Case study

WIvEy rpubtishing Or.r October 18, 2012, Ster-en E11s, t1.re tbunder, ch:rirr-n:rn of the board, and co-chief executive otficer (CEO) oi the Denver, Colorado-based restaurirnt chain, Chipotle Ilexican Grill (CIlG), conrpleted the conference call tbl_ iorlrr.rg the release of the cor.npirr.rr''s tl.rrrd cluarter l01l results. \\-hile the reported results u-ere positir-e. analr-sts picked on the slorving don'n of sane-stores -.ale: (a ier. nretric fot restallrant cl-rains), the con-rpetition tiorn \unr Brands' 'faco Bell and their recent launcl.i oithe Cantina Bell ntenu and CXiG's annollncenent that ibod costs \rere e\Lrected to increase in the near tiltllre. Follo\\-ins the announcentent of thircl qnarter tesults. C-\lG's stock rr'ent dorr'n br- r-rearlr- 12 percent itr ir-rtra-dar- trirding tr.) lirr.rllr .t.rbilizc tr .r -.1 l-ereerrt ,irop nr:.,: if-',. p*,

",,.dar-'s price. At the end oi trading on October 1U, C-\lG,s stock price n'as at 5285.93, a sigr-riticat-rt decline tl.ont a ,51-rveek high oi S1.12.,10. CliG l-racl been tl.re clarling oiboth \\all Street and its crlstoller bnse eler since the compiln\'s tbunding in 1993 ancl its 1006 initial public oit-eling (IPO). Ltvestors \\-ere attrltcted to CllG ibr its fast glorlth ar-rd sizeable protit rr-rargins, rr,hile custonters responded t'ar-otablr-to its "Food rvith Integr.itr.,' tnission oi serving good qualitr- ibod n-ith inputs sourcecl r-rsing sustain:rble t-arrr-rir1s practices. Both Eils and his co-CEO, -\fontgonrerr- F. \loran, l-rad to respond to the challer.rses contionting the contpranr'.

Profile Fol tl.re I'ear 2011, the National Resl.aurant Association projectec-l total U.S. restaurant sales of S63l.g billion (corr-rpared ro S-3t9 billion in 2000 and 5239.3 in 1990), rr'hich represente d nearlr- -1 percent o1, the gross doniestic procluct. There rr'ere 9;0,000 restaurant locatior.rs, and the industrl elnploved 11.9 million peopLe (10 percer-u oi the total n'orktbrce). The restauriLr.rt indr,istrr.'s share oi the tbod dollal rr.as -18 percer.rt in Z01l contparecl to l5 percent in 19-;,;.'

The restaurant industn- consisted of a number ol seg_ ments sucl.i irs eating places, bars and tat.erns :rnd lodeing place re staurirrrts. Tl.ie three largest segments rvere iirll ser- r-ice. quick service iirrd lirst casual. Fuil sen.ice restaurants otteled table orclering, and tl.ie average check (revenue per custonter') rvirs the highest of the three segments. \\-hile national chair.rs suci.r as Dirrden Restaurants (oper..rtor oi Red Lobster, Olir.e Garden ar.rd Longhorr.r Steakhor-rse) and Dine Equitr'(IHOP ;rnd Applebeet) existed in this seglilent, the ntirjoritl r-ri 6prg1.i16r.5 rvere indir-iduals, firmilies or lin.rited paftnerships. 1'his segrr-rent accounted tbr il.i percent oi indr-rstrv re\-eltlles in 2011.

The quick serr-ice segnlent (previouslr. ref-erted to as "fast lbod") consisted oi restaurilnts that otiereci tast

Ch potle [,1exican Gril or any of ts employees.

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84 Vers oni 2013 C6-11

counter seryice ar.rd meals to eat in or tirke out. This seg_ ment \ras turther broken dorvn into outlets that special- izecl ir-r selected menu iterns such as hambureers, pizza, sandrliches ar.rd chicken. Because oithis segn.rentt focr.rs on quick service and price (the ar-erage check rr-as the lorvest of tl.re thlee segments), Jarge chains tended to dorninate. Accor.intit.rg tbr abor-rt S168.5 billion irt rer-- enues in 2011, this segment heid a 28 percent share of the restaurant market.

