Earnings Call: Q3 2013

Oct 17, 2013

Good afternoon, and welcome to the Chipotle Mexican Grill Third Quarter 13 Earnings Conference Call. As a reminder, this conference is being recorded. I would now like to introduce Chipotle's Director of Investor Relations, Alex Fong. You may begin. Thanks, Amber. Hello, everyone, and welcome to our call today. By now, you should have access to our earnings announcement released this afternoon for the Q3 2013. It may also be found on our website at chipotle.com at 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 projections of the number of restaurants we intend to open, comp restaurant sales increases, potential menu price increases, trend in food costs, marketing spend, G and A and other expense items, effective tax rates, stock repurchases and shareholder returns 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 the annual report on Form 10 ks as updated in our subsequent Form 10 Qs for a discussion of these risks. Our discussion today will include non GAAP financial measures, a reconciliation of which can be found on the presentation page of the Investor Relations section of our website. I'd like to remind everyone that we've adopted a self imposed quiet period restricting communications with investors during that period. The quiet period begins in the 1st day of the last month of each fiscal quarter and continues until the next earnings conference call. For the Q4, it will begin in January and continue through our Q4 release. On the call with us today are Steve Ells, our Chairman and Co Chief Executive Officer Monty Moran, Co Chief Executive Officer and Jack Hartung, Chief Financial Officer. With that, I will turn the call over to Steve. Thanks, Alex. I'm pleased with our results for the Q3 and the continued strength of our business throughout the year. During the quarter, we generated revenue of $826,900,000 an increase of 18% from the Q3 of 2012. Comparable restaurant sales grew by 6.2% in the quarter and diluted earnings per share increased 17.2% to $2.66 These results are the product of our combined focus of our special food and our special people cultures. This focus is helping us realize our vision of changing the way people think about and eat fast food. Throughout the quarter, we continue to make progress in each of these areas. We introduced more customers to the new menu item Sofrita's, expanding our catering program, continued our quest to remove GMOs from our food, developed more restaurant tours and field leaders, brought our field leadership together for a conference to share thoughts on how they might become more successful and continue to nurture the seeds we have planted for our future growth. During the quarter, we expanded the rollout of Safrita's, the vegan option we have been testing in our West Coast restaurants, and that is now available in all of our restaurants in California, Oregon, Washington, Colorado, New Mexico, Idaho and Utah, or about 25% of the restaurants overall. Recall that Sofritos is an organic artisan tofu that is braised with Chipotle peppers, roasted poblanos and a blend of aromatic herbs and spices. We're encouraged by what we're seeing with Sofrita so far. It currently accounts for over 4% of sales in the restaurants where it's offered. And our customers, including vegans, vegetarians and meat eaters alike, really seem to enjoy its complex and bold flavors. In developing Saprita's, our aim was to create a menu item that would offer additional offer another delicious option for our vegan and vegetarian customers that would also appeal to meat eaters who might want an occasional meat free option and that would fit into our service line and not burden our operations or throughput. So far, we are seeing success in each of these areas as about 50% of Sofrita sales seem to be coming from vegan and vegetarian customers and about 50% coming from customers who are substituting Sofrita's for one of our meat options. Our Chicago, Baltimore, Philadelphia, Richmond and Washington D. C. Restaurants will begin testing Sofritas on October 21. And by the end of the year, we plan on having over vegetarian customers is the removal of bacon from our pinto beans. From the beginning, our pinto bean recipe included a small amount of bacon. In testing some different recipes for pinto beans, we determined that the bacon was not adding to the flavor in a meaningful way and that removing the bacon would not negatively impact the taste of our pinto beans. In fact, we noticed that the smoky background notes come mainly from the addition of Chipotle peppers and not the bacon. By removing the bacon, we are widening the appeal of pinto beans to even more customers, including those who may have other dietary restrictions. And I'm pleased to report that we have already phased the new bacon free pinto bean recipe into all of our restaurants. Our efforts to replace GMOs in our food with non GMO ingredients is an important focus for us in our ongoing quest to improve the quality of our ingredients. There is considerable debate right now about the environmental, health and economic implications of GMOs in food and more than 60 countries have restricted or prohibited certain GMO foods. Given the lack of consensus regarding the impact of GMOs, we feel that it's best not to use them in our food. In March, Chipotle became the 1st national restaurant company to voluntarily disclose the presence of GMOs in the ingredients we use in our restaurants. And while these and other GMO ingredients can be found in the food in virtually all national restaurant companies, we have been working quickly to remove non GMO working quickly to move to non GMO alternatives. We are also making progress in our marketing efforts to help get customers thinking about where their food comes from and how it's prepared. During the quarter, we hosted our Cultivate Festivals in both Denver and Chicago, following the San Francisco event earlier this year. In all, these festivals drew over 100,000 attendees who came to enjoy live music, celebrity chef demos and to learn more about food Chipotle serves and how it's prepared. Each event includes a number of important Chipotle experiences where attendees can learn more about our ingredients, the elimination of antibiotics and added hormones, alternative to processed foods and more. Visiting 4 or more of the experiences earns attendees a free burrito at Chipotle. Additionally, the advertising and PR outreach surrounding the events has shown to have a strong positive impact on the perception of Chipotle, even for people who only see the advertising or PR and do not actually attend the event. During the quarter, we also released an animated film and an arcade style game called The Scarecrow. The film immediately went viral across Facebook, Twitter and YouTube. Since its release, the film has been viewed more than 7,000,000 times online and the game has been downloaded more than a half a 1000000 times. We supported the game with a small online and mobile advertising campaign along with a PR outreach, which has generated more than 500,000,000 media impressions so far. In making The Scarecrow, our aim was to generate curiosity about where food comes from and how it's prepared. The film is set in a future world where all food is produced and processed