Chipotle Mexican Grill

Strategic Analysis Report

__________

Conducted by

Kermit W. Kuehn

University of Arkansas Fort Smith

Fort Smith, Arkansas

Spring 2017
 Executive Summary
Chipotle Mexican Grill (Chipotle) has been a leader in the fast growing fast-casual segment of the
restaurant industry. As such, the company has positioned itself as a quick-serve restaurant offering
high-quality fast food, carefully prepared, customized to customer preference, offered within a
pleasant environment, and at a reasonable price. By most metrics, it has been successful until
recently.

In this analysis, we assessed managements performance by examining both stated and implied
strategic and financial metrics. The analysis included the evaluation of governance and
management, alignment of mission and activity to broad and specific market forces affecting the
industry and the company to date and going forward. The report concludes with recommendations
to restore company reputation and growth.

Our research indicates that turmoil caused by the food-safety issues has harmed the brand and
stifled growth. Recent leadership changes were necessary and governance has been more engaged
in management oversight and choices. We view these as positive things.

Trends in recent years have favored the Chipotle growth commitment with sociocultural shifts and
supported by general economic recovery providing the company ample opportunities for growth.
Our team believes that consumer preferences for healthier food and the socially sensitive business
remains intact, but the economically supportive cycle may be ending. Technology is also seen as
a potential challenge to the Chipotle concept.

Within the industry, there are an array of competitors, all attempting to take part in some way in
this change in consumer preferences. Suppliers seem to have considerable control over these rather
unique inputs (ie. Organics) and can be expected to hold the upper hand against the variety of
buyers seeking to participate in the trend. While revenue growth is essential, cost containment will
continue to be key to Chipotles success formula, a capability that is not a given at this point.

In the end, we believe Chipotle needs to pursue a broad differentiation strategy. We believe the
segment is evolving very quickly and with that will be increased pressure on price. We dont
believe this will bode well for the companys current best-cost play.

Our recommendations focused primarily on the mid-term and revolved around restoring consumer
confidence in the brand and thus, revenue growth. This depends on insuring food safety issues are
fully addressed essential to restore a premium brand. Finally, the cost of restoring traffic to stores
and assuring food safety going forward suggests the cost structure of the business has changed
fundamentally, and risks threatening profitability going forward. This must be addressed.

In sum, assuming management is able to restore consumer and investor confidence, the business
brand seems legitimate. We think the premium path will bring greater and more sustainable
benefits going forward.

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 Strategic Analysis of Chipotle Mexican Grill
Introduction

Chipotle Mexican Grill (CMG) has been the industry darling in the fast-casual restaurant
segment as media attention, above-average growth in terms of restaurants and sales, and positive
trends in numerous financial metrics suggested that the firm may be a long-term winner in the
competitive hospitality industry. However, recent events have cast doubt on the effectiveness of
management in terms of food safety and those processes that insure food with integrity is a
sound operating principle for long-term success. This analysis sets out to assess the companys
progress to date, evaluate the firms strategic decisions and options, and recommend a course of
action going forward.

While it is a company that has essentially defined the fast-casual segment, the company
understands that it is competing in the quick-service restaurant segment.

Current Situation
Performance

We begin our assessment by looking at selected performance metrics over the most recent 7-year
period in terms of financial and strategic performance. We conclude the section with an
evaluation of the merit and clarity of the companys strategic approach. We begin with a look at
financial objectives.

Financial Objectives. In general, it had been difficult to find fault with Chipotles financial
performance through Q3 2015, until the food safety issues arose in the latter part of 2015. On
virtually every metric, whether on the revenue, cost or profitability side, or asset and debt
management, the business had maintained or improved performance often impressively. That
was the story from 2009 through much of 2015. Compound annual growth rate of sales of 18%
over the past six years (through 2014) was very solid, as was the nearly 24% CAGR for EPS for
the period. During the same period, annual sales growth in the restaurant industry averaged less
than 5% during the same period.

In contrast, including full 2015 results in these calculations, we observed a decline in these
metrics over the period to 16.8% and 21.2%, respectively.

The turmoil caused by these issues from late 2015 through 2016 (to date) have reversed virtually
every one of the positive trend lines noted above. Sales are off nearly 15%, gross margins have
dropped by 12%, operating margins down from 17% to under 3%, while liquidity, debt-to-
equity, and many other financial metrics reveal significant declines since 2015.

In sum, financially, the business has been hit hard by food safety issues. Management appears to
have used a combination of internal cash flows and debt in initiatives to combat the declines in
customer traffic and revenue. There has been a clear weakening of performance across most
metrics and the health of the company has clearly been hurt. However, that said, the company

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has considerable room to maneuver as the company continues to have substantial resources to
work with for the intermediate term.

Please see Appendix A for financial data for recent performance highlights and comment.

Strategic Objectives. Strategic performance focuses on how well the business has succeeded in
the marketplace in terms of non-financial metrics, such as store growth, market penetration,
brand development, product and resource development. Assessing performance in this area is
more ambiguous as hard measures are difficult to come by, and the company has been less
forthcoming as to the objectives being pursued in many areas.