The fast casual segment \\'as the sn-rallest of the three, :rccounting for about .{ percent ir.r natket share and S2-l billion in 2011 rer.enues. Operators in this seg- ment of-tered portable convenient tbod ar.rd tbcr-rsed or.r tresh healthtul ingreclients trnd ci-rstomizabie n-rade-to- order dishes. The ar-erage check in this sesment ranged betrr-een S7 and S10, price points tr-picalir-ion-er than the tull service segment and l-righer than the qr_rick service seqment. Fast casual n as the t-astest grotving oi the three segments, n-ith an 11 percent grorrth rate betrveen l00i iir-rd 1011. The NPD Group, :rn industrr- research tlrm, indicated that as this segnent rvas it.t its grorr-th phn5g, it ihced intense con-rpetition ti.om botl-r the quick serr-ice and the full service segments. Buoled bv the grorr'th in fast casual restaurants, several tull service operators had recentlr- entered this segn.rent. For example. pF. Chang's olrened its Pei \\rei locatrons, and Rr_rbv Tuesdav pianned to increase the number of its Lin-re Fresh eateries to 200 locations bv the end oi 1012. Panera Bread. CIIG, Fir.e Gur-s Burgers ar-rd Qdoba (orvned br- Jack in tl-re Box) rrere the leading t-ast casual plar.ers.

Industry Economics Restaurant running costs valied bv segntent. In acldition, costs \\-ere a tur.rction oisize and location. Upscale tor.mats (tvpicalll flll service restaurants and sonte t-ast casr,ral chains) ntade higher in\.estments in interior design and also ir.rcurred higher input costs. Ilar.n-chain restaltrants tvpicallv chose locations rr'ith high population rlensrr\.or a larqe geographic drarv. Food ancl beverage, labor and real estate costs \rere the three largest e\pense catego ries tbr restaurants. Tt'picallr; both tbod and bcverage ar.rd labor costs accounted tbr aror.rnd 30 percent each oi re\-enues, u'hile real estate costs rlere around 5 percellt. \larketing ar.rd general trdministrative overheird u-ere the significant non-operating exper-rse categories. The Niltior.ral Restaurtrnt Assoclation reported that in 1010 the average income betbre income tares oi a restaurant operator ranged betrveen 3 and 6 percent oi revenues.

To cot.rtrol the cost of inputs, manr- large national ar.rd regional chains negotiated directlr' n-ith their suppliers (to benetit both con-rpan\'-o\\-ned and fianchisee-orvned

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restaurirnts) to ensure competiti\-e prices. \lanv chilins also engagecl in toru'ard pricing to ensure stabilitv ir.r input costs. The Ntrtional Rest:rurant Asstrciatioit reported that beef prices hit record ler.els in 2011 ancj \rere e\pectecl to be er.en higher u'hen the prices tbr l01l rrete flnallr- tallied. Beef prices rose 53 percent in 1012 abor-e 2009 ler-els as the three largest exporters oi beef to the Ur-rited States - Australia, Canada ilnd Nerr- Zealar-rd - all redr-rced their shipn.rents ilue to a r-ar.ietr- of global tactors. \\'hile the price of r.trrious dain- item-s (n.rilk, butter, cheese) had remained fairlr- stable or er the last terv \-ears. the price of grains such irs rvheat and corrr had t-luctuated due to changes in supplr- and der.nand as rr-ell as rr-eather-related fhctors. The price of tr br.rshel of wheat \rent L1p from 56.-18 in 2007 to S7.30 in 2011, alter fhlling to S-1.87 in 1009. Similarh., u'hile the :rr-erasg p1l6s of a bushel oicorn l-as 5-1.20 in 2007, it rose to 56.10 in 1011 atter falling to S3.55 in 2009.'

Key Comp€titsrg A tbrn-rer CEO oi Taco Bel1, the tr,lexican tbocl ci.rair-r ouned br' \-um Brands, captured the corr-rpetition ir.r the restaurant industn- in the follorving obsen'ation: "\\-e are irll competing tbr tr share of the custonter's stoilach.".

Plar-ers in the restnurant industr\-coulpeted not onh-n-ith their segrnent's plavers but also rvith those oi other segtnents. in addition, thev competed rr-ith r.neirls prepared at home as rlell as frozen or packaged tbod items atailable in supermarkets. \\'hi1e restaurants t.tccounted ibr about -18 percer-rt of the dollar alroLlltt spent on tbod in 2012, the economv plar-ed a major role in this. In a 1011 National Household Surr-er. renorred irr Strrndard & Poor's t,rdr.,rtr, iu"r.r,. :'-p.,1.1.',r,'"i those surveved indicated that ther- n'or-rid increase their etrtir.rg out spending ln 2011, rr-hile ll percenr rlould decrease it slighth- and 37 percent n'ould reduce it significantlr'.

CIIG t-aced tr-o major contpetitors in tl.re Iiexicar.r fbod categorv oithe restnurant industrr-. \\-hile Taco Bell rvas a plaver in the quick serr.ice segment, Qdoba cor.r-r- peted, like CIIG, in the fast casual segment.

