso, during which time we will evaluate a national rollout, which we think could happen as early as mid-September. But the decision for a national rollout is subject to the results of the test that begins August 1.

At this time, the other items in the Next Kitchen are still in their operational test phase, but we expect that some of those items may also proceed to consumer testing at some point. Last quarter, we launched our first national marketing campaign that included television.

The campaign is called As Real as it Gets, and is focused on the use of real whole ingredients in our food. The campaign consisted of television, out of home, digital, radio, social, and search marketing.

The digital component of the campaign was successful in driving 45% of all online orders and 60% of all catering orders during the advertising flight.

Based on our research, the first wave of television advertising during the April flight resonated with existing customers, but was less effective at driving transactions among non-customers, even though it scored above industry averages for television effectiveness.

Prior to the second flight in May, we updated the creative to feature more appetite appeal, which contributed to a 10-point increase in intended visitation among fast food and fast casual diners who viewed the advertising.

But while the feedback on the campaign was positive, we have an opportunity to make the television advertising more effective at driving traffic into our restaurants.

In preparation for the upcoming advertising push in September, which again includes significant television advertising, we further refined the ads to include even more appetite appeal and tested the creative approach. We anticipate these ads will drive increased consideration in visitation with new and lapsed customers.

In anticipation of successful consumer testing of queso and a subsequent national rollout, we have developed advertising, both for television and elsewhere that features queso.

The inclusion of a new menu offering has the potential to significantly improve the impact and traffic-driving potential of the campaign, especially with the television advertising.

As we head into the new quarter, we just launched a new traffic driving program called SAVOR.WAVS, working in partnership with RZA, the multi-platinum hip-hop artist, producer, and founding member of the Wu Tang Clan.

We created an interactive experience where customers compose their favorite Chipotle order, which SAVOR.WAVS then translates into a unique musical and visual experience based on their order. During the experience, customers see how each of our real ingredients was paired with a musical sound created by RZA.

We also invited several well-known artists to create their own order and remix the songs in their style. RZA and the Wu Tang Clan created one of the remixes, all of which are available on Spotify.

We are supporting SAVOR.WAVS with an advertising campaign that targets our fans as well as new and lapsed customers through our own social channels, as well as paid promotions that include unique partnerships with Spotify and support from Pandora, SoundCloud, Complex, Bustle, Facebook, and Instagram.

And to tie SAVOR.WAVS directly to our continued effort to drive sales, we have included a BOGO offer for consumers that go online and complete the SAVOR.WAVS experience. So far, 2.6 million customers have composed their order within SAVOR.WAVS and earned a BOGO offer.

Before I turn the call over to Curt, I'd like to provide an update on our development efforts. During the quarter, we opened 50 restaurants and remain on track to open between 195 restaurants and 210 restaurants this year. I will now turn the call over to Curt..

Thanks, Mark. As we've discussed before, Chipotle has taken a holistic approach to digital.

We've made significant improvements to the digital customer experience through the launch of our new ordering website, smarter pickup times technology and most recently, meal customizations, which allows our customers to personalize their Chipotle meal through our digital ordering platform the same way they order in line.

We've also improved our staffing and training of our existing dedicated second make lines, which we have in nearly every restaurant, to ensure that digital orders are fulfilled without impacting throughput on the front serving line.

And as Mark mentioned, these improvements have allowed us to begin to invest in digital marketing with a clear call to action for digital ordering. This holistic approach has created a digital flywheel that has driven a strong customer response and set records during the quarter.

Web ordering increased 52% compared to Q2 2016, while mobile ordering increased 37%, and catering increased 9%. Second make line sales as a percentage of overall sales rose to 8.5%, a new record for the company in terms of sales dollars and percent of overall sales.

Our busiest restaurants continue to see the highest sales gains on the second make line, with our top 250 restaurants recording second make line sales at almost 15%, a sign that our flywheel is improving the customer experience in our highest volume locations.

Looking forward, we will continue to invest in improving the digital experience for our customers as part of the overall customer experience strategy that Mark discussed.

We've recently deployed our new tech-enabled second make line to 25 restaurants in Manhattan and have plans to have approximately 100 of these new second make lines installed by the end of the year. Early results have confirmed that these new tech-enabled lines have as much as a 40% improvement to throughput.

We are working through the details of the plan for 2018 and estimate several hundred additional restaurants will receive the new tech-enabled line next year. Additionally, we remain on track to launch a new mobile app this year.

This will be the first major release of a mobile app at Chipotle in years, and will contain substantial improvements to the digital experience for our customers, including the ability to pay with a mobile wallet, rapid order and reorder, and integrated digital offers.