A quote at the end of the CEOs 2014 letter to shareholders, found in the annual report, gave us a
clue as to some of the areas of distinction that he believes will propel success going forward: a)
the right food culture, b) the right people culture, and c) the right unit economic model to
reinvent the category and to deliver outstanding results for our shareholders.

The company has grown units by between 10-12% a year during the 2009-2016 period. There
were 240 net new units in the ground in 2016, with projected growth of 195-210 units in 2017
suggests a more modests 10% or so growth model reflects an acceptable growth objective in the
medium term. These numbers include Shophouse Asian and Pizzeria Locale outlets.

At the end of 2015, there were 13 Asian cuisine and three pizza stores built along the same lines
as the Chipotle business model. The growth objectives had appeared to include these emerging
brands as part of the overall corporate growth model and unit counts. However, company filings
in late 2016 indicated a change in direction with the announced divestment of the Shophouse
business.

The food with integrity focus is a central component of the food culture emphasized by
company leadership. Organic or more humane, natural grown inputs appears to be pursued
with persistence and with apparent success. This is intended to move the food industry toward a
more healthy product.

The ability to meet this objective has been brought into question in recent months as the food
safety issues lingered. This is no little issue. Aside from damage to immediate financial
performance, especially evident throughout 2016, it is the longer-term reputation of the brand
that is of greatest concern.

The people culture reflects the desire to provide customers with a high-quality dining experience
within a fast-food paradigm central to the fast-casual business model. Motivated people and
leadership are viewed as key to delivering a dining experience that people dont mind returning
often for, and paying more for.

As of now, it not clear when a full recovery to trend can be expected, if ever. The company has
set out to lure customers back with significant discount and loyalty incentives. These may have
helped slow the decline, but remains unclear if a turnaround is under way. These investments,
plus the continued expansion of physical locations reflect the key growth initiatives chose by

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management. Operating efficiencies is being pursued on the cost side, but much more needs to
be done here as costs metrics have degenerated during the crisis.

Strategic Posture

In this section, well discuss the strategic posture of the company in terms of vision and mission
statements, strategic objectives, and strategies, and how well these are articulated.

Vision/Mission. There are numerous references to the vision of Chipotle, though it has not
separately and succinctly stated on the corporate website. The notion of a separate mission
statement had been absent until recently. We might describe them as follows:

The vision of Chipotle is Our vision is to change the way people think about and eat fast food.

Ells announced a reimagined company mission1in 2016. He states the expanded mission as
follows: "Ensure that better food, prepared from whole, unprocessed ingredients is accessible to
everyone" is the next step in the evolution of Chipotle's mission-driven business."

There has been confusion in the vision-mission concept as used by Ells in company documents.
However, it is a definite plus for the company to specify (and distinguish from vision) its mission
in a more concrete manner. While the evolution is positive, the mission could still use a more
pronounced operational clarity and specificity, if it is to guide company decisions.

Objectives. There are general statements about shareholder returns, food with integrity and
developing the people culture, but it is generally difficult to identify formal objectives set by
management to guide operational priorities. Having said that, several objectives have been
identified in company documents and statements.

We note the following for 2017, taken from company documents and reports:
Comparable restaurant sales increases in the high-single digits
195 - 210 new restaurant openings
Streamline operations to deliver higher efficiencies (my interpretation)
Realign & simplify career path with emphasis on guest experience (my interpretation)

There has been marked improvement in delineating company vision and mission. These need
further development, but it is a positive outcome from this difficult period for the company. A
number of key objectives have been noted, as well, but we recommend additional disclosure.

Strategies

Corporate. Until the announcement in late 2016, there was clearly movement toward a portfolio
of restaurant concepts oriented around ethnic foods. How the identity of the restaurant group
would be developed going forward was unclear. That all came to a halt with the December

1
See Mission on Chipotle.com/mission. In Business Insider, H. Peterson, Chipotle co-CEO steps down as chain struggles to
recover from sales slump. December 2016. http://www.businessinsider.com/monty-moran-steps-down-chipotle-2016-12

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announcement of the intention to divest of the Shophouse Asian stores and return to a focus on
the Chipotle brand.2

Business. Currently, Chipotle is largely a business-level entity. There are at least three key
strategies being used to grow the business.

1) Grow revenue and market share through growth of existing store revenues, expansion of
the number of company owned/operated stores in the U.S., and examination of growth
opportunities outside the U.S.
2) Grow revenue, profits and market share through healthy, high-quality offerings, a great
customer experience, and efficient store operations. Theyre also expanding product
offerings.
3) Develop positive, long-term relationships with employees and suppliers to insure the
necessary inputs and performance consistency their high standards require.

Governance

A review of the directors and top management team suggest that recent challenges have brought
pressure on the company leadership for change. We briefly review each group.

Board of Directors

The board is comprised of twelve directors, including Chairman and CEO Ells. The remaining
eleven directors are non-executive and bring extensive high-level executive and diverse
backgrounds to the table, including restaurant, strategy and risk investment and entrepreneurial
startups. The firm also has named a Lead Director, whose role is typically to manage, coordinate
and communicate issues between board and executive directors a role that is apparently more
and more common in governance circles.