*ds:b*t. Qdoba u-as a nho11v oryned subsidiarv of the San Diego, Calitbrnia-based Jack in the Box chain and in 1012 had 600 restar.rrants in .12 U.S. states anci tl.re District of Columbia. Qdoba rvas tbunded in Boulder, Colorado in 1995 and grerv nationallr- br. t-eatr.rring -\lission-str-le burritos (made thn.rous tirst in San Francisco). .\tier Iack in the Box acquired Qdoba in 2003, it expirnded the brtrnd rapidlr'. Of the 600 restaurants in the chain in 1012, around 3-r0 rvere tiar.rchisee-or\.ned and the rest

\\'ere compan\'-o\rned. A franchisee spoke about his raticln:rle tbr launching a Qdoba restaurant:

\\-ltt'tt lttrLtcted us to tlrc cht'titt tt'tts tltrnlitt. \\-lrat broLrglt us to tltis is thot ererl,thing is l.trmtlcrtt-itetl ttnd tttatle tlttily. 1\'e cottsider ouireh,e-s fo be on Llrtistln.fast.toorl c/r,iiri. l\l conte in every ntorning about three hours prior to opert_ ing ond stort cookirrg lur tneals. I\'e st(lrt 01ff sllr,rlasted pork artd sltcddetl bee,i thdt cooks .ior 6 to g ltottrs. Otu. cltickert is tttarinated in otlolto splce-s./br 2.J lrotn.s Lte.f'ore 11'c -{ci-1,e it. I\'e haye an artistttt table t'here t,e tttoke ottr pico tle gn//o .srl/.sa, rnix our cilt:utro rith rice arrtl prepare our guocantole Lts cttstotnet.s :r'atcl.t. I\-httt trtoke s Lts stattLl oLtt is tlrc qtnlitt, of'tlrc irtgredietis tr'e trse tvrtl orrr.-si97i,1_ ttu'e.f7ovt'trs. I ltelieye being.fon,.iriettdlt, anLl .iresh is trhat ilcfte,i l-i ,slrcccs.:-/ir/ in business.-

The companl reported an a\-erase check of S9.i.l in fis_ cai 1011 tbr contpar.rr--operated restaurants. 1'he irr-erage r-earh- relenue per restaurallt was 5961,000 in 2011, irn increirse oi-r.-3 percent or.er 2010. iack ir-r the Box had rer,- enues of S2.17 billion irnd net income oi S6,.g,3 ntillion in 201i. The corr-rpanr. stated that there rras long-term potential to open 1,600 to 2.000 units across the Unitecl States.'

T;q* **ii. Taco Bell was part of \ur.t.r Brands, inc., rlhich also ol'ned the KFC and pizza Hut chains. \unt Brancls rr'as the \\-orlcl's largest rest:rLtrilnt cc-rr-npartr. ir-r terlns of units, t.ith nearlr- ,38,000 resttrurants in ll0 countries. In flscal 2011, \'unt Brirnds reported re\-enues oi S1l.616 billion and a ner incorne of SI.,lt9 billion. -\t tl.re er.rd of fiscal 2011, there rr-ere 5,6,0 'faco Be1l res- talrritnts in the United Sttites, oi n-hich li percent \rere corlpan\'-o\{ned. Taco Bel1 reportecl a,10 percent urar.ket share in the U.S. Ilexican quick serr.ice segntent. For. tjs- c:rl 1011, the irlerage annual re\-enlles per restalirant \rere Sl.l8-1 r.niliior.r.'

1n -\];11.-11 l0Il, Taco Bcll begair testing .t ne\\, rr-renu called "Cantina Bell" iit ;5 U.S. rest:rLlrants. It rr'orked rr-ith a Ilianti-based chef irnd television per.- sor-ialitr-, Lorent-r Garcia, to create a nerr'1ine of up5gnlg menu items including C\lG staples such as black beans, cilantro rice and corn strlsa. Greg Creecl, Tacct Bell's president, talked abor.rt the motivation bel.rind Cantina Bell:

Cltipotle is art opportunitl, becttust y'ltot it's cittrtc Jt,ts expartded tlte trial ond usttge o,i )Ic.ticttrt,/bor/. 1t-s got people to ltelicve thet' can pd\, 58./br rr ltowl ttr n lturrito. Toco Bell cttrt rnake-fotttl eyer),bit os gttotl tts Chipotle Ltrttl irtsteod c/irlr.gc /e-s.s tltttrt 55.)'

Fart r Case:

Zagat Comparison of Cantina Bell and CMG in New york City

Burrrto bowl with chicken

Steak burrito

Overall assessment: For practically half the price, the Cantina Bell menu is a definite value, bLit you get what you pay for, and the overall quality and taste ofChipotle still has an edge overTaco Bell.