Customers ordering from restaurants with the new tech-enabled second make line will get enhanced features such as order completion notifications and arrival detection for the vehicular pickup window.

While we are in the early days of positioning Chipotle as a leader in digital, we have great momentum and are encouraged by the customer reaction and results we have seen so far. I'll now turn the call over to Jack..

Thanks, Curt. We continue to face significant challenges as we work to restore customer trust and restore our economic model. The events of the past week have made those challenges even more difficult. But we've made important progress so far this year, and we have opportunity to build on that progress in the coming months.

Specifically, we changed how we define and reward success, based on providing an excellent guest experience, which has resulted in improving internal restaurant grades each month since last year. We have the highest percentage of internally rated A restaurants that we have had since we redirected our Restaurateur program.

Our general manager turnover is the lowest it has been in more than eight years and our labor deployment is the most efficient it has been in the past seven years.

And while we're pleased to see this early progress, we remain committed to continue to elevate the guest experience by investing in the training and development of our restaurant crew and managers.

We know there's a strong correlation between restaurants with a strong culture of training and creating an excellent guest experience, and there's also a strong correlation between great training and low turnover at both the crew and manager levels.

At our upcoming field leader conference next month, where all of our field leaders throughout the country will gather, the main focus will be around creating a strong culture of training and development in each and every restaurant.

We also have the potential to delight our guests with new menu items, such as queso, as Mark discussed, which is the single most requested item our guests ask for. We'll continue to invest in technology to improve the guest out of store ordering, which already is our fastest-growing sales channel, as Curt discussed.

And finally, after absorbing inflation in our economic model for more than three years now, we believe we have the ability to recover some of that inflation through price increases, as the increase we have taken so far in about 500 restaurants has seen little resistance. And I'll talk more about that in a few minutes.

During the second quarter, our comparable restaurant sales grew 8.1%, fueling a 17.1% total sales growth to $1.17 billion. The comp was primarily driven by an increase of 5.3% in paid traffic comps over last year. Average check increased about 2.8%, mainly as a result of fewer promotions, primarily BOGOs from last year.

The news surrounding a cyber-event had a temporary impact for a few weeks, and overall for the quarter had an impact of around 30 basis points to 50 basis points on the comp. In markets where we increased prices, the overall resistance was less than 20%, and most markets saw no resistance at all.

This gives us confidence that we do have pricing power with our existing guests in those markets.

Remember, we selected the first group of market primarily based on identifying them as low-risk markets where the negative sales impact in 2016 was less severe, where competitor prices were generally high, and where we expected the resistance would be low.

We are currently reviewing the next year of restaurants for a possible price increase using the same risk profile analyses.

While we would like to execute the price increase on the next tier of market sometime in the fall, the exact timing will depend on the timing of a possible queso rollout and the consumer sentiment and visit habits following the events of last week.

Through the first two and a half weeks of July, our average daily sales levels have held steady to June and the two-year comp trend was holding at the same level as Q2. As a perspective, with last year's Q3 comp of negative 21.9%, maintaining the same two-year comp trend would require a Q3 2017 comp of a positive 5.6%.

It is too soon to know what enduring impact last week's events may cause, if any, but comps have been negatively affected by about 5.5% on average over the last several days.

Of course, our hope is that the impact will fade over the coming weeks, and that the marketing and buzz around the queso expanded test will change the narrative and encourage our guests to quickly return to their previous visit frequencies.

While at this early stage visibility is limited, we have reiterated our full-year comp guidance of high single-digits, which assumes some recovery of the impact from last week, along with the possibly of a queso rollout and a likely menu price increase in Q4.

Our restaurant level operating margins improved in the quarter to 18.9% from 15.5% in the second quarter of 2016.

While sales growth remains the most important lever to restoring our economic model, we continue to look for opportunities to find cost savings through better contract negotiations with our suppliers and improved controllable costs inside the restaurants, especially with our food costs and our labor management lines.

Our margins are not quite at the 20% target we had set late last year, but we are within striking distance and can get there with help from normalizing avocado prices and by building greater comp momentum. Food costs during the quarter were 34.1% of sales, mostly in line with last year.

The short supply environment for avocados continue to pressure our food costs by about 140 basis points compared to last year and by 70 basis points compared to last quarter.

These higher avocado costs mask our cost savings achieved related to reduction in food waste and resulting from changes in food safety procedures and lower paper and packaging costs. We also benefited from higher rebates at the end of the quarter tied to an agreement milestone that contributed 15 basis points.

And this benefit was not anticipated in our prior guidance for the second quarter. On a sequential basis from Q1 to Q2, our food costs increased 30 basis points from 33.8% to 34.1% due to higher avocado prices.