Significant changes have taken place in governance since the 2015 food safety incidents,
including the removal of all executive members, except Ells, the addition of more members,
especially those associated with activist investor Bill Ackman took substantial positions in the
company in 2016. He has at least two representatives on the expanded board (9-12 members), a
sign of significant displeasure with governance of the past.

Top Management

The top management team included the co-CEOs, Ells and Moran, until late 2016 when Moran
suddenly retired. This is a convenient way to say, youre fired, since the food safety issues were
under the operational oversight of Moran. The team is also comprised of a CFO with
considerable experience in the restaurant industry, as well as a creative and design director of VP
level that oversees the product and store design/development, both of which have been retained,
so far.

2
In Fortune, J. Kell, Chipotle Ditches Its Asian Food Concept. 2016. http://fortune.com/2016/10/26/chipotle-
shophouse-asian-kitchen-investment/

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To reiterate, there have been significant changes made to the board and the management team as
a result of the food safety issues. These were not the only issues that raised some eyebrows in
previous years and the changes suggest a more appropriate relationship between management
and the board going forward.

External Environment Opportunities & Threats

In this section, well examine key features of the macroenvironment and competitive
environment that would potentially impact Chipotle now and going forward. We begin with the
general environment.

Macroenvironment

Of the six broad factors included in this component, it is clearly the sociocultural dimension
having the greatest impact on the companys success up until the 2015 issues. This is supported
by a more positive economic environment in the U.S. over the past five years. It might be
expected that technological changes, which have swept so many industries in recent decades
will also be a factor in the future of this industry. Chipotle will have to assess its importance to
operational efficiency going forward.

It has the potential to create more challenges for Chipotle than other quick-serve competitors, as
their model depends on a higher-caliber workforce to provide the experience people are paying
for. While robotics and digital solutions grow as a response to labor shortages and cost pressures,
Chipotle faces a dilemma cost containment through human efficiency is limited, but
technology replacing the human interaction appears problematic to the value proposition, as well.
How does it balance this customer experience with cost containment.

From the sociocultural dimension, we see that lifestyle changes have been a major driving force
in changing the eating preferences of many Americans, particularly the under 40 demographic.
Preferences for a healthier lifestyle and more careful response to nature and the environment at
large is an important feature of this shift.

Within the same component, as mentioned earlier, is the question of generational attitudes
toward work, especially this type of work. Their business model requires a stable, dedicated-to-
the-cause workforce, more so than the Taco Bells and McDonalds of the world. How they
deliver the value of friendly AND fast, at a reasonable cost, seems to be a valid question here.

The sociocultural shift appears to be longer term in nature, and thus a medium-term, sustainable
tail wind for Chipotle, assuming they have righted the ship in the food safety area.

Economic conditions in the U.S, while hardly vibrant, do favor increased consumption and a
willingness of consumers to pay the higher prices that Chipotle commands for this dining
experience. This feature of the general environment, however, is more tentative and cyclical. If
one is to view Starbucks as a surrogate for these value-focused business models, then the impact
of cyclical downturns may not be a major concern long term.

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In sum, the sociocultural dimension is a fundamental and positive driver of Chipotles success,
and can be expected to continue for some time. Other components do suggest more distant
challenges in the medium and long term. That is, there are opportunities here, but also potential
threats on the horizon.

Industry and Competitive Environment

In this section, well seek to better understand the competitive nature of the industry in which
Chipotle operates.

1. Dominant economic characteristics of industry

a) This is a fast growing segment within a rather slow-growth industry. The U.S. restaurant
industry, per the National Association of Restaurants (NAR) 2016 estimate3, does close
to $780-plus billion in sales for the year. Growth in the segment exceeded 10% for 2015,
while overall industry growth was a more modest 5.3%.
b) Until recently, Chipotle was a segment leader in the fast-casual segment.
c) The segment tends toward more premium pricing, at least relative to quick serve.
d) The growth potential is still quite strong and competitors relatively few but growing
quickly.

2. Five competitive forces and how strong

a) Rivalry within the segment has to be seen as relatively weak-to-moderate at this time.
This seems supported by the ability of Chipotle to raise prices without regard to buyer
push back (in 2015), though much more constrained after the 2015 events.
b) Buyer power seems weak to moderate at this time in the segment, though it could be
argued to be at least part of the issue for Chipotle now, as a value proposition.
c) Supplier power seems significant as Chipotle has had difficulty getting consistent and
sufficient supply of the somewhat unique inputs it requires. This challenge is notable and
seems ongoing at this stage.
d) Threat of new entrants seems likely, largely from experienced players looking to take
advantage of the growth and profits in the segment. However, several smaller players are
expanding aggressively. Names such as El Pollo Loco and On the Border are two such
brands with developing regional/national market share.
e) Substitutes seems to be an ongoing issue of the industry, so is not seen as unusually high,
unique to this segment, or pressing at this point.