Source: httpi b cg.zagat.ccm 2012,07 taco be l-vs chipot e taste testrng.ntnr. accessed O.:obe. I 9, 2!-2

Taco Bell's tarqet market \\-as an 18- to 2.1-r'ear-old r-:rlr_ie- Jon:cioLr. rrr.rlc. Creed :a\\ Cflntiltit Bell rr, hclpirrg Tcco Bell appeal to ar.r older and less value-consciorls group of custorners. Tl-re Cantina Bell launch (and sr,rbsequent erpansicrlt nirtionrride in Julr- 2012) lvas cited as one of the reasons for Taco Beil's sarle store sales grol-th of l percent ior third quarter 2012 (contparecl to the srmr- lar period in 1011).r: Exhibit I presents the sumntart. oi a Z:rgat coltrparisolr sllrvev of Car.rtintr Bell and CllG in \err-\brk Citr'.

Orlgin and FarlSi Growtlr In 1990. aiiei. qracluating lion.r tl.re Culit.rarr- InstitLlte oi Anrelica in \eir' \brk Citl-, Colortrclo-born Ster-en Ells n.roved to San Francisco to rlork as a sous chef at a restauritltt. In 199_1, he oper.red a totluerict (tr Sp3ni5l n-orcl nteirning "taco shop") in Dent.er, Colorado, usins S85,000 as capital obtained fron.r his t'ather. His gorii rr.as to reinvent -\lexican tbod. He r-et-lected on the or:isins of hrs ilrst restaLlrant:

I tt'trtttetl iore rs o.f bttld -tloyors tltt'tt lutd nututce ortcl Lleptlr. n()t .tLtst liot, ttot,lt.t,r/ -?lc,t'r cutttirt, cilLtntro, c/crle_,, ./j-e-.ft oreg(1t10. ie rtrott, ttrtd lirrte. It looked, sntelled, tuttl tastetl tli.t'ferettt .lj'ont trnLlitittnal .fnst .iootl. Antl it tlitln't tLtke lortg bt.ittrc tltere :nas a lirrc o.i peoplc t,aitirtg to gct ijt. So I tliougltt, trttt.t'lte I'l/ open one nlore. 1 rlrt,s r?irr,rl,i,-s tlttitt rebellious (u1d did tlirtgs tttt' ov,tl lt,o\,. FrienLjs sttitl -lferlcrlr .Ioo(/ l-( clteLtp -

1,'oLr c(ut't clnrge 55 ,ior tt bur- rito. Bttt I said tltis is real .iood, tlrc ltigltest-t1uttlitl,-fttocl. Friertds sttid yt'tLt cttrit ltttt'c otr opeil kitclrcn, Ltti I wru.Lted tlte restitttrctrtt to be like it dinner part\', vhere eler lorrc-. itt tlte kitchett t,tttcltirtg q1,/i171ls goir{ on. Thet, sttid ptople ItLtt,e to ordcr tlteir mtal ltt'ruuttber. But I said trr), r,o1l

hnve to go tlrough the line dtld scle ct t'ttur inqretliertts. -\rul eyer)'orte garte me grie,f ot'er tlte nttrne: -\oboril rlll1 fu nhle to prortouttte it.:

Ells opened a second restaurant usins the protlts tron.r the tlrst and a third (a11 in Denr er., Colora.lol rrith a loar.r tion.r the Small Business Adrllnistration. \\-hen he l-rad opened 16 restaurants bv 1998, \{cDonalcl's Corporation (the global leacler in thst tbod in tetms oi rer.enue) ntacle ar.r initial investment to help fund the contpan\.'s gro\\-th. The con-rpanr. quicklv grew to more than 500 units in 2005 (prinrarlh' r-rsing IlcDonaid's 5360 n.rillion capr- ta1 infusion) and on lanuan'16, 1006 made its IpO. In October 2006, IIcDonald's fullr- dir-ested its holdings in CIIG ibr a r.alue of S1._; billion. Ells talked abor_rt CIIG and \lcDonald'-s: "Thev funded our grortth rr.hici-r allorved L1s to open 531 restalrrrnts. \\'e iear.ned lrom each other, but u'e use ditterent kinds of tbod. and u.e aim tbr a ditterent kind oi erperience and cultr.rre alto- gether. So rve ended up going our \eparate rrar-s.",'