We are already starting to see some minor relief in pricing as we transitioned seasonally from California to Mexico in July along with higher supply than expected from Mexico. If avocado prices continue to improve, we believe that our food costs can improve by about 40 basis points in Q3 and move to the low 33% range in Q4.

And that is before the impact of any possible future price increases. Our labor costs in the quarter were 26.2% of sales, or a 160 basis point improvement over last year. The combination of sales leverage in our peak seasonal sales period and better scheduling and deployment of labor contributed to year-over-year decrease.

These efficiencies were offset by wage inflation of about 4% and we believe that that inflation will continue at least at this level through the back half of the year. Other operating costs were 14% during the quarter, down from 15.2% during Q2 2016. Excluding marketing and promo costs, other operating expenses improved by 50 basis points.

Our combined marketing and promo expense was 3.7% in Q2 and decreased 70 basis points compared to last year as we lapped a high volume of promotional offers related to direct mail in Q2 2016. For the second half of the year, we currently expect our marketing and promo costs will ease slightly to about 3.1% of sales.

On a sequential basis from Q1, underlying other operating expenses, including marketing and promo, improved 35 basis points due to leverage on higher seasonal sales, but was offset by 25 basis points due to higher advising and promo in Q2.

To add a bit more perspective on other operating expenses, as you know, the line item consists of about 20 individual expense line items.

In addition to marketing and promo, some of the other larger line items include bank fees, which actually grow faster than sales, as credit card sales continue to grow at a faster rate than cash sales; and utilities, which are generally fixed and will move with energy cost changes and seasonal usage, but typically not move with sales fluctuations.

All other components are under 100 basis points each, and include items such as employee meals, M&R, insurance, et cetera, and generally are semi-fixed in nature.

These grow in absolute dollars as we build additional restaurants, so sequentially from Q1 to Q2, excluding marketing and promo, other operating expenses grew 6%, or $6.8 million to $121.5 million and were 10.4% of sales.

This $6.8 million increase is comprised of a $2.4 million increase in credit card fees, about $1.7 million increase from net new stores with the remaining $2.7 million increase arising from the semi-fixed nature of the remaining line items.

So prior to adding new stores to the base and prior to the increase in credit card fees, our underlying leverage on the other operating expenses would have been about 70 basis points from Q1 to Q2, but including the new stores added and the higher credit card fees, the leverage was about 35 basis points, again not counting changes in marketing and promo.

To add a bit more clarity, the nature of these line items sometimes results in quarter-to-quarter volatility, such as with insurance adjustments or changes in energy costs and often these moves go both ways among the line items and often offset each other. And when they don't, we will point out unusual non-recurring increases or decreases.

In the second half of the year, these other operating expenses, including marketing, will continue to grow in absolute dollars with seasonal expenses like utilities and as we continue to open new restaurants.

I hope this discussion provides better clarify for how sales leverage works for this relatively small collection of often misunderstood line items. G&A was 6% of sales, down from 7.1% of sales last year.

G&A dollars were down $700,000 from Q2 of last year, driven by lower legal expenses and maintaining a disciplined approach across the rest of our underlying G&A costs. These reductions were offset by increased employee bonus accruals and stock comp expense.

For the quarter, stock comp was $19.2 million and we continue to expect full-year stock comp to be approximately $65 million to $70 million. In Q3, we'll also hold our biennial field leadership conference, which will cost about $1 million.

For the full year, we now expect G&A to be slightly lower than previous guidance, in the $290 million range, which is down from prior expectations of $300 million for the year.

However, I would note that we have not accrued any possible liability related to the cyber incident from earlier this year, and we also haven't included any possible liability in our G&A estimate for the rest of the year.

During the second quarter, we reported a slight gain on the disposal of assets due to $3 million related to proceeds on the disposal of a ShopHouse, along with a reversal of ShopHouse straight-line rents. For the second quarter, our effective tax rate was 38.1%, and for the full-year, our effective tax rate is expected to be about 38.4%.

The Q2 tax rate was impacted by non-recurring adjustments related to state income taxes – tax deduction for stock compensation. This new effective tax rate is lower than the prior year of 40.8%, as our pre-tax income has improved.

During the second quarter and through yesterday, we repurchased $77 million worth of our shares at an average share price of $423. We have $167 million remaining in our share repurchase authorization as of yesterday. We generated cash from operations of $93 million during the quarter and finished the quarter with cash and investment of $569 million.

Our entire organization is aligned behind supporting an elevated guest experience. We're committed to creating a strong culture of training, simplifying our operations, pursuing innovation that will lead to a better guest experience.