3. Driving forces impacting industry

a) As stated in the discussions of the general environment, the industry is being impacted by
the changing eating preferences of consumers, who have been shying away from
traditional sit-down and/or fast-food formats. This favors Chipotle and others in the fast-
casual segment who seem to have become synonymous with healthy food with a social
conscience.
b) Chipotles product innovation has done for Mexican food what Starbucks has done for
coffee repackaged and marketed a valued experience. Chipotles difficulties recently do
not detract from the segments general attractiveness to consumers.
3
Research and industry information can be found at http://www.restaurant.org/Home

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4. Market positioning of industry rivals
a) The fast-casual segment is relatively new and is represented by few players, if you
exclude the traditional fast-food players. Chipotle might still be considered market leader
as far as concept development and market footprint, though one could argue that Panera
Bread has essentially defined the category before it was fashionable. Further, 2016
consumer polls drop Chipotle out of the top four Mexican restaurants, a reflection of a
serious public reputation problem created by the 2015 issues.4
b) Large players, such as Taco Bell, have come forward with competing products, but little
to engage the full value proposition offered by the fast-casual crowd.

5. Anticipated strategic moves of rivals

a) There appears to be a flurry of activity in the segment as traditional fast-food brands,
such as Taco Bell, even McDonalds, respond to the challenges of offering healthier
product lines. The full-serve restaurants have been for some time moving toward
healthier offerings as part of their menu realignment. Other options will be forthcoming
in other ethnic or product types, such as pizza. Companies will either offer these products
as part of their current dining experience, start new subsidiaries that focus on the
segment, or acquire existing smaller players in the segment to compete. It can be
expected that these moves will come together quickly.
b) Moes, Qdoba and smaller regional players will continue to pull Chipotle customers with
their own versions of the quality Mexican food.

6. Key success factors (KSFs) to compete: By definition, KSFs include strategy concepts,
product attributes, competitive capabilities, OR intangible assets with greatest impact on
future success.

In this industry, due to the great variety of offerings available, the relative maturity of the
industry, and well-established nature of most of the big players, success will likely be built
on strategies that take advantage of underdeveloped or emerging niches or segments catering
to shifting consumer preferences, and are responsive to the evolving aspirations of a
significant segments (healthy, social conscience). Cost containment always seems important
to this industry, as well as supply chain reliability. Perceived food quality (including safety)
is central to surviving in the industry.

7. Industry outlook for profitability

a) The overall industry characteristics have been challenging with nominal sales growth
rates running in the 3-4% range. If you look at the traditional players, it is even less
impressive. Talk of a restaurant recession is now common.
b) For the fast-casual segment, however, growth prospects/results have been and remain
particularly attractive. NARs own research indicates that this can be expected to
continue as consumer preference for healthier, more socially sensitive concepts continues
to grow.

4
http://www.eater.com/2016/6/9/11895326/moes-americas-favorite-mexican-chain

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The industry prospects are still positive and are expected to remain so for the 3-5 year window in
focus here. This is good news for Chipotle as it attempts to return to its status as a segment
leader. However, there are several smaller entrants in the genre, who are growing quickly.

Internal Environment Strengths & Weaknesses

In this section, we analyze the Chipotles resources and capabilities. The purpose of this process
is to identify key assets and competencies that might be used in extending the companys current
success into the future.

Resources & Capabilities

1. What are the firms competitively important resources and capabilities?

a) Tangibles: relatively new stores/locations, moderate but improving liquidity position,
quality of inputs
b) Intangibles: service/production culture, developing supply chain relationships,
brand/image is excellent, marketing skills, employee base maybe unique
c) VRIN:
1. Culture/employee connection could be a powerful resource to hold off challenges and
expand market position. It is rare in the quick-serve business and hard to imitate.
2. Brand/reputation has grown quickly, was quite positive and reflected espoused key
values of the segment until recently. The concept is certainly valued, based on growth
and company success to date. To the degree it is unique and hard to imitate, rooted in the
culture being supported as noted above, has sustainability. It has been damaged, but how
badly is unclear at this point. It does appear to be serious.

There is some evidence that both of these, culture and brand, are being seriously
questioned with the recent food safety scare. Some regional employees have sued for
wages and claim to have been cheated.5

2. Are the firms cost structure and customer value proposition competitive?
a) They seem to be mindful and aggressive in the pursuit of cost reduction and productivity
per store (per store sales have grown significantly year over year until issues of late
2015). They offer a product that is of higher quality and there is a price premium for that
feature. They are pursuing a differentiated product strategy within a cost-conscious
framework.
b) The value proposition seems well connected with their customer aspirations at this point.
This is reflected in positive reviews and increased same-store sales year-over-year.

3. Is the firm competitively stronger or weaker than key rivals?

a) Depending on how you view strength and rivals, will result in a different answer. Table 1
below summarizes the relative capabilities of Chipotle relative to immediate competitors
Taco Bell, Qdoba and Moes.

5
Employee lawsuits over underpayment of wage to hourly workers.
http://money.cnn.com/2016/08/29/news/economy/chipotle-lawsuit-nearly-10000-workers/

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 Table 1. Competitive Strength Assessment (post-food safety)
Chipotle Qdoba Moe's Taco Bell
Key Success Factor Strength Strength Strength Strength
Weight Rating Score Rating Score Rating Score Rating Score
Menu Select and Customization 0.1 6 0.6 8 0.8 8 0.8 8 0.8
Food Quality and Taste 0.2 4 0.8 8 1.6 9 1.8 6 1.2
Brand Image/Reputation 0.2 5 1 8 1.6 9 1.8 10 2
Number of Locations 0.1 7 0.7 4 0.4 3 0.3 10 1
Competitive Pricing 0.05 8 0.4 8 0.4 8 0.4 10 0.5
Dining Experience/Ambiance 0.1 7 0.7 8 0.8 9 0.9 6 0.6
Relative Cost Position 0.1 7 0.7 7 0.7 7 0.7 9 0.9
Financial Strength 0.1 7 0.7 6 0.6 6 0.6 9 0.9
Sum of Weights 1.0
Weighted Strength Rating 51 5.6 57 6.9 59 7.3 68 7.9

Taco Bell is a major player with significantly larger resource base to work with. It
competes with a line of products geared toward the same segment as Chipotle, but most
of its business is in traditional cheap unhealthy lines. However, it has offered a
healthier, more upscale line of products to address this growing segment.