by the fictional company Crow Foods. The film also depicts the lengths that Crow Foods goes to in order to obscure the truth from unsuspecting customers. The film is a cautionary tale about the future we may all encounter unless we commit to producing affordable, helpful food in more sustainable ways. Ultimately, our aim in making the film was to spark conversation about these issues and that has certainly happened since the film was released. To help keep Chipotle top of mind with customers, we have continued to run our skillfully made advertising campaign in Chipotle markets around the country. Results of this advertising are encouraging as the campaign appears to be resonating with consumers. During the course of the campaign, we saw noticeable sales lifts in sales comps and average daily sales compared to our non advertising markets. Other wave of this campaign began in August in proven and mature markets and will continue through October. Finally, in the quarter, we opened a 3rd Shophouse, this one in Washington DC's Georgetown neighborhood. We will open several more Shophouse locations, all in the Washington DC and Los Angeles areas over the next 12 months or so. We also opened our first Chipotle in Frankfurt, Germany bringing our total number of international restaurants to 14. We continue to view both Shophouse and our international expansion as future growth opportunities rather than near term drivers of our growth. And we will continue to carefully support these growth seeds as we develop them for long term success. Shophouse is the first test of our belief that Chipotle success is not dependent on serving burritos and tacos, but rather is rooted in our commitment to finding the very best ingredients, preparing them using classical cooking techniques, welcoming our customers into a space that is thoughtful and that says something about the food we serve and developing teams of top performers that are empowered to achieve high standards and create a welcoming customer experience. Our restaurant in Germany opened in September and we are encouraged by its strong performance in the 1st few weeks of operation. But I would remind you that opening Chipotle restaurants in the U. S. Will continue to be the primary driver of our growth for the foreseeable future. I'll now turn the call over to Monty. Thank you, Steve. To advance our objective of developing restaurant cultures with teams of all top performers who are empowered to achieve high standards, we held a field leadership conference in Las Vegas last month. Our aim in hosting this meeting was to bring together all of our field leaders, restaurant tours, apprentice team leaders, area managers, team leaders, team directors and regional directors to lay out very clear expectations about their priorities and to provide them with tools to help them with the most vital aspects of their jobs, which is developing restaurant tourism and restauranteur cultures. To help better prepare our field leaders to do this, we clearly laid out expectations for them in terms of how to best use their time in the restaurants. We shared new tools with them to help them identify and diagnose opportunities in their restaurants, and we conveyed thoughts on how they can dedicate themselves fully to developing teams of top performers empowered to achieve high standards. We continue to make progress in developing and expanding our restauranteur program by developing 28 new restauranteur in the quarter, which now gives us a total of 409 restauranteurs, 40 apprentice team leaders as well as 47 team leaders. But I know we can do much better and I'm confident that we will over the next year because our field leadership structure is better staffed, the tools we provided at the conference are the best and most impactful we've ever had and we experienced the incredible energy and commitment of our field leaders at the conference and as they were leaving the conference to go back to their patches. So while I'm happy with our current development of restaurant tour cultures in our restaurants, I do expect to see a significant uptick over the next few quarters in terms of restaurant tour development. We also talked at our conference about the importance of leading our teams to provide great throughput since this is key to providing a great customer experience and driving our unit economic model. During the quarter, we made strong progress in delivering faster throughput in our restaurants at the busiest times of the day. In the Q3, we saw our throughput increase by an average of about 5 transactions during the peak lunch hour rush, and our lunch comp has just about caught up to our all day comp. This is on top of last year's increase of 4 transactions during lunch. In addition, our throughput also improved during the dinner rush between 6 and 7 p. M. By 4 transactions in the Q3. We expect to see further improvement to these already high levels as we continue to emphasize and teach the 4 pillars of throughput to our crews and to our field leaders. While you've heard me talk about these 4 pillars for some time now, we still have a significant opportunity to execute them consistently, which we know is going to lead to even faster throughput. And we now have better tools in place to identify exactly where our greatest throughput opportunities lie. For example, you've heard me say that of the 4 pillars, the expediter is the most important because this person speeds up the slowest part of our line, which is the cash register. Our new tools demonstrate the incredible opportunity as it shows that we are deploying an expediter in our restaurants during the lunch peak hour only 65% of the time. In other words, 35% of the time that person is not in place. If they were in place, we'd go even faster. Having a line backer in place is also critical during the lunch rush to ensure that the frontline has great communication with the kitchen, that food is flowing smoothly from the kitchen to the line and that our line staff can focus 100% of their attention on the customer at all times to provide a great and speedy customer experience. But again, while it's critical to have this position for fast throughput, our new tools show us that we have this dedicated linebacker in place only 73% of the time. We also know that some of our markets are showing very strong dedication to the 4 pillars. For example, our team director is Steven Hart on the West Coast, has a dedicated linebacker in his restaurants 96% of the time at lunch and Laura Martinez and Travis Moe, both team directors in the central region have dedicated linebackers about 80% of the time. This has led to them having very impressive gains in speed of service. All of our field leaders know the importance of consistently executing the 4 throughput pillars, but now we have tools in place so that they know exactly which markets and which specific Given the improved strength of our field leadership team, we know that we will improve even more in this regard in the coming months and that with these improvements, our guest experience will be even better. Another significant accomplishment at our field leadership conference was the rollout of a new tool that helps our field leaders write specific plans to help their general managers become restaurant tours more