Creating and sustaining sales momentum is the most important lever for restoring our economic model, and that begins with great execution and delivering an excellent guest experience in each and every restaurant.

We're grateful to all of our team members for their hard work and commitment and we're confident that strong execution of our strategies will result in long-term profitable growth, all while fulfilling our mission of preparing better tasting food made from real ingredients for our guests.

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

The first question comes from Jason West with Credit Suisse. Please go ahead..

Yeah, thanks. I guess, Jack, just starting off, I just want to clarify some of the comments you made about recent trend, just so we're all on the same page. So, when you said the first two weeks of July had a similar two-year to 2Q, can you just clarify what that implies on a one-year? Just I'm not sure which two-year stack you're using there..

Yeah, well, the two-year stack, I think it would be better to clarify what the two-year stack is. If you do the geometric two-year, in the second quarter our comps were in the down 17.4%, 17.5%. To maintain, looking at the first couple weeks of July, we were at that same kind of two-year rate.

The one-year is going to be lower, Jason, because we're going up against Chiptopia, you've got the holiday.

We did pick up a little bit because we opened for part of the day on the July 4th, but I think the way to think about it is on a two-year trend comparing back to 2015, first couple of weeks were right in line with June and right in line with the rest of the second quarter on that two-year, down about 17.4% range..

Okay, so the first two weeks of July last year on a one-year, what would that have been?.

Well, on a one-year, like the second week, for example, it was the best week we had during, I believe the entire quarter, because remember that was the kickoff of Chiptopia. And so, we left the quarter, or the entire quarter, and the second quarter was down 23.6%.

We were in for that second full week, not counting July 4, we were like in the down 20% range. And that was, I believe, the best or near the best week of the entire third quarter. So, that's why the one-year is going to be lower, but that's because of comparing against some of the early Chiptopia returns..

And then July commentary on the first two weeks does that include the benefit of being open longer on July 4? Or is that....

Yeah, the relatively, Jason, in terms of the week and two weeks, relatively modest impact. And we were only open for part of the day. And I would say even for the hours that we were open, our hourly sales were less than normal. It was the first time we opened on July 4.

We're not sure how many people knew we were open and people are not in their normal trading pattern. So, it had an impact, but not a very significant impact on the week or the two-week comp..

Okay.

And the last thing for me is just the comment that trends have been slow the last few days, down 5.5%, is that – you mean it slowed by 5.5 points from where you were running? Or are you saying it was down 5.5%?.

No, if you go back and look at like the last few Mondays, look at a normal Monday for the last two weeks, a normal Sunday, normal Friday, we're down from where we were running by 5.5%. So, it does not mean a negative 5.5% comp..

Okay. I'll pass it on. Thanks..

Thank you..

The next question comes from Nicole Miller with Piper Jaffray. Please go ahead..

Thanks, good afternoon. I just wanted to ask about the latest round of TV marketing. It ended with great money, yet you have ongoing BOGO offerings. So, what's the right balance between those messages and why? And I was just specifically wondering basically what's the brand proposition or value messaging at this point? Thanks..

Thanks, Nicole. So, the campaign that we ran in the spring actually included actually three different waves of television across one flight. So, what happened across those three waves of TV is that we actually changed the creative.

So, you may remember actually the campaign started with the comedian spots, and those were typically longer spots of 30 seconds.

But, as the campaign went on, we optimized it to ads that included more appetite appeal and it eventually ended up running predominantly something that we called the burrito assembly spots, which is the one you're referring to, the bring money spot. But all of these ads are part of the real ingredient marketing platform that we have.

You know, I think as you're probably aware, this spring we accomplished the ultimate removal of the very, very last preservatives and any other industrial additives in our food, leaving us with 51 real ingredients, all of which you could just go buy at the store and you'd recognize as a real ingredient.

So, the campaign across all the different facets of it is built on that platform. You'll see, though, different manifestations of it. On the digital ads and a lot of the online work that we do, we have an opportunity to be a little bit more descriptive and create a more immersive experience.

When you're on television, and particularly when you're on television in these 15-second formats, there's room for some appetite appeal and then we get some of the brand voice into it. What I mentioned in my prepared remarks is that we've continued to refine the creative.

I mentioned that that entire flight, although it improved from the beginning to the end because we morphed the creative, still has the opportunity to be way more effective in terms of driving the traffic into the restaurants.

So, the creative that we're going to be using for the upcoming flight of TV, which begins in mid-September, has gone even further on the appetite appeal side. And, as I mentioned, if we decide to roll queso nationally, will include queso. It also includes a comedic tone, although it's much more oriented toward the appetite appeal.