Qdoba, on the other hand, is a direct competitor with weaker resources, but a strong
partner in the Jack in the Box owners. Moes also is a weaker player, but has access to a
private equity partner with considerable finances and experience. Qdoba and Moes have
been aggressively pursuing market share during this period of trouble for Chipotle.

From Table 1, we see ratings based on Chipotles post-food safety issues. A pre-food
safety table is listed in Appendix B. It could easily be argued that food quality and brand
reputation have been hurt by these recent events. Based on revenue, it is hard to conclude
otherwise.

b) Chipotle is still a solid player on several dimensions, relative to direct competitors Qdoba
and Moes, at least prior to the food-safety issue: brand/reputation, number of units in the
ground, revenue, and momentum. Not so much since these problems emerged.

All in all, as a result of the food-safety issues, the strong position of Chipotle eroded
significantly, in our opinion. Taco Bell is a formidable competitor on a number of levels, but
has yet to directly take on the segment good news for Chipotle. But Moes and Qdoba have
continued to strengthen, and at the expense of Chipotle. This survey of competitors excludes
smaller, more regional players with strong product offerings that are popping up.

4. What strategic issues and problems merit front-burner managerial attention?

As well as things are going for Chipotle, and these look to continue for some time, we
identified three areas that will need continuous attention going forward.

a) Food with Integrity supply chain. The emphasis on organic vegetables and clean animal
products has created challenges to the companys commitment already and will likely
continue to pressure the supply chain to provide the necessary inputs. While store growth

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 has been moderately strong, the increased demand for an already limited key resource is
subject to the volatility of the commodity markets, in general, but especially due to
increasing supplier power as other markets (ie. Grocery chains and other restaurants)
beyond Chipotle seek these scarce inputs. One recent example was the doubling of
avocado prices in October 2016 caused by labor strikes in Mexico. Further, agricultural
products are also subject to weather that can be very unpredictable year-in year-out. This
creates upward pressure on prices.

To date, the company has pursued supply contracts that provide it with favorable access
to necessary quality inputs. However, these agreements will be an ongoing challenge.

b) High performance teams and the search for talent. The pursuit of productivity and the
essential delivery of the Chipotle customer experience will keep pressure on stores to
recruit and retain talent. This will be especially difficult during strong labor demand
periods of the business cycle.

Up to this point, the company has been very attentive to this issue and apparently has
been able to meet current requirements. In the end, however, this is a quick-serve
environment and as competitors adjust to labor demands, Chipotle will be challenged to
distinguish itself from other outlets of a similar type.

c) Cost management and the quality experience. The two issues noted above, food and labor
inputs, are key to delivering the Chipotle experience to its customers. Management seems
to understand that while there is considerable forgiveness in the market as far as price, it
will not always be so. Productivity has been a major emphasis from the outset, with
impressive results to date. A slack labor market has worked in their favor up to this point
but upward pressure on raw input prices has revealed how significant an impact these
components can have on the companys financial performance.

As indicated earlier, the fallout from the food safety issues is still unclear. 2016 sales were
definitely hurt and what is happening in the current year appears to be improving, though it
remains a question. This experience should strengthen the company for future growth, assuming
the fix is in. Again, the window is closing to easy growth and wide open spaces the breadth and
number of competitors is growing quickly and the market will be very different in just a few
years. Chipotle needs to promptly get on track.

Structure/Design

Chipotle is in a single-industry business, featuring Mexican cuisine. To date, it has chosen to

operate all stores. No franchises have been discussed. This provides the company more control
over the day-to-day activities of its restaurants and retain all profits for future investment. At this
time, there appears to be limited hierarchy with store management being central to company
success. However, corporate control is prominent and active. Store management is held to a strict
standard when judging store performance as evidenced by regular store audits which provide
feedback to store management as to how well it is doing relative to valued corporate metrics.

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There was evidence that the company is moving toward a more corporate portfolio model with
multiple ethnic-focused businesses operating under the Chipotle corporate umbrella. This
appears to have been abandoned, based on recent announcements.

Culture

Management seeks to maintain people-oriented, performance-based culture in each Chipotle

restaurant (course text, p. 306). The company seeks to promote from within and communicate
the career opportunities to employees. Leadership was systematically developed from within and
given opportunities to demonstrate competence and increase earnings and promotions.

Situational Analysis

Having reviewed key aspects of both the current and future context of the fast casual
phenomenon, as well as the capabilities and resources of Chipotle relative to its competitors, we
conclude four things.