quickly. Using this tool, our field leaders will provide quarterly plans for every single general manager in the company, which we believe will improve our ability to develop more restaurant cultures throughout the company more quickly. The tool asks field leaders to use the symptoms that they see in the restaurant to identify themes that once corrected will allow our general managers to create a more empowering culture in their restaurants and ultimately our restaurant tour culture. Let me now give you an update on the catering program we launched in January and how we're expanding our ability to bring the Chipotle experience to more people outside of our restaurants. On October 7, we rolled catering out to 17 more markets serving an additional 460 restaurants. And next week on October 21, we're going to roll catering out to all the remaining restaurants in the United States with the exception of New York City, which is going to be rolled out in 2014. We remain encouraged by the performance of our catering program. Overall, for restaurants that are offering catering, we're already seeing catering sales approach 1% of total sales with most of this being incremental. We will also be starting our 1st national catering promotion in mid November in time for the holiday party season. We believe catering is off to a promising start and showing great potential as we continue to roll this program out across the country and as more customers have an opportunity to try it out. During the Q3, we opened 37 new restaurants for a total of 129 restaurants year to date. Total company wide restaurants totaled 1539 at the end of the 3rd quarter, which includes 3 shophouses, 6 restaurants in London, 5 in Toronto and 1 each in Vancouver, Paris and Frankfurt. Based on our year to date openings and our scheduled openings for the balance of the year, we are confident that we will meet or exceed the high end of our guidance range of between 165 and 180 new restaurant openings. I'm pleased to report that our real estate pipeline continues to look very solid right now, and we can now announce that we expect to open between 180195 new restaurants in 2014, which gives us confidence that we can continue with strong unit growth next year and beyond. I'd like to now turn the call over to Jack Hartung. Thanks, Bonnie. We are pleased with the strength of the underlying business trends during the Q3. Despite operating in a very competitive industry and with mixed signals about the strength of consumer demand, we continue to show improved traffic as more and more people chose to visit our restaurants. Our top performing crews and management teams continue to delight new and existing customers by providing an exceptional dining experience to our customers during each and every visit. Our same store sales were up 6 2% in the Q3 and our average sales volume for restaurants that have been open for at least 12 months is $2,140,000 the highest it has ever been. Overall sales for the quarter increased 18 percent to $826,900,000 driven by new restaurant openings and a comp of 6.2%. Year to date sales were $2,370,000,000 an increase of 16.7%. The quarter year to date comp increase was driven by increased customer visits. We pleased to see our underlying transactions accelerate sequentially during the year from an underlying comp of 3% in the first quarter to an effective 4.5% comp in Q2 to the 6.2% comp we saw in the Q3. Our improving sales trends are benefiting from the greater awareness we believe we're achieving with our marketing campaign, as Steve talked about, as well as from faster throughput, as Monty mentioned. Our comps accelerated around the end of July or beginning of August and have continued at that higher level through September and now into October. Assuming these trends continue through the rest of the year, we would expect Q4 comps will be similar or slightly better than what we saw in Q3. As a result of these stronger trends, we're raising our full year sales comp guidance for 2013 to mid single digits, up from our previous guidance of low to mid single digits. As we look to 2014, we expect comps in the low single digit range excluding the impact of any future menu price increase. And I'll talk about how we're currently thinking about menu prices a little later. We expect to end the year with a total new restaurant openings at or above the high end of 165 to 180 opening range. And in 2014, in light of our strong real estate pipeline, we expect to increase our new restaurant openings to a range of 180 to 195 new restaurants. And our new restaurants continue to perform very well. And as a result, we now expect opening sales volumes in the $1,600,000 to $1,700,000 range, up from our previous expected range of $1,500,000 to $1,600,000 These new restaurant opening volumes along with our current comp trends and strong margins allow us to deliver industry leading unit economics and returns for both our new and existing restaurants. Diluted earnings per share for the quarter was $2.66 an increase of 17.2%. Our operating margins were down 20 basis points to 16.6 percent, while restaurant level margins were down 60 basis points to 26.8% compared to last year. This higher food and other operating costs more than offset sales leverage in the labor and occupancy lines. Year to date diluted earnings per share was $7.93 an increase of 16.7% over last year. Restaurant level margins year to date were 26.9 percent, a decrease of 110 basis points, primarily due to higher food costs as labor leverage was offset by the higher other operating costs. Food costs were 33.6 percent in the quarter, up 50 basis points from Q2, primarily related to the higher cost of California avocados, which as we mentioned on our last call, have been challenging from a supply standpoint and therefore are more costly. To a lesser extent, our tomato salsa costs also increased a bit in the quarter due to adverse weather on the East Coast causing us to incur higher shipping costs to some of our East Coast markets as we were forced to source from other distant suppliers. Our tomatoes on the East Coast will continue to cost more until next month when tomatoes will begin to be harvested from nearby Florida. Compared to Q3 last year, our food cost was up 90 basis points due to higher prices for all of our salsa ingredients, our tomatoes, corn and tomatoes, as well as higher costs for dairy and chicken. We're also beginning to see higher oil costs as we convert from GMO soy oil to non GMO sunflower and rice bran oil. On a sequential basis going forward, we expect our food cost to remain in this 33.5% to 34% range for the next few quarters or so, as we expect continued pressure from avocados as suppliers in Mexico are expecting near term supply constraints, which combined with rising demand for avocados will keep the costs at an elevated level. And we hope that inflation on the rest of our produce and our meat will be relatively tame. As a result of this elevated food cost level and with expectations of making additional investments in moving to non GMO ingredients for all of our food by sometime next year, we expect to raise prices sometime in 2014. Now while the timing is difficult to predict as we still have work to do to remove GMOs from our ingredients, a price increase around mid year is a