So again, the brand proposition is that Chipotle serves food that's delicious but made with real ingredients in a way that no other brand does and it manifests itself in different ways, depending on the actual medium that we're using. But hopefully that answers your question..

Thank you..

The next question comes from Andrew Charles with Cowen & Company. Please go ahead..

Great, thanks.

Obviously, a significant amount of robust drivers you guys are implementing, but Steve, what gives you the confidence that you guys have done enough here, just damage control, that last week's events just won't set off a similar sales pattern that persisted through 2016?.

Well, so, Andrew, we need to ensure that we do a much, much better job after the events of last week, and we take this very, very seriously. We conducted a thorough investigation and it revealed that our leadership there didn't strictly adhere to our company protocols. And we believe someone was working while sick.

And we took swift action and made it clear to the entire company that we have a zero policy for – zero -tolerance policy for not following these protocols. Our protocols are excellent.

I mean, these protocols were designed by leading experts on our food safety council and in-house by our food safety expert, Jim Marsden, and – but you need to ensure that you're following the protocols. They work. When followed, they work perfectly. So, I'm thrilled that we have Scott Boatwright joining us.

He's already brought a really high level of discipline and greater focus on the fundamentals of operating great restaurants. Something that we're getting better at, we were in the past, perhaps too focused on softer cultural kinds of things, but he's brought back a real rigor and I'd actually like to invite Scott to share his thoughts on this..

Thanks, Steve. Hi, Andrew. Steve's right, we conducted a thorough investigation of what transpired here in Sterling, and we found out it was very clear that procedures were not being followed as prescribed by Chipotle's rigorous standards.

I assure you that we've taken swift action on what's transpired there and making it clear to the entire organization that not following our procedures will have severe consequences.

Beyond that, we're putting in stronger measures in place to uncover when our procedures break down, and we will – we have and will continue to reinforce our zero policy – zero tolerance policy to our standards.

I've talked to Steve and the officers here, and what I plan to bring to the organization here at Chipotle is a maniacal focus on the fundamentals of our business, more specifically, ensuring the integrity of our training programs to lay a strong foundation for the organization's success.

This type of rigor and discipline has been absent from the brand for some time and we will re-instill, again, a maniacal focus on how we operate our business and one best way to run a Chipotle restaurant.

I will say, after spending several weeks in training in our restaurants since joining the brand, I am inspired by the uniqueness of our offerings, the quality and the freshness of our products, and the culinary skills that go into preparing our foods on a consistent daily basis.

I'm also inspired by the wonderful people throughout the Chipotle family, specifically in our restaurants that work tirelessly every day to not only deliver a great and consistent guest experience, but also ensure the safety of our food really nationwide.

It's unfortunate that this incident happened on the heels of again what transpired months prior, but I assure you that we will get back to the discipline and the rigor necessary to ensure that we protect our employees and our guests as we move forward..

That's helpful. And just one more for Jack.

As we kind of think longer term here, historically, even as kind of the margin sensitivities to different levels of AUV recovery; can you just refresh us on that? Just anything else we should be thinking over those numbers that you presented a few quarters ago, are those still intact?.

Yeah, they're still intact. We're within striking distance of 20% right now. We're not getting any help from avocados, although avocados has – the pricing has receded recently. If we can also build some complement, and we do have some exciting new news ahead with technology that Curt talked about with queso.

And queso is by far the most requested item we've ever had, and so if we can build some – complement them, get a break from the cost of avocados, we can push up to that 20% level at this current sales volume.

And then as we continue to gain complement them, as we move from just about 2 million to 2.2 million to 2.4 million, we can step-by-step recover our entire economic model. Some of that will require offsetting some inflation.

We've eaten inflation now for more than three years, we've absorbed the highest labor inflation that we've ever seen over a three-year period, so that's eaten into the model, but we think that with a little help from avocados, build and complement them, and passing on some of the inflationary costs to our customers we can get our full margin back..

That's helpful, thank you..

Thanks, Andrew..

The next question comes from David Tarantino with Baird. Please go ahead..

Hi, good afternoon. Just a question on the sales trends that you were seeing, I guess, before the latest norovirus incident. The two-year comp, or however you want to look at it on a seasonally adjusted basis, looked to be holding very steady, despite a lot of effort to drive improvements in the operations and launch new advertising programs.

So, I'm just wondering sort of what your thoughts are on why you haven't seen more improvement to date.

Is there anything in your metrics that would suggest you're not making progress in certain areas in the operations? Or if there's something else going on that's preventing that sales recovery?.

David, nothing that stands out. We can definitely get better at operations.