The Fush to Sustainable Sourcing Ells happer-red to read an article br- Edrr-ard Behr that told the storv of an lorr'a thrmer rr.iro r.aired !.iss with- otit using antibiotics or contining them. Behr \\.ent on to add that the meat tasted rnuch better than the ntass mar- ket meat that rvas sen'ed in most restaurants. f he Behr. article led Ells to learn about concentrated anin-rtrl t-eed- ine operatior.rs (CAFOs).ir Iu manr- c-ler-eloped countries, tl.re dominant rnethod of raising lir-estock fbr. commer- cial purposes \\.as through CAFOs, startine rr-itl-r poul- trv in the 19,-r0s and extending to cattle tlnd p61L [1- 1].r. 1970s. A CAFO enabled raising lir-estock br-using lin-rited space. The U.S. Environnter.rtal Protection Agencr' (EpA) deiined a CAFO as "irn anim:rl ieedine operation tl-rat contines animals lbr more tl.ran -15 davs dr.rrir-rg the erorr- ing season in an area that does not produce \-egetltion and rneets certain size thresholdsl':

CAFO confined large number oianintals in a limited space ancl substituted man-made structures (ibr f-eed- ing, temperature and manlrre control) fbr natural ones. A studr'r'' reported that rvhile it took one million tan-r.rs in 1966 to house 57 million pigs, throueh CAFO it took onlr' 80,000 f:rrms it.r 2001 to house the sane number of pigs. CAFOs had a negatir.e impact or1 \\-ater and air qualitv and hence rvere regulated br- the EPA. In addi- tron, manr. commercial CAFOs established agricultural \\'ater treatment plants to control ntanurej u.hicir htrcl a negatir-e impact on the environnent.: Atler Ells r-isited several CAFOs, he decided to sollrce trom open-range pork suppliers starting in 2000, naturalh-raised chicken

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iror.n 2001 and natllrallv raised beef soon alter. The companv tbrn-ralized its sourcing policr- in l00l rvher.r it lar-rncl.red its "Food u'ith Integritr-" r.r.rission statentent:

FooLl :l'itlt integritt, is our contmitment to.iinding tlte vert ltest irtgredients roised n'ith respect .for the r'urittrnls, tlte ern,irottrrtertt and tlte ,farnters. It menns -serllri.q tlrc t,ert Ltest sttstttirtoblt, raised _fbod possible n,ith ttn ete to greor toste , great rttttritictrt ttnt.l great yttlue.t"

CllG ol'ned and operated 1,316 restaurants in lune 2012, of rrhicl-r lbur u'ere in Canada, three in the United Kinsdom, one in France, and the rest in the United States. It reported revenues of $2.270 billion and a net income of Sl15 million in tjscal 2011. It emploved lg,_3,0 hourlr- rr'orkers and 2,,;;0 salaried emplor-ees. Ells rr-as CllGs CEO ti1l .lanuarr-1, 2009, rvhen trlor-rtsornerr. F. Iioran (rr'l.ro l-rad been the compan\-'s chiei opslnling otficer since llarch 2005) rvas appointed co-CEO alor.rg rr-ith Ells. Ells, l.rorr-ever, retained his title as cl-iainnan oi the board.r''

Restaurant 0perations -\11 of CIlG's restallrants \\.ere companr--ou-ned. Thei. rr-ele either end-caps (at the end of a line of ret.ul out- lets), in-lines (in a line of retail or-rtlets) or-tiee,standir.rg. A trpical restaurant ranged ir.r size betu-een 1,000 and 2,800 square t-eet depending on the market and cost S850,000 to open. The smaller restaurants rvere called "-\ Ilodel" restaurants, the first of n'hich rvas opened in 2010 to serr-e less denseh'trafficked ;rreas. Restaurants serr-ed a linited menu of burritos, tacos. burrito borr'ls (a burrito l-ithout the tortilla) and salads, all preparecl t'ith tresl-r ingredients. Customers placed their order (burrito or taco) at the beginning of a line and adcled insredier-rts of their choice as thet'moved along the iine. Nor-re of the lestaurants had freezers, microrr'ar.e o\-elts or can openers.l

Given tl.reir higher than average fbod costs, CllG tbcr-rsed on operatior.ral efllciencr- at the restaurant ler-el. The restaurant size u'as tvpicallv snraller than those ofits peers, ancl it economized on labor br- keeping its ntenu options lin-rited and bl using an assembh-line sr-stent tbr fbod preparation. Chris Arnold, CNIG's corrntunication director. spoke about the compant.'s eftlcieno-fbcus:

\\-e nre I'ig belieyers in y'hat author lin Collins cL'tlls 'the genius o-f ond.': \'ou can sert,e grettt.food nttttle r.ith ingre- dierts.irom more sustaindble sources and tJo it ttt n rettsort- oble price. \bu can have ligher.food costs than t'tttn- peers