reasonable assumption. Labor costs were 22.8 percent of sales in the quarter, a decrease of 40 basis points from last year, driven by the higher sales comps. Labor leverage was a little better than we might normally expect, as our average crew labor rates were similar to last year, as we were able to offset higher wages from inflation with lower overtime as a result of better staffing levels at the restaurants. Year to date labor costs were also down 40 basis points and we expect labor costs as a percent of sales will move higher in the 4th quarter due to seasonally lower sales. Other operating costs were 10 point 8% for the quarter, an increase of 30 basis points and year to date other operating costs were 10.6%, up 40 basis points from last year. In the quarter, other operating costs moved higher primarily from higher marketing which were 1.55 percent in the quarter, up 15 basis points from last year and year to date were 1.4% or up 30 basis points from last year. We expect marketing to be at a similar level in the 4th quarter and to step up to around 1.7% in 2014. G and A was 6.4% in the quarter, 50 basis points lower than last year. And remember that last September, we held our 3rd Biennial All Manager Conference, which will also occur in 2014. The conference cost about $5,500,000 in 2012 and will cost an estimated 7,500,000 dollars to $8,000,000 next year, as we expect about 2,300 managers and sports staff to attend. The decrease from the all manager conference held in 2012 was partially offset by higher legal costs. G and A includes non cash, non economic stock comp expense of nearly $16,000,000 in the quarter and nearly $50,000,000 for the year so far. And we continue to expect non cash stock comp for the full year to be around $66,000,000 Our annual burrito promotion and fundraising event will add about $1,000,000 in G and A in the 4th quarter, which will benefit the Chipotle Cultivate Foundation. In 2014, we expect to manage our underlying G and A to grow at a slower rate than sales before considering the impact of the all manager conference and before any increase in the non cash stock comp. Of course, the stock comp next year will depend on the stock at the time of grant and the number of options issued. But if a similar number of options were granted next year, with a strike price equal to about the current stock price, the accounting charge for non cash stock comp would be about $75,000,000 compared to about $66,000,000 this year. We expect our effective tax rate for 2013 to be 38.9 percent. In 2014, the tax rate will rise to about 39.9 percent without the benefit from the work opportunity tax credit and the R and D tax credit. If these credits are renewed by Congress for 2014, our rate will be lower by about 50 basis points. During the quarter, we repurchased about $17,000,000 worth of our stock or over 41,000 shares at an average share price $402 At the end of the Q3, we still had nearly $103,000,000 left on our share buyback program previously approved by our Board. And over the last 5 years, we've invested nearly $600,000,000 to purchase about 4,000,000 shares at an overall average price of 148 dollars per share. We finished the 3rd quarter with over $835,000,000 in cash and investments with no debt on the balance sheet, And we continue to believe that the best use of our cash is to invest in our high returning restaurants and we'll continue to plant seeds for future growth, including Shophouse and Chipotle outside the U. S. In the meantime, we'll continue to opportunistically repurchase our stock to enhance shareholder value. Thanks for your time today. At this time, we'd be happy to answer any questions you may have. Operator, please open the lines. Yes. Thank We'll go to Matthew DiFrisco with Lazard Capital. Thank you very much. I was just curious about sort of the international strategy and the success that you were speaking of as far as the volumes in the U. S. Can you speak about the volumes that you're seeing internationally in respective markets and what that might mean for growth in 'fourteen and beyond as far as more meaningful growth potentially? Yes. I would still expect over the next year or so that international won't be a very large part of our growth. We're still in the brand building phase. There's still the vast majority of people in the markets we're in, in we're in and outside the U. S. Are not yet aware of Chipotle. We're seeing nice growth trends in the restaurants that we've opened. Most of the restaurants we've opened in London, for example, have gone comp and the comps, we're very pleased with the comps. But the awareness level is still very low. People are still figuring this out. And so I would expect to not see the number of restaurants be meaningful part of our growth. And in terms of sales, the sales are when you convert to dollars are attractive, I would call them in the same ballpark. We're similar level to what we're seeing in the U. S. But because costs are much higher, we're in major cities there, the rents are higher, there are social costs that are higher as well. So that as awareness build, we expect those volumes will grow over time to a much more significant level than our averages in the U. S. And then Shophouse as well, are they seeing similar type volumes? Or is that too early to tell in the L. A. Market? I think it's too early to talk about the volumes of Shophouse. I would say though, we're really focused on building a great in store experience and introducing a new kind of Asian cuisine than most fast food customers are accustomed to. And if I compare teaching them about this new kind of cuisine and the ordering system, It's much the same as it was at Chipotle 20 years ago. I would say though that it's going a lot faster. Our growth at Shophouse is much faster than Chipotle was in the early days. But really now, we're just building better awareness and improving on the customer experience and introducing people to a new kind of Asian cuisine. And if we do this all very well, I think be preparing ourselves for future growth potential, which is really what it's all about. Excellent. Thank you very much. We'll go next to Jason West with Deutsche Bank. Yes. Thanks. Just a question around the pricing. Can you guys talk about sort of magnitude what that might be? And the timing, I think you said mid year, I mean, I guess what would skew your thinking there earlier or later in the year? Yes. Jason, we're not going to make a decision today on pricing, but I think that it's probably in kind of a mid single digit range, whether that's 3%, 4%, 5% kind of percent. What it will depend on is what happens with general ingredient inflation between now and then, and then what it costs us to remove GMOs from the rest of our ingredients. So once we have all that information at hand, we'll be able to do a better job of figuring out what the price increase might be. And in terms of timing, it's really hinging more on removing GMOs. We'd really like to make more progress, understand what that's going to cost, how much time that's going to take, all that kind of stuff. And then we'll feel better about coordinating a price increase around the time that we're moving GMOs. And we think that there might be a PR opportunity as well. We think it will be a pretty exciting time for