You've heard us say that we spent more time than we should have over the last few years with more of the feel and the culture in the restaurant and not enough in the rigor of great training and good, solid culinary skills and running a good operation such that the restaurants get a great experience every single time.

And that's something that we're recommitted to. Scott, as Steve mentioned, as you heard from Scott, is bringing a huge commitment to get those fundamentals back because that's something we're going to continue to work on. But we came to the conclusion recently that our sales did improve.

We were down on a two-year basis at about 21% in January and as we closed last year, so we did pick up some momentum to get down to the 17.5%, but we came to the conclusion that we need new news and we think that queso, we think, is going to help us with that new news and we're excited about the tests to come.

With that, Mark may have some comments as well about the customer and what it means as well..

Sure, David, I can add a little bit to it.

I mean, one of the things we've encountered, and this has been true really since throughout all of 2016, and we're actually seeing evidence of this in the middle – beginning in to the middle of 2015 is that our customers really do want to see something new from Chipotle and there's a lot of pent-up demand for this.

And in the type of marketing that we do, it's incredibly effective to have something new and exciting for customers to come in and enjoy. And so, we've been up against trying to claw back occasions that were lost to other competitors, of which there are very, very many, of course, now in this category.

And as we studied our customers, they fall into several different categories, but within the lapsed categories we have people who are called lapsed defectors and then lapsed rejectors.

And when you look at these different types of customers, the majority of these fall into lapsed defectors, so these are people who used to be regular Chipotle customers and now are very, very infrequent at the cadence of maybe once a year or they stopped coming altogether, and these customers, when we talk to them in research, have a couple of primary objectives which are interesting.

I mean, one is that we saw boredom as the number one. And second, as no queso.

So, we're talking a lot about this one particular menu item, but I shouldn't underestimate how much potential it has, and then when you combine it with some of the other things that we're looking at doing, it really could add a lot of momentum to the marketing programs that we've had.

So, I'm very encouraged by all this, so hopefully that gives you a little bit of perspective into why maybe some of our marketing hasn't driven as hard as we would like..

I guess and if I could just follow up on that, if I may.

I guess on the whole notion that customers asking for something new, does this mark a change in the philosophy at Chipotle? Because, I guess, the business was built around sort of simple and focused execution, as you mentioned in your prepared remarks, Steve, and now we're talking about new products and putting advertising behind them, which sounds a lot more like a traditional approach in the restaurants category.

So, I just wonder, I guess, if you could comment on whether you think there's a new reality at Chipotle where we're going to need to see new menu items to drive traffic on a longer-term basis..

Sure. Well, so these new menu items come out of a desire to look more strategically at what Chipotle might look like in the future, not only menu item-wise, but how we cook in the kitchen, how our restaurants are set up, how the digital experience might be part of it, all sorts of things.

And the Next Kitchen has told us a lot about what the future might look like and it's very, very promising.

You know, when I've said over the past many years that we have a desire to keep things simple so that we can execute at a high level and that our menu didn't grow, it was really a desire to make sure that we did execute at a very, very high level.

Let me give you an example of an innovation in the Next Kitchen that actually has created something that's much more appealing and much easier for the crews to execute and much faster, and that is margaritas. For years, we individually mixed margaritas and shook them per order, taking a couple of minutes per customer.

We installed a frozen margarita machine where we still use fresh citrus and make the mix ourselves in the restaurant, but then dispense it out of a frozen margarita machine, so it's actually preferred by our customers and operationally it's much easier. And so, we really need to be open to exploring ways where we can do things differently.

You know, queso is an interesting one in that the main reason we rejected queso in the earlier days is because we couldn't come up with a recipe that didn't have a bunch of the kinds of ingredients that we don't want to serve, the kinds of ingredients that are really part of processed food. And so, we came up with a recipe that we like.

It's a clean recipe and it's a delicious recipe, and operationally, queso is very, very easy for our teams and for our customers. So, we're going to put it in a couple of markets and test it, and I think we're going to be happy with the results.

We're going to test other things, too, David, but we'll test these things in the Next Kitchen with an eye toward operational ease, to make sure that we can offer the very, very highest quality experience.

I will also add that our training in the past was not as perhaps – it wasn't specifically designed for new menu items, and since we've made advancements in our training technology, I think we're much more prepared to try new stuff.

One of the tools that we have now available in our restaurant kitchens for training is a digital system and a tablet where we can play videos to show people new procedures, and that just wasn't available years ago. So, I think we're well-positioned to try new stuff that will be very efficient and delicious, too..

Great. Thank you..

The next question comes from the Will Slabaugh with Stephens. Please go ahead..

Thanks, guys. Wonder if you could give us a little more color on the update on where we are from a digital standpoint. You mentioned mobile order and pay and a new app launching soon.