First, our conclusion is that Chipotle is using a best-cost strategy. While there is evidence to
argue for a focus-differentiation strategy, the explicit statements by management and the actual
behavior of the organization suggests a more complex strategic focus. Its commitment to bring
higher-end features of the full-service dining experience into the quick-service segment is classic
best-cost language. This is supported by rapid growth in market coverage to date, plus a
concerted effort to reduce costs through increased efficiencies and expense management.

Second, to date, recent events notwithstanding, Chipotle has successfully ridden a wave of
positive economic and supportive social trends that is reflected in its financial and strategic
performance over the past 6 -7 years. It recognized early a shift in consumer preferences and has
been effective in exploiting, even defining, what these value-conscious consumers want in a
dining experience. The trend seems intact, but competitors Moes and Qdoba have been pursuing
market share as Chipotle struggles, as have several other smaller players.

Third, even with the growth and success that can come with leading the charge into a new
growth area, Chipotle has exhibited good discipline in pursuing those competencies necessary
for long-term success as the industry matures and becomes less forgiving. Developing a valued
yet efficient customer experience, building a winning corporate culture, aggressively pursuing
reliable supply chain relationships, and extending its market foot print at an upbeat but
sustainable rate reveal a management team that is both aggressive and disciplined.

There is reason to skeptical, however, in light of recent issues that appear to focus on supply
chain deficiencies. Management must not only work to insure that food-handling processes
support the food-with-integrity mantra, it must convince customers that it has done so. These two
things remain to be proven at this time.

Finally, the dynamics that have supported Chipotles growth to date will not all align to promote
easy growth going forward. Aside from a likely business cycle downturn within the next few
years, demographic data suggest that a declining labor pool in the prime labor segment, as well

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as declining labor participation rates, will make recruitment and retention of quality labor more
expensive going forward. Further, competitor responses will begin to take root that will require
everyone to up their game in the healthy-food segment.

Overall, we conclude that the segment still has further upside, but the environment is becoming
more competitive. Intensity of competition will grow more intense from here. Chipotle has put
together the right ingredients to be successful in the medium term. They have strengths to work
with. This assumes they have resolved the food safety issues and is successful in winning back
customers. The team is aggressive and reveals adaptive skills, important to responding to shifting
consumer tastes and rival actions. Yet, at the writing of this paper, revenue has yet to show the
rate of recovery wed hoped to see if were to be confident that this rough patch is behind
them.

Strategic Alternatives & Recommendations

Strategic Alternatives

We see three general directions that Chipotle could take.

The first option to be considered is to continue to refine the ingredients of the best-cost strategy
that have made Chipotle successful. This approach emphasizes the delivery of some of the high-
end features of a full-service restaurant to a quick-serve customer. This appeals to the classic
value-conscious buyer they serve. This means that while price is important, it is the higher
quality experience that is crucial to satisfying this customers desires.

They have had their difficulties here, however. The supplier issues and the temporary removal of
a product due to supplier problems shows the challenges they face in maintaining the food with
integrity principle. Further, the option will attract competitors from both the higher-end and
low-cost end, who have not been passive as the fast-casual phenomenon has grown.

The best-cost strategy requires the player to possess and maintain a cost advantage over higher-
end full-serve competitors, while reinforcing to their customers value the receive for the higher
prices they will pay over lower-cost quick-serve players (ie. McDonalds). This is the challenge
inherent in this strategic position.

A second alternative might be to extend the scope of the product offering but retain the higher-
end features offered, an approach associated with a broad differentiator. This would view
growth of market footprint and product offerings as the prime ways to maintain revenue growth.
While costs must be a concern for any strategic approach, it is less an issue for the differentiator
on the front end. The emphasis is on enhancing customer perception of unique value that is
worthy of the premium price. While Chipotle had come far in this regard, it has struggled of late
to re-establish itself as the best of the rest.

Broadening market appeal and access are key, so geographic and product line growth are likely
ingredients for success here. Chipotle has opportunities in both of these areas.

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A third alternative would take the differentiated approach as described above but in a different
direction. This view would involve pulling back from the potential squeeze of the best-cost
player or the expansions described for the broad differentiator and turn instead to focus on the
niche ethnic-cuisine segment with enhanced service and quality experience toward a smaller,
more passionate and loyal segment. The appeal of this more focused strategy is that it allows for
a less cost-sensitive approach toward a more narrow, loyal fan base, while providing a high-
quality, interactive, hands-on experience for their customer.

This would suggest that slower unit growth would be expected, coupled with a cautious view of
menu expansion. This would be wrapped in a persistent campaign to present the brand as a high-
quality and unique offering, involving a more high-touch experience.

Recommendation

It seems clear that Chipotle is quickly leaving behind the possibility of a niche player, as a focus
differentiator option would suggest. The latest data indicate that store growth is accelerating
while revenue growth is flattening out. Projections for same-store revenue growth was estimated
in the low single-digits for the remainder of 2015 and the same for 2016. This is a significant
shift from historic performance and reflects a recognition of competitive and broad economic
conditions as the company moves into the next 24-36 months.