us when we can announce that. We're not aware of any other restaurant company anywhere near our size that's even attempting to do this. And so to actually it will be pretty exciting and we'd like to time kind of that excitement around with the price increase. Okay. That's helpful. And then just one other one on the throughput opportunity. Monty, you talked about some nice lifts in the peak launch period, I think 5 transactions Can you remind us what the sensitivity is to comps per say each transaction per hour improvement that you see on throughput and so kind of how that flows through comps? Yes, Jason, it really, really depends store by store. I mean, we generally say that there isn't a direct tie to comps in the sense that if you have a certain amount of people in line at lunch and you go faster, you might serve them from the 12 to 1 hour as opposed to the 1 to 2 hours. So in various quarters in the past, you've heard me say that at times we've had an increase in the comp sales or actually the or comp transactions in the peak lunch hour only to lose a few in the 1 to 2 o'clock hour sort of cannibalizing from ourselves that kind of thing. So initially speeding up throughput does not automatically generate a comp unless it's done in a restaurant where people are walking away from the back of the line and a shorter line would have kept them. But that being said, we do see over time a really nice correlation between our ability to continue to move faster and customers' willingness to come to Chipotle, willingness to wait in line and so forth. So, there is no formulaic way to measure that, Jason, but we have absolute confidence that it's one of the key drivers of our success. It's one of the key ways in which we distinguish ourselves from competitors because we are so much faster. It's really a huge advantage to us and it's just such a critical part of giving a great customer experience to our customers, most of whom would report the only thing negative about Chipotle is the need to wait in line. So we were able to improve substantially at the peak hour of lunch and substantially at the peak hour of dinner, which makes us really, really proud. And also, we had faster comp transactions at absolutely every single hour of the day as well. So we're really pleased. We're incredibly thankful to all of our teams in the field for generating that kind of throughput improvement, which is really one of the most substantial we've achieved in any quarter, I think, in our history in terms of absolute numbers. Okay. Got it. Thanks a lot. We'll go next to John Glass with Morgan Stanley. Thanks. First could you talk a little bit about the lift you're getting in the ad spending? In other words, you cited some specific statistics where when you were on either air or advertising, I'm not certain what you're referring to, you had a discernible lift. Can you talk about how great that lift was? How sustained it was? And can you also just tie that into what are you figuring your final ad spend will be run this year in total? Yes, John. We'd rather not parse out our the components of the comp. Over time, we believe that if we just do a better job of hiring great people, empowering great people, create restaurant tour cultures in our restaurants and then communicate well with our people, communicate this message about where our food comes from and that we really have skill and we use classic cooking techniques with these higher quality ingredients. And we can do that with our ads in an authentic way because when our customers come into our restaurants, they actually see that we're cooking it and they can see the ingredients. And we think all that adds up to creating a great experience, creating this feeling that people have where they trust and they enjoy coming to Chipotle. Steve had mentioned that we did see we don't often see this because a lot of our marketing is more about educating encouraging people to be more curious about where their food comes from. But we did see in markets where we did advertise compared to markets that we didn't advertise that we saw a lift and it was a meaningful lift. But in terms of saying how much of that was in the comp, we'd rather not say. I would say in general though, we believe going forward, we believe that in the past and going forward, the vast majority of our comp is based on creating a great restaurant experience, that the marketing should complement that. It should be authentic to what the actual experience is, but we believe the vast majority of our comp will always be based on having wonderful people creating wonderful dining experience. And just 2 other follow ups. One is just on, Jack, do you have a view yet on food inflation next year? And will is it going to be the kind of thing where your pricing will be fully used to offset that or only partially? Do you have a view generally on the basket for next year? Yes. I mean, I wouldn't say our crystal ball is great, John. I don't see anything that looks terribly troubling. So, we would hope that we would stay in this kind of 33.5% to 34% range, not counting the extra costs related to removing the remaining GMOs. So if it stays in that range, I would call that pretty tame. I mean, that would mean from here, we'd be looking at a 1% to 2% inflation. And so if things don't change, if weather doesn't if extreme weather doesn't change things, we think that our food costs should not rise very much. Then in terms of the menu price increase, talking about this kind of mid single digits, we think that should be more than adequate to cover the inflation that we've seen so far, as well as hopefully absorb the cost of removing GMOs as well. And hopefully, there'll be some leftover to and we expect there would be some left over to improve our margins as well. Okay. And just one final question. Steve, you mentioned in your comments about Shophouses, one other example of how you can extend the platform of Chipotle into other brands. What would the timing be? I presume that means you're the 3rd and the 4th. Correct me if I'm wrong. And if that's the case, how do you think about the right time to introduce those seed concepts to give them time to grow? Do you mean grow the existing ones, John? No, I mean like have a 3rd concept besides the first two you have and a 4th because you need time to let them expand, so they're becoming meaningful. I'm just getting a sense of if that's something imminent or something that the very long term that you think about not anytime in the next few years? Sure. Well, I mean, if I think about the last 20 years, I mean, the vast majority was spent building the Chipotle brand, really showing that there is a better fast food models. I mean, we wrote the fast food rules by introducing high quality ingredients and interactive service format and this concept of having empowered teams who are really top performing to deliver a different kind of experience. It takes a long time and we're really perfected or are perfecting this model and just a couple of years ago thought it was prudent to explore a different kind of cuisine. I think that if you could envision many different kinds of cuisines fitting into this model, it is potentially the new fast food model. And while it would be exciting to open a bunch of different brands now, I think