Can you talk about the stats around that, the growth that you're seeing there? And then also where we stand with loyalty, if there's any stats you're willing to give around that?.

Yeah, thanks for the question. Well, I said in the prepared remarks that we have seen the highest increase in our digital properties on our web ordering platform, which is the platform that has seen the most innovation.

Earlier in the year, we moved to a responsive online ordering site that gave our customers a fresh, new experience with Chipotle when they ordered digitally. That responsive ordering site automatically optimizes itself based upon the device you're using, so, if you're using a phone, it portrays itself like an app.

If you're using a tablet, it portrays itself like a tablet system, and likewise for a laptop or desktop. We're encouraged with that growth because we're now to the point where we're going to make a similar release of innovation in a dedicated ordering app.

And as I said, we haven't made a change to that platform for several years and the folks that use that app tend to be our most regular customers because they've taken the step to download it and install it on their device.

Even without making those changes to date, and we expect the new app in the first part of the fourth quarter, we've seen a 38% increase in mobile ordering because of the efficiencies that we've been able to drive with meal customizations and also because of the emphasis that's been put into the restaurants operationally around staffing and running the dedicated second-make line that already exists in the majority of our restaurants.

As it relates to our loyalty program, the new app will also offer digital offers for the first time, and we see that as the first step towards what a loyalty program would look like for Chipotle..

Got you. And if I could just do a quick follow-up on a comment you made earlier. Jack, you mentioned the core to-date comp, and I apologize for going back to this, so I wanted to make sure I was clear. So, you mentioned if you held the two-year through the quarter you'd be at, I think you said a 5.6%.

Was that the trend the first couple of weeks on a one-year basis of 5.5%-ish or so? Or was it a little below that, depending on your comps?.

No, no, no. What I was trying to say is that the trend in the first two weeks was still at that two-year trend of like down 17.5%. If we were to hold a 17.5% two-year trend throughout the whole quarter, our comp for Q3 this year would be 5.6%..

Got you. So, we're somewhat below that the first couple of weeks..

Yeah, the comparison, like I said, especially in that second week were tougher, but we've seen consistently throughout the last two, three months that we've held that kind of two-year trend, and so when we've gone against tougher comparisons, easier comparisons, you'll see the current year comp bounce up and down, but the two-year has been pretty darn consistent throughout..

Got you. Thank you..

Thanks, Will..

The next question comes from David Palmer with RBC Capital Markets. Please go ahead..

Thanks. Just revisiting the two major drivers that I thought about from last quarter, which were the marketing and digital, and Mark, you were talking about the marketing and perhaps adjusting the creative. How much do you think is the creative versus not really having the news yet? Menu news or value news is traditionally what we see in restaurants.

You're talking about queso, do you think the advertising and queso kind of need each other? And is that – how much of that do you think is the issue?.

Yeah, I mean I've said consistently for years that one of the reasons we haven't done television in the past was, well, one, early days we didn't have really enough restaurants to make it as efficient as it needed to be, but we passed that several years ago.

More of the reasons I said we didn't do television was because we don't have the types of offerings that really lend themselves to these formats, and particularly now, the most pervasive TV format is a 15-second spot. So, the way you said it I think is exactly right. I mean, I think the advertising kind of needs queso.

I mean we're in a really unique position right now in that we're restoring a brand that's lost a bunch of customers, and at the same time, trying to bring in new customers, and so, when you look at something like queso, it's a really interesting product because let's just compare it to, say, a dessert, for example.

Queso is something that could attract new customers, could attract lapsed customers, could increase frequency of existing customers, and then also have the ability to increase check average.

It hits on all four, whereas, if you look at a dessert, it's unlikely that you're going to get somebody who's a competitor's customer to come to Chipotle because of that, whereas we know that it's one of the main reasons why people reject Chipotle that we don't have queso.

So, that – it's one of the reasons why I'm excited about the potential to actually add it into the television campaign this fall.

So, I do think that the entry into television accomplished what I predicted it would when we did it last year and then in the spring, which was it delivered outsized reach that's very efficient, so it's a great way to reach a lot of people.

But absent a compelling reason why people should get up and come in, it's going to be reduced in terms of its potential, and so we have that now. So, yeah, I mean, I do expect that given it's in television that this sort of thing is going to be pretty effective..

And just one other follow-up, the digital front, it seems like similarly digital seems to need delivery to really be leveraged.

You get an incremental user from remote order, if it's a high-volume store and they're trying to really avoid all that negative time of waiting in the line, but do you feel like delivery is the big unlock on that? And where are you on that?.