The fast-casual segment has existed in large part by charting a course between the low-end
quick-serve and high-end full-serve players with a fast, mid-priced good food value
proposition. The challenge for Chipotle is that its costs are not its competitive strength, typical
for a best-cost player. This has gotten worse of late. This lack of capability suggests it may not
be able to sustain the strategy (nor margins) as the industry matures.

With this reality, it appears that a broad differentiation strategy may be the better option. This
direction seems in line with the Starbucks strategy and may better fit Chipotles aspirations and
capabilities. As it can be expected that competitive pressures will grow as the segment matures,
expanding its footprint, steadily increasing product offerings, and enhancing customer
experience seem opportunities will help establish Chipotle as a premium brand. Maintaining cost
consciousness will be necessary, in any case, but the shift allows for greater focus on the
customer experience and less on cost cutting.

Our view is that Chipotle is best positioned among direct competitors to establish a premium
presence in this market as the segment matures over the next decade.

Execution and Control

Were looking for four things to happen in order to conclude that management has taken the
actions necessary to move the company forward for the next 12 -24 months, assuming a
differentiation strategy. These are summarized as follows:

1. Revenue growth must return to above-segment averages. Considerable resources continue

to be spent to attract customers back to Chipotle. This effort has met with some success,

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 but the damage has been considerable and the path to growth has been slower than
expected. Heavy promotional activity is important to restoring store traffic and revenue.

2. Food safety incidents must be a thing of the past. Considerable effort and resources have
been focused on resolving recurring food safety issues. It remains to be seen how
effective these have been and at what price this result has been purchased. But, the food
with integrity mantra must again have real meaning and soon. This IS the basis for the
premium branding were recommending.

3. Margins need to improve. The above initiatives appear to have come at a cost to
margins. Margins were improving before the food safety issues, but the initiatives to
resolve these issues appear costly, and permanent. This is a key metric to watch.

4. Enhance Offering. As a differentiated company, it is expected that a carefully

orchestrated introduction of new products over the next three years will be part of this
evolution. Further, further investments in customer experience should complement this.

Management has demonstrated competence and responsiveness in the past. The fast-casual
segment remains attractive. We are watching to see if management can restore Chipotles
reputation and potential. If so, we expect that premium branding will provide a viable path to
future growth and profitability.

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 APPENDICES
Appendix A Financial Analysis and Detail 2009-2015

Q4 2015 2015 2014 2013 2012 2011 2010 2009

Statement of Income: CAGR
Revenue $997,507 $4,501,223 $4,108,269 $3,214,591 $2,731,224 $2,269,548 $1,835,922 $1,518,417 16.8%

Food, beverage and packaging costs 337,065 1,503,835 1,420,994 1,073,514 891,003 738,720 561,107 466,027
% of Sales 0.34 0.33 0.35 0.33 0.33 0.33 0.31 0.31
Labor costs 260,585 1,045,726 904,407 739,800 641,836 543,119 453,573 385,072
% of Sales 0.26 0.23 0.22 0.23 0.23 0.24 0.25 0.25
Occupancy costs 68,143 262,412 230,868 199,107 171,435 147,274 128,933 114,218
% of Sales 0.07 0.06 0.06 0.06 0.06 0.06 0.07 0.08
Other operating costs 136,184 514,963 434,244 347,401 286,610 251,208 202,904 174,581
% of Sales 0.14 0.11 0.11 0.11 0.10 0.11 0.11 0.11
General and administrative expenses 46,875 250,214 273,897 203,733 183,409 149,426 118,590 99,149
% of Sales 0.05 0.06 0.07 0.06 0.07 0.07 0.06 0.07
Depreciation and amortization 34,140 130,368 110,474 96,054 84,130 74,938 68,921 61,308
% of Sales 0.03 0.03 0.03 0.03 0.03 0.03 0.04 0.04
Pre-opening costs 5,452 16,922 15,609 15,511 11,909 8,495 7,767 8,401
% of Sales 0.01 0.00 0.004 0.00 0.00 0.00 0.00 0.01
Loss on disposal of assets 5,450 13,194 6,976 6,751 5,027 5,806 6,296 5956
% of Sales 0.01 0.00 0.002 0.00 0.00 0.00 0.00 0.00
Total operating expenses 893,894 3,737,634 3,397,469 2,681,871 2,275,359 1,918,986 1,548,091 1,314,712
% of Sales 0.90 0.83 0.83 0.83 0.83 0.85 0.84 0.87
Income from operations 103,613 763,589 710,800 532,720 455,865 350,562 287,831 203,705
% of Sales 0.10 0.17 0.17 0.17 0.17 0.15 0.16 0.13
Interest and other income (expense), net 1,795 6,278 3,503 1,751 1,820 -857 1,230 520
% of Sales 0.00 0.00 0.001 0.00 0.00 0.00 0.00 0.00
Income before income taxes 105,408 769,867 714,303 534,471 457,685 349,705 289,061 204,225
% of Sales 0.11 0.17 0.17 0.17 0.17 0.15 0.16 0.13
Provision for income taxes -37,534 -294,265 -268,929 -207,033 -179,685 -134,760 -110,080 -77,380
% of Sales -0.04 -0.07 -0.07 -0.06 -0.07 -0.06 -0.06 -0.05
Net income 67,874 475,602 $445,374 $327,438 $278,000 $214,945 $178,981 $126,845
% of Sales 0.07 0.11 0.11 0.10 0.10 0.09 0.10 0.08
Earnings per share
Basic $2.19 $15.30 $14.35 $10.58 $8.82 $6.89 $5.73 $3.99 21.2%
Diluted $2.17 $15.10 $14.13 $10.47 $8.75 $6.76 $5.64 $3.95
Weighted avg com shrs outstanding
Basic $31,027 31,092 31,038 30,957 31,513 31,217 31,234 31,766
Diluted $31,312 31,494 31,512 31,281 31,783 31,775 31,735 32,102