there's really an importance that we've learned at Chipotle of focus, on focusing on just doing a few things and doing them very, very well. Once you've done them very, very well and are confident things are moving forward nicely, then you can layer on additional projects and challenges. So we feel that we're we've got a really good pace going now with introducing the Shophouse brand. We're really pleased with the results. I was in the Washington DC Shophouses 2 weeks ago and sitting down and talking to customers. And the kinds of things that I heard coming from them were just music to my ears, which was this food feels so good. I love the way it tastes. It's the kind of food that I want to come eat often. And is creating the dining experience that people want to have often, which I think is really powerful. It's the kind of thing that we heard about Chipotle in the early days and it's the kind of thing that obviously drives Chipotle's comps today. So we're going to focus on those two things right now. Thank you. We'll go next to Nicole Miller with Piper Jaffray. Thanks. Good afternoon. In talking about the development you outlined for next year, can you give us a little color on how many are maybe LOIs signed leases? Where you're accelerating development? Is it existing markets, new markets? Is it international? Particularly different in next year except for the little uptick in our development as we forecast and going up to a higher number of new restaurants. But we're still going to have a similar ratio of new markets and proven markets. You won't see much additional work in international. We've talked about how we're working on we talked about how we're working on Germany. We got that open and we'll just be again letting those stores mature, so you won't see a significant push in international. Again, there's going to be a few additional Shophouse restaurants, and you won't see a huge push there either, because we want to really make sure that those brands are established that we start to develop awareness and that we allow them to generate the kind of demand that will cause us to be able to respond by giving more supply. So I think you'll see a lot more of what you see now with a small number of A models. Again, we'll look for as many A models as we can find. This year, it can end up being something like 25 for the year. Next year, we'd love to see that many again if we can find them. We're always out trying to find those opportunistic deals. But again, I think you'll see a very similar ratio of new markets, existing markets, as you did this year, just a little bit more per quarter. And I think very level loaded again, as best we can. And we anticipate that they'll be quite level loaded next year because the pipeline is very, very healthy right now. Okay. It looked like the preopening dollars were just a little tiny bit weighted towards the back part of the year. So just want to make sure we didn't need to front end load anything in the next year, but it sounds pretty even? Yes. The Q3 was pretty, pretty high, Nicole. We typically have preopening costs in kind of the 75,000 to 80,000 or 85,000 range. This quarter, I think it was more like 120,000. Dollars That's more a function of we've got a nice pipeline of openings teed up for the 4th quarter. But those preopening costs, they're incurred. Most of that is rent. Most of that preopening cost is rent. And so because of all the restaurants we've got under construction that will open up in the Q4. We had a little bit disproportionate amount of the preopening costs hit in the Q3. If you look at kind of year to date for the 129 we've opened so far, our preopening costs average about $83,000 and I think that would be more normal. And so, 4th quarter should return to a more normal preopening. And then next year, yes, as Matti said, we feel like the pipeline has set us up for reasonably level loaded, nothing too extreme to expect. Thank you. Thanks, Nicole. We'll go next to Jeff Farmer with Wells Fargo. Great. Thanks. Just looking to follow-up a little bit on pricing. I guess, how do you guys generally test a price increase if you're still doing that? Would a price increase be across most of the menu? Would it be most of the markets? How would you guys tackle the price increase this time around? Yes. We don't really test it per se, Jeff. What we do though is we go market by market and we look at competitors and we look at what prices they're charging and we'll look at it item by item. So we'll look at sandwiches and burritos and drinks and sides and things like that. And so we will look at the whole menu. It's likely that the entire menu will be touched. But we like for example, if we had an overall average increase of 4%, we might increase some items higher, some items lower just based on what looks competitive out there in the marketplace. And then market by market, we'll also look at what consumer demand looks like as If we feel like there's more room to increase based on where competitors are in terms of their pricing and we have healthy comp momentum as well, that might cause us to take that particular market that we're looking at and maybe inch up the price increase a bit there. And our expectation is that we will have increases in every single market. Most of our markets by the time we get to next year, it will be 3 years that we've had a price increase in any of the markets except for on the West Coast when it would be more than 2 years. And so our expectation would be when we do this, we had a price increase, it will be across all markets. That's helpful. And just one other quick one, just coming back to catering a bit. I think it's been in Denver since the early part of this year. But really, I'm just looking for any color you can provide on sort of the sales progression. You continue to point to approaching 1%, but I didn't know if you started at 20, 30 bps and it's grown to 1% over the summer. And then any other sort of pieces of information you've learned as you've rolled this out into new markets in terms of potentially how to get customers a little bit more on board with the idea of potentially using the catering service? Yes, Jeff. We're learning a lot about catering and we've not even been through a full season yet. What we did see though is the early summer was a lot bigger than any part of the rest of the year we've seen so far and that's because of graduations. And so when we look at catering in markets like Denver that we've had it for the entire year, That was our peak season so far. We think we might be moving into another peak season now with the holidays. And Steve mentioned that we're going to be doing some advertising around that to encourage people to try it. The other thing we've seen is that the longer catering is in the market, that generally we do see the catering build over time. Now it's not a straight line because like I said, there's seasonality to it where we had a lot more catering in the kind of graduation season in the May June period. So it's not a straight line. But generally, like in a Denver, it started out slower and I would say Denver is higher than average. So when Massey talked about catering being approaching 1%. The markets that have had it the longest are a little higher than that. The markets that have not had it as