Thank you, David. I agree that delivery is important and we integrated delivery into our second make line earlier in the year and have seen a substantial increase in the number of guests that are taking advantage of that functionality, talking specifically around web and app ordering.

Our vision for the future is to integrate that experience more directly into the online and mobile sites, because now customers that are taking advantage of that service tend to go to the service provider site first and order from there, and we'd like to give them the option as they're checking out through Chipotle.

So, that is certainly one of the areas that we're investigating and investing in as part of our digital roadmap. We've also launched delivery for catering in about 1,000 restaurants in the quarter.

But we've not advertised that yet, as we're getting our teams spooled up for what that order volume looks like, but have a plan to make that part of our digital advertising campaign in the fall as we get back to what is typically a heavy season for us in terms of catering..

Thank you..

The last question comes from John Glass with Morgan Stanley. Please go ahead..

Thanks very much. First, just on the food incident that happened a couple – a week ago, I guess.

How – were comps declining or were they softening across the country? Was it just a geographic concentration and by the time you got to California consumers didn't really notice? How widespread or concentrated was the decline in comps relative to prior trend?.

Yeah, John, as you can imagine, it's much more intense in that area. If you take the entire market, the dozens or the – 30, 40, 50 stores around there, they were hit the most, but this did receive national news.

And so, if you look at every single market, every market was impacted, but it was obviously much heavier in the mid-Atlantic region and the rest of the country, so pretty much every market did see some impact..

Okay.

And then on store openings, how do you think about – what changes you view on how fast you want to grow in this environment given the competitive environment, still some operational challenges you need to overcome, some customer reacquisition? Is it – what metrics are you looking at to say, listen, maybe growing slow and focusing on the base is a better idea? And maybe, Jack, can you just talk about how the class of 2016 has performed a year out from when they initially opened to maybe how your class of 2017 is performing year-to-date?.

John, I'll go ahead and answer that. In early 2016, we reevaluated our approach to the restaurant portfolio. We focused, at that time, on proven markets, we reduced our development costs, they're now down at $760,000, and we began to support all openings with marketing.

As a result, the new restaurant sales are actually improving at a faster rate than the rest of our restaurants. So, right now we recovered about a third of our sales volume from the pre-2015 incidents, whereas, for the restaurants in the company as a whole, we've recovered a little more than a sixth.

So, right now when you look at these group of rookie restaurants, they are delivering us an ROI of 31%, which continues to be compelling to us, and that is up from 15% in 2016. Of course, it's off of the 55% ROI we saw prior to the incident in 2015, but it's still very compelling.

So, the triggers that would cause us to change our approach to development are essentially our ability to operate the restaurants at the level that we want to, and so we're constantly talking to our operations team and we've made some adjustments to the way we're opening the restaurants.

We've pulled back in some markets, in the Northeast we've slowed, we've pushed openings. We've reduced the number of openings in new markets and in remote markets, which are particularly challenging for the ops team to support.

But we're constantly having a dialogue, and we just had one again yesterday with Scott about his feeling about our ability to continue to support these openings, and at the moment, Scott asks us to pull back on these things for those reasons, we'll do it.

Having said that, you can appreciate that this portfolio or this pipeline is two years in the making, and so, changes to it takes some time. But that's the reason why we would pull back on these things, and yet we – and we'll be constantly re-evaluating that. Of course, the events of late could have some impact.

It's way too early right now to tell what the ongoing impact of this is going to be.

Yes, Steve, do you want to add?.

Yeah, John, the only thing I'd add is similar to prior years, the newest stores, so those opened in the last 12 months to 18 months, are the highest comping stores. So, they opened up at a respectable volume, they opened up at a respectful return, even at these lower volumes, and then they're the fastest growing.

The only thing I would add is, while we're focusing on training, our most structured training right now happens in new stores. It's a new-store, dedicated team. It's not fragmented as you go from region to region to region, and so the training is more thorough than hiring new people in an existing store, new crew in an existing store.

And it's more consistent. And so, we have some of our best welcoming of new people into our new restaurants just because we have this better training approach. Frankly, what we'd like to do is, Scott is looking into this, is take that same regimented, very thorough approach and make sure that we have a more thorough approach across the entire company.

So, from a people standpoint and from an opening standpoint and then from a comp growth standpoint, it all suggests to us that we should keep going at this measured pace. It's lower than we were a few years ago, but we think we should be thoughtful about going at a measured pace..

Thank you..

Thanks, John..

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to Mark Alexee for closing remarks..

Great. Thanks, everyone for your time today. We really appreciate it. We look forward to sharing our third quarter results with you, which is planned again for October 24. Great, and have a great day..

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