88

otr.l still hore strong margins. It .just tttkes the discipline to _figurc it out.':

In 1009, the conrpanr- entered into a partnership 11.11[ 4 compan\-to install solar panels in its restaurants. CllG ain.recl to be the largest dlrect producer oi solar ener.gr- in the restatuant industrv in the next tir.e r.ears. Ells talkec-l abor-rt this:

Our t.lfort to chonge tlte u'a1, people thiilk aboti tnrd eat -fast .iood Ltegan with ottr cornnitntettt to sert,irtg .ioocl ntnde t'itlt ittgredients -fronl more sttstainctble sotrces, tutcl tlttt stttrre kind o.f thinking ilott irylTuences (1ll (1reas o.t oLrr &ii.siirc-s-s. Todat', n,e).e .fbllot,ing a sintilttr pcttlt in tlte tr,ttt, rle de-slql orttl build restaurants, looking _for ntore ern,i_ r o t t r r t e r i cr I l;, .ti' i e n d l;' b uil din g m ttt e r i ttl s tu t tl s I,st e n t s t h ttt nloke our restourotts ntore e,fticient.1.

C]1G's rationaie for usir.rg solar panels was to reduce the restaurarlt's traditional energr. consuntptiotl dur_ ins tlte peak peliocl of 11:00 a.m. to ,:00 p.n.r. Solar panel-s also reclr,rced the con.rpanr-'s carbon footpriut. Starting l-ith a restaurant in Il1inois, C)lG began to obtain LEED certiflcatior.r (Leader.ship in Energr- and Enr-ironrtrental Design, a certitlcation prrogram of dif- ierent lelels) bl r-rsing on-site n-ind tr.rrbir.res and cis- terns tbr rainn-irter l-rarr-estir-rg. It rr-as the tlrst restau_ rant to obtain the highest ler-e1 (platir-rr_rnt) oi LEED certitlcation.:- Br- 2012, three of its rest:rL1r.atlts \rer.e LEED certifled.

Supply ehain C)lGs supplv cherin l-as closelr- tied to the contpirnr-'s "Food rr-ith Integritr-" nisslon. The companr-'s ll incle _ pendentlr- otr-ned and operated distr.ibution centers servecl restaurtrr.rts in ir specitic geoerirphic L1l.ei1. These centers soutced inputs from sr.rppiiers tr-ho tvere evaiu_ trted or.r qr-ralitv erncl understar-rding of the conlpilrl\-'s ntis- sion. Kel ingredients included r-aric-rLrs r.neats; r-egetables sucl-i as lettuce. cilantro and tomatoes; and clairr- items such as sor-lr cream and cheese.

In 2008, the companv embirrked on a progrant ro increase local (grorrn n'ithin 3-r0 n.riles oi the restiru_ rant) sourcing to 3-; percent of trt least one bulk procluce rtenr. The seasonal produce progran was meant to cLlt dol-n on tbssil firels used to transport proclucc, give locai thrr-rilv farms a boost, and intprole the taste oi the tbocl sen'ed to cLlstonrers br. using in.qredier-rts dr_rring their peak season. C\IG created a netrvork of 15 local tarr.ns to supplr' some of its romaine lettuce, green beli peppers. jalapeno peppers, red onions, :rnd oregauro to area resiiturauts.r' Tire local sourcit-rq Lrrogrant resultecl

ra': j Cases

in iive million pounds of produce in 2009 and 10 million pounds br'1012.r'

In 1011, 100 percent oi CllG's pork, g0 percent oi its chicken lrnd 50 petcent oi its beef rr-ere classitied as "naturallr-raised" meat - detlned as open range, antibi- otic il'ee and ted rvith a vegetarian diet. Fortv percent oi CllG s beans rr'ere organicaliv gro\\rt, n hile all of its sour creant ancl cheese u.ere made from milk that cante tiom corvs that \\'ere not gir-en tBGH (recor.nbir.rant bor-ine grorr'th hormone). L.r additiot.r, a sr,rbstantial percentage of the rrilk lbr sour cream and cheese rr.as sourced tronr dairies th:rt prolided pasture access fbr their corr-s.

-

Orgar-ric agriculture:' rvas sti1l in its it.rtano. in the United States in 2012. Less than 1 percent oi the total :rgricultural area \\-as managed organicallr.. Of that, tl-re percentage rr-as highest tbr prodr-rce, tbllorved br-livestock and then poultlr-. Sttrrting in the 1990s, the derrand tbr organic fbod dror-e the conr.erslon of traditional farms to organic at a rapid rate (tbt exan.rple, 1,1 percent in l00i_ 1008). The U.S. Deparrrrent of Agriculture (USD_\) reported that the average annual profitabilitr. of org.rnic thln.rs ii.r l0i1 rrt.rs S+5,69; r'ersus S25,.1.18 for traditional farms. Hor-er-er, the do\rnturn in the economr. that startecl ir-r 1008 slorr'ecl clon'n the conr-ersion to organic titr.nring to 6 percent betrr'een 2009 ar-rd l0l1.r', Retail chair.rs such as \\-hole Foods and Trader joe's cor.npeted rr-ith fill ser vice rest:rurants and other restaurant chair-rs tbr organic inputs, otien drivins up the prices l.ell above those tbr conr-entional ir.rputs. Ells cotnmented or.r the pricing chtrl_ lenses ancl continuir.rs ar-irilabilitv oi organic inputs: "'fhe supplr- chain h:rs tet to ctrtch up, organic ingredients are still pricer, and sr-rpplv is lintited. \\-hnt rve are doins i5 all 'inclenrental lelolution,' If rr-e ir-ent all-organic and natu_ ral norr', a bunito rr-ould be like S1, or. S18l'j

Marketing C,\lGs n.iarketitr.et budget r-as S,i2 n.ri11ion it.r 2011 r.er- sus 516 rnillion in 1010 nnd S21 nilliolr in 2009. The companl hacl recluced its aclr.ertising spencling ntore thar.r three vears iror.n 57.9 miliion in 2009 to S7.,; n.ril- lion in 1010 and S5.S ntillion in l0l1.r: It stated its polil. on ;icllertisins ir-r its annuai report: "Our rlarketinq ha, irhtals been birsecl on the belief that the best and most recogr.rizable brarncls arer.r't built tl-rrough adr-ertising ur. prornotit'rnal cantpaigns alone, but rather tl-rrough all oi the rrt.tl-s people erpgrisn69 the brand. Our ntain method oi pronotior.r is rr-ord of-ntoutit publicitrj-'r:

\\-hen C,\lG hired IIark Ctr.rmpacker irs its tlrst cirief marketins oifrcer ir.r 1009, the tirst decision that he rnade rlirs to bltng the contpanr''s advertising in-house tather than use the services oi irn outside agenc\-. He also made

Ca:e 8 Chlpctle Mextca'r Clll. hc F.cl !,,/tth jr:aJ"i::

the decision not to ad\.ertise it.r traditional meclia such as T\- at.rd instead rel)- on various lor-altr- programs. He gare his rationale tbr it

The olternatit,e is to st,itch to the tt,pe of ntttrketing thttt erery other -fast-footl cotllpan)' uses t,ith these nev ntenrr itents and big ad campaigrts to promote them. I thittk once tou get on thot moclel, I thntk it's \,ert'j t,ert hartl to get o-ft. I v,ont to try to do tl.ris flot'alty programsl ris /o/rg d-s I cott.))

One ior'altr- program n'as called "Ftrrnt Team." This rr.as an iitr-itation-ot.rlr. online program tl.rat qr.rizzed users on sustainabilltr., organic farmir-rg and hurlane lbod sourc- ir-rg and rervarded then.r u.hen ther. shared the knorvl- edge rvith others via soclal rr-redia. Arnold t:rlked about the program: "This is a passion program. Through Farm Team, rve are looking to identiti.oLlr most lor-al and pas- sionate customers, and eiving theur tooLs to share their passion fbr Chipotle. It's much more about building evangelism than it is about ren'arding frequencrr-'r-

In Augr.rst 2011, CNIG released an online commer- cial titled "Back to the Start," that teatured \\-illie Nelson singing a reu.orded r.ersior.r of Coldplarrs "The Scientistl' The commercial told the ston- (in animtrted tbrm) of a t:rrmer rlho moved tiont inhumtrne industrial tar.ming that used confir.red spaces to a ntore hurrane sustain- able farrr-ring rnethod. The popularitr-of this comrlercial led to CN{G releasing it tlrst in 5,100 n.rovie thetrtres rn September 2011 and runnfi.rg it once on teler-isiotr .ir-rring t1-re 2012 Gramm\. Ar.r'ards shon-.':

A one-dav tbstivtrl called "Cultir-ate" held in Chicago in October 2011 brought together thrmers, chefi and rrusic bancls. The goal of the festival \ras to promote sus- tair.rable fantih- fhrms. Other promotional items included lPhor]e games and local prir.rt trdr-ertising to accompan\- store openings.''u A marketing expert assessed CIIGs non-traditional marketit.tg strateg\-:

Clripotle has.fbund n "s:i''eet spot" tt'ith ntillenrtittls Ltt' solid- i,ff ing its reput(ltiot1 fbr ,freshness and o_ftering tt hettlthier .fore thott its competitors. The brarttl .liso grtin-{ repLttatiotl lry sltyittg tu.t,ay from tratJitional nteditt, ltecttttse ).olutger oudiertces.t'eel like it's more tufthentic, tlown-to-enrth and eos1' to connect with. Millennials yiet' the lttck of f\' ns tttore cuthentic. Millenniols ore likelt' ro di-snli-ss d lot o.i clairns. T|rc1, 61's responding to eter1'tlting the brtuttl tloes and says.)-

Finances Exhibit 2 gives a cost comparison of kev expenses fbr CIIG and its competltors, Exhibit 3 presents CllG's

89

Selected Cost Comparison - Key Competitors

(Costs as Percentage of Revenues)

YUM Brands'

Food & packaging

Labor

Occupancy & other reSlaurant operat- ing costs

Qdoba

Food & packaging

La bor

Occupancy & other restaurant operat- ing costs

CMG

Food & packaging

LA DOT

Occupancy & other restaurant operat- i ng costs

32.ss

23.93

17.56

YUlvl Brands does not break down data for each of its three chains IKFC pizza Hut, a nd Taco Beli i.

Source: Company i0 K's.

CMG Consoiidated Statement of Income (for year

Ending December 31 in 5 Thousands)

Reven ue

Restaurant operating costs

Food, beverage and pa ckag i ng

La oor

Occupancy

Other operating costs (marketing,

credit card, etc.)

General and admin istrative expenses

Depreciation and amortization

Pro-nneninn rnct<

Loss on disposal of l assets

Income from operations

Net income (after interest and taxes)

2,269,548

738,720

543,119

147,274

251,208

149,426

74,938

8,495

s,806

350,562

214,945

1,835,922

45? 571

128,933

202,904

68,921

7,767

6,296

287,831

178,981

1,518,417

466,027

385,072

114,218

174,581

qq 110

61,308

8,401

5,956

203,705

126,845

28.30

27.70

30.00

(Continued)

90

Consolidated Balance Sheet (condensed for December 3l in 5 thousands)

D:"'/

CMG Selected Stock Price Data (in S At Close of Day)

Assets:

Current assets:

Cash and cash equivalents

Accou nts receivable (net)

I nventory

Current deferred tax asset

Prepaid expenses and other cur- rent assets

Income tax receivable

Investments

Leasehold improvements, property and equipment, net

Long-term investments

Other assets

Goodwill

Total assets

Liabilities and shareholders, equity

Current liabilities:

Accounts payable

Accrued payroll and benefits

Accrued liabilities

Current portion of deemed land- lord financing

lncome tax payable

Deferred rent

Deemed landlord fi nancing

Deferred income tax liability

Other liabilities

Total liabilities

Total shareholders' equity

Total Iiabilities and sharehold- ers'equity

401,243

8,389

8,913

6,238

21,404

55,005

7 s1 ,951

128,241

21 ,985

21 ,939

1,42s,308

46,382

60,241

46,456

133

4,241

143,284

64,381

12,435

381,082

1,O44,226

1,425,308

289,191

224,838

5,6s8

7,498

4,317

16,416

23,528

124,766

676,881

16,564

21 ,939

1,121,605

33,705

s0,3 3 6

38,892

121

123,667

3,661

50,s25

9,825

310,732

810,873

1 ,'t21,60s

260,673

167,2A8'1

\61 ,943j

January 26,2006 (lPO)

)anuary 3,2007

January 2,2008

January 2,20Q9

January 4, 2A1 0

January 3,201 1

January 3, 20 1 2

April2,2012

April 13, 2012

May 1,2012

June '1, 2012

.)uly 2,2012

August 1, 201 2

October 1, 201 2

October 2, 2A12 Einhorn)

45.00

59.42

120.38

47.76

96.46

218.92

367.29

414.15

442.40

413.07

37 9.95

292.33

288.64

31 6.33

302.96

Net cash provided by operating activities

Net cash used in Investing activities

I Net cash used in \94,522) financing activities

The company made an ad.justment for exchange rates tc feconci e open ng and closing cash ba ances.

Source: Chlpotle I\,1exican Grl l, Inc.20l I lC K.

Source: ComDiled fron Yahoo Finance, wwv!.finance.yahoo.come,chartsls=CiVG -rnteract ve:symbc =cmgirange=5y;compare-;indlcator=vo unre;charttype=are a;crossha r=on;chicvarues=0;lcgsCale=off:source=Undeflned;, acCeSsed October r 9. 20'2.

tl.rancial statements. n'hile Exhlbit 4 gives a list