long are a little lower than that in general. That's not a perfect formula, but generally what we've learned so far. And we do know that we have to create awareness. And so I know that Mark is considering a number of ways in addition to advertising about how we can create more awareness. What we found so far is that when our customers get a chance to try the catering, it's a really neat experience and they love every bit about it. They love the control, they love the food, they love the packaging. They really love everything about it. And so I know Mark's working on a number of ideas in terms of how to encourage more people to try catering, because we think that will help us continue to build the business. All right. Thank you for that thoughtful response. We'll go next to John Ivankoe with JPMorgan. Hi, guys. It's Amode filling in for John. You're very forward thinking on a lot of different things, including moving to non GMO. I was curious what your thoughts are development of a stronger mobile app platform and maybe more specifically how you could tie that into throughput? I know there are some companies out there that have mobile payment, for instance. And on top of that, also layering in loyalty? Yes. Listen, great question. We're working on it. We have something that's in what I would call a beta test right now. We think it's got lots of opportunities right now. We just want to make sure that the technology works. Just from a payment standpoint, if we come up with technology that has any glitches whatsoever, it would kill us from a throughput standpoint. And so we have to make sure technology is perfect from that standpoint. And so we're working on that right now. Once we get that, we do think there's lots of opportunities to communicate with our customers to speed up throughput, to communicate with our customers on a more customized way, customers who haven't been for a while or customers who've never tried guacamole, for example, that there's lots of ways to communicate. But we're actively working on this and hopefully we'll see something in 2014. And then can you help us understand the non GMO supply chain? I don't think a lot of us are that familiar with it. I would think that as you switch over to that, it's obviously a lot of demand probably coming on the market with a company of your size. So is the entirety of kind of the potential structural cost increase going to be passed on with the price increase that you take mid the middle of next year? Or should we expect COGS to just to move up because of that? Well, we don't know for sure. But right now we don't have many ingredients that have GMO. And so while it's complicated to change some of our recipes, we've made very, very good progress so far with changing out some of the oils. We need to work now on our tortillas. And there's just in some cases, just small amounts like our flour tortillas, just small amounts of oils in the tortillas that we need to try different recipes with different oils and make sure that the taste is still delicious that we can still roll the burritos that they hold up well with our ingredients and things like that. So we don't have that many GMOs left. So I wouldn't say that we're going to have this huge demand per se. So we're hopeful that it while it will cost more in our foods, we hope it's not I think you were implying that it would be a dramatic increase in our food costs. We're hopeful that it's not going to be dramatic that it's manageable and that the menu price increase that we're thinking about would more than cover the inflation we've seen so far and cover the GMO the cost of removing the remaining GMOs as well. Okay. That's helpful. Thank you. Thanks. We'll go next to Nick Setyan with Wedbush Securities. Hi. Thanks for taking my question. I just wanted to ask sort of a bigger picture question around how you guys think about pricing general. I mean is it really just a function of your unique supply chain and the way you source the food? And to what extent do you kind of think about competitive pricing within both fast casual and obviously the casual dining category has been a lot more competitive in terms of pricing as well. To what extent, I mean, does the competitive pricing come into that decision? Well, when we think about pricing, we already have and have for a long time spent more money on our ingredients as a percentage of sales than our competitors or in fact more than any public company or company for which we have the records. So we have high food costs and that's not something that troubles us too much as long as we're able to run a very successful unit economic model, which we've been able to do primarily through having really high sales volumes in our restaurants. So we do buy more expensive ingredients, but that's been something we've been doing for quite some time. And our purchasing department is really, really good at going out and working finding suppliers who are eager to do or raise animals or grow crops in ways that are consistent with our protocols. And so they're always working constantly on trying to increase the supply of those ingredients that are available to us, so that we can continue to increase the amount of food with integrity that we serve in our restaurants. So the main thing that governments are thinking about pricing is that we want to continue to make this kind of this new way of eating very accessible to people. So we want to keep our prices low so that our customers continue to enjoy this very different way of eating. But by the same token, we want to still have a very strong unit economic model. And we've been able to do that by virtue of the fact that our food tastes better, and we have high average unit volumes enough to cover this more expensive food cost. Great. Thank you. And then just you mentioned a very strong pipeline in terms of development. Are you seeing a nice acceleration in new construction? Is that the key factor in why you're able to up the guidance for next year? Yes. I think that's I mean, it's only a small part of it. But yes, the answer is yes. The amount of new construction has increased. It's been increasing just incrementally each quarter over the last several quarters. But it does continue to keep making up more and more of our future portfolio, just like it was making up correspondingly less and less to our portfolio after 2,008, 2009. But yes, that amount of new construction has ticked up such that it's exceeding 40% of the restaurants that we'll see that will open in the Q4 this year and probably a little bit higher than that for next year. And so in other words, more than 40% of the restaurants we have in next year will be will come from new construction. So that amount keeps ticking up gradually as a result of more folks being willing to put their money into building new shopping centers and so forth. So that is helping us, I think, to find more great real estate. Great. And then just lastly, I've been getting a lot of pictures today from friends here in LA of your Shothouse in Santa Monica. It looks like I can't see the end of that line. There's a huge line out the door apparently and it goes all the way through the street. It's just FYI. Well, that's great news. And again, we're really, really excited about Shophouse, not only about the teams that we've built, but the incredible food and this different kind of food that we're making available to people. It's an exciting way to eat and it's fun to make this available to people. We'll go next to Brian Elliott with Raymond James. Good afternoon. Just a point of clarification on the move to non GMO food. The proteins need to be only fed non GMO corn? No. I mean, right now, in order if you want animals that have not eaten any GMO, you have to find organic meat. And so when we talk about GMOs, right now, there's really no way to find adequate supply of animals that have not eaten any crops containing GMO ingredients. So that is not what we're talking about when we're talking about getting rid of GMOs right now because none of the animals are obviously genetically modified, but animals in this country are eating grains that are often GMO. Another thing that I'd mentioned, Brian, just while you're clarifying that issue is that our soft drinks contain high fructose corn syrup, which is a GMO ingredient. So there is not an effort on our part to eliminate GMOs from soft drinks. So this is an effort to go through all of our food ingredients and remove GMOs from every single food ingredient that we serve. Where possible? Yes. Okay. Well, I mean, yes, where possible, but I will be able to remove them from all of our food ingredients, because again, an animal that each GMO ingredient is not technically a GMO, not a genetically modified organism because the organism is the animal. All right. I'm sorry, maybe I misunderstood the soft drink comment then. So I'm making a distinction between food and drinks, I guess. I'm saying the soft drinks are yes, yes. And you really can't get raw sugar or regular cane sugar drinks much in the U. S. Anyway, right? I mean, it's something we always are looking at. It's very difficult to do at this point and certainly not from the mainstream fountain drinks that you would see. Yes. Okay. All right. Thanks. Thanks, Brian. We'll go next to Steve Anderson with Miller Tabak. Good afternoon. A couple of quarters ago, you mentioned about having some of the breakdown of new units looking more at food courts as a potential source of unit growth. Have you given any more thought to that as a potential of your unit portfolio? Yes, we aren't looking more at food courts per se, but as a part of our continuing expansion of our portfolio, we have found success in a whole bunch of food court settings. But there's a number of real estate locations that we call sort of non traditional. And in 2013, we had we opened 13 food court locations by way of example, but it's not that we're looking to increase that. We just are open to considering those kinds of locations as well as airport locations or highway locations, even military locations in the future is something we're looking to get more involved with. So we call all of those sort of non traditional locations. If you talk to us 5, 6, 7, 8 years ago, we were very hesitant to get involved with locations like that because it was a time during which we were establishing the Chipotle brand and it was very, very important to us that we did so in a way that represented what we were doing. But as the awareness of Chipotle has grown and as the demand for this new way of eating has grown, it has been appropriate, we find, to go into some of those locations to allow folks the Chipotle experience in malls, airports, highway stops, other places that we wouldn't have considered while in that initial brand building stage. Thank you. We'll go next to David Tarantino with Robert W. Baird. Hi, good afternoon. Jack, just a question to follow-up on how you're viewing the food cost ratio. And if I look at how that has trended historically, 33.5% to 34% is as high as it's been in the last 10 years. And I just want to come back to the question of where you would like see that food cost ratio long term and specifically where you'd like to get it to when you take the price increase at the middle of next year? Yes. David, our food costs generally has ranged between 31% up to around 34%, it's gotten as high as or close to 34%, and that's kind of the range we're talking about right now. As a perspective, and while my preference would be or our preference would be around 32% seems to be kind of a sweet spot. But the food cost isn't as important as what our overall margin is and then what our return is. And so let me give you an example. Just as a perspective, just on math, if you push the math around a 4% price increase and if you have little or no resistance on that price increase, the food cost will improve by about 130 basis points. And so 4%, now I'm not considering the cost of GMOs, but just to work through the math here. So our food costs, which is now in the 33.5% to 34% range, now drops down much closer to that 32% or 32.5% range. And so that's nice. But the margin on a 4% price increase, again, just based on today, not taking other factors into account, would increase by 250 basis points to 2.60 basis points or so. So that would put us at all time high margins and even if there is more inflation and even with covering the cost of GMOs, there's a lot of room there for our overall margin to be kind of at record levels. It would give us the opportunity to have returns that are at or above what our record levels have been. And our returns have been in the 65% to 70% cash on cash return range. And so when I think about the pieces and when I think about the inflation that's happened and is about to happen, when I think about the cost of GMOs and I think about our pricing power, which we believe and everyone who's tried to go out there and either prove or disprove whether we have pricing power either by surveying customers or by comparing us to competitors just confirms that we have pricing power. I feel like a mid single digit inflation will do everything we need to do. And if our food cost ends up being closer to 33% than 32% or so, but our margins end up being at or above where they've ever been, that would be just a fine result as far as we're concerned. Great. That's really helpful. And then I guess on the inflation outlook for next year, you mentioned it being pretty tame. I guess with corn prices where they are, what are the chances you might see some favorability on the food costs themselves as you move into maybe the second part of next year? Well, what that might affect David, it would affect the prices of our meats, if corn continues to be favorable. I don't know that it would we're not predicting at least nothing we're seeing is predicting that costs will go down, but if they hold kind of at this level, that'd be great. We buy white corn for our salsas and so that is more expensive already. And so we're not seeing that that's going to go down. But certainly, we would welcome if the feed prices do decline and if that causes our meat prices to relax a little bit, that'd be welcome. But right now, we're seeing more of a tamish environment, not a deflationary environment. Okay. Thank you very much. Thanks, David. All right. Thanks, everyone. It looks like we've lapsed our time. But we thank you for joining us today, and we look forward to speaking with you next quarter. Thanks everyone. Thanks everyone. Thank you. This does conclude our conference. You may now disconnect.