Chipotle's Q2 Earnings Report Bodes Well for the Future

The COVID-19 pandemic has crushed restaurant traffic this year. While restaurants focused on sit-down dining have been hit the hardest, fast-casual chain Chipotle Mexican Grill (NYSE: CMG) didn't escape unscathed, either.

Nevertheless, while Chipotle's revenue declined and its profit margin collapsed last quarter, business trends have improved rapidly over the past several months. This quick rebound during a period when many consumers haven't returned to their normal routines yet suggests that Chipotle is primed for explosive growth once the pandemic ends.

Looking beyond the raw numbers

On its face, Chipotle's second-quarter performance was unimpressive. Revenue fell 4.8% to $1.36 billion on a 9.8% comp sales decline. While digital sales more than tripled to $829.3 million, making up 60.8% of the sales mix, that still wasn't enough to offset the drop in sales inside Chipotle restaurants.

Meanwhile, restaurant-level operating margin plummeted to just 12.2% (down from 20.9% a year earlier), because of temporary labor inefficiencies, higher delivery costs associated with the surge in digital sales, and other pandemic-related expenses. As a result, adjusted earnings per share dived 90% to just $0.40.

That said, sales and margin trends improved rapidly as the quarter progressed. Comp sales plunged 24.4% in April -- around the peak of the pandemic -- but fell just 7% in May and increased 2% in June. Furthermore, between higher sales, more efficient labor usage, and the imposition of a $1 delivery fee to offset the higher costs of that channel, restaurant-level operating margin bounced back to around 20% last month.

A wide-angle view of the interior of a Chipotle restaurant

Image source: Chipotle Mexican Grill.

Sales trends strengthened again in the first few weeks of July, with comp sales up 6.4% year over year. That's particularly impressive in light of the recent surge in COVID-19 cases in many parts of the United States.

Digital engagement is working

While Chipotle has started to see more customers coming into its restaurants to place orders (even if they take food to go rather than eating in the dining room), digital sales are still close to 50% of the sales mix. In the past, management has said that digital customers are likely to be "stickier," and the early evidence is validating that hypothesis.

Chipotle has acquired a lot of new customers through its digital channels over the past few months. This has helped drive strong signups for the chain's rewards program. Once a customer signs up for Chipotle Rewards, the company has tools to create incentives, such as offering personalized offers to drive more frequent visits. Starbucks owes much of its recent success to using similar tools through its rewards program -- and Chipotle's chief technology officer is a Starbucks veteran.

Over the past few months, the digital sales mix has shifted toward order-ahead for pickup, as opposed to delivery. Pulling back on free delivery promotions helped to drive that shift, along with improved customer awareness of Chipotle's order-ahead options, including a growing number of "Chipotlane" drive-thru windows. This is great news for Chipotle, as order pickup is its most profitable transaction type, while delivery is least profitable.

Look for rapid growth as the pandemic eases

It's quite impressive that Chipotle has already returned to comp sales growth. The company still has about 30 temporarily closed restaurants in malls and similar locations. It also has more than 150 locations in dense urban environments that rely heavily on business lunch traffic that has suffered while people are working from home. The shift toward takeout and delivery instead of dine-in orders is weighing on high-margin drink sales. And of course, some people simply aren't eating restaurant food right now due to COVID-19 concerns.

While there's no way to be sure when the pandemic will end, Chipotle has a strong balance sheet and has continued producing positive free cash flow this year. Thus, the fast-casual pioneer isn't at risk of running into trouble if it takes longer than expected to develop an effective vaccine.

When the pandemic does end, many of the headwinds that have been holding back Chipotle's sales recently will lift. By that point, even more of the chain's restaurants will be outfitted with a Chipotlane. Finally, the company will have an even bigger base of rewards program members and more experience with using special offers to induce them to choose Chipotle more frequently -- and to order ahead for pickup.

Chipotle stock is incredibly expensive. It recently touched an all-time high and trades for about 55 times forward earnings. However, comp sales growth is likely to accelerate dramatically after the COVID-19 crisis passes. As a result, Chipotle is primed for massive margin expansion over the next few years, which could justify that hefty premium.

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Adam Levine-Weinberg has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill and Starbucks. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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