Balance Sheet Data:

Total current assets $814,647 $878,479 $666,307 $546,607 $501,192 $406,221 $297,454
% of Total Assets 0.30 0.35 0.33 0.33 0.35 0.36 0.31
Total assets $2,725,066 $2,546,285 $2,009,280 $1,668,667 $1,425,308 $1,121,605 $961,505
Total current liabilities $597,092 $245,710 $199,228 $186,852 $157,453 $123,054 $102,153
% of Total Liabilities 0.47 0.46 0.42 0.44 0.41 0.40 0.40
Total liabilities $279,942 $533,916 $470,992 $422,741 $381,082 $310,732 $258,044

Total shareholders equity $2,127,974 $2,012,369 $1,538,288 $1,245,926 $1,044,226 $810,873 $703,461
% Equity of Total Liabilities and Equity 0.78 0.79 0.77 0.75 0.73 0.72 0.73
Average restaurant sales (in 000s) $2,424 $2,472 $2,169 $2,113 $2,013 $1,840 $1,728
Comparable restaurant sales increases -14.60% -1.90% 16.80% 5.60% 7.10% 11.2% 9.4% 2.2%
Number of restaurants 2,010 1,783 1,595 1,410 1,230 1,084 956
Number of restaurants opened , net relocat 79 229 188 185 180 148 128
Net cash provided by operating activities $683,316 $682,067 $528,780 $419,963 $411,096 $289,191 $260,673
Capital Expenditures 257,418 252,590 199,926 197,037 151,100 113,200 117,200

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Analyst Comments:

1. Revenue growth began to stall in late 2015 and then decline significantly through 2016 due to
multiple food poisoning incidents in 2015.
2. COGS rose significantly (nearly 12%) while revenue declined 14% from 2015 high.
3. Operating margins declined sharply going from 17% in 2015 to <3% in 2016.
4. Profitability ratios plummeted.

In sum, the customer reaction to the food poisonings was significant and the company has struggled to
recapture momentum a year after the breakdown. Increased COGS reflect the extensive giveaways to
draw customers back into their stores, while increased operating expenses reflected heavy promotional
activity to woo customers. Other expenses likely reflect costs associated with increased testing, process
adjustments. The question is whether these are temporary costs or permanent operating costs likely
both. Overall, operational efficiencies have ceased to improve. It is unclear to what degree these costs
have become permanent in order to insure food safety going forward.

5. Capital expenditures continued to grow, suggesting new store growth has continued, even
accelerated some. This will hopefully be clarified via management accounts in the annual reporting for
2016, which is not yet available. Quarterly reports should provide some insight in the interim.

6. Liquidity, as expected, has deteriorated over the past year. Balance sheet current assets reveal
significant declines relative to previous years. This is consistent with free cash flows from the decline of
operating cf due to increased expenses to counter revenue declines. Shares outstanding were relatively
stable during the period, suggesting that internal cash and debt, not equity, was used to finance
initiatives to restore revenue/store traffic, with limited success to this point.

7. This is further supported by the increase in AP outstanding and the reduction in AR (the latter grew in
2015 and were retightened in 2016). In sum, CLiab grew by some 3%, while CAssets declined,
proportionally. LT liabilities grew significantly, as well. Equity declined, probably due to share price
declines and some reduction in shares outstanding.

8. Efficiency ratios suggest management has not only been throwing money at initiatives to turn around
store traffic and reverse revenue declines, but have tried to maintain discipline in operating details, with
some success.

Overall, the company experienced considerable degeneration in financial performance and condition
during the late 2015- 2016 period. Initiatives appear to have used available cash flows and debt to
finance these activities, while attempting to support share prices. Q4 2016 reports just released suggest
the efforts may be having a positive effect as YOY performance looks to be stabilizing. If this result is in
fact a reflection of a real turnaround, then the question will be how fast a turnaround and at what cost.

Most metrics have been seriously damaged/distorted in the past 12-15 months.
Analysis:

(This is the area where a more extensive analysis and discussion would take place as to the
patterns/changes observed in the companys performance across a number of metrics youve
selected to look at in order to gauge the health and direction of the company. You would provide
a summary of these in the document, highlighting key metrics to represent your conclusion.)

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Chart of Revenue and Key Expenses

Chipotle P&L (Partial)

2015-2009
2,000,000
1,500,000
1,000,000
500,000
0
2015 2014 2013 2012 2011 2010 2009

sales Food & Beverage Occupancy Other Operating G&A

Appendix B Competitor Strength Assessment (pre-food safety issue)

*Source is text support materials for faculty. Note: miscalculation of Moes score; should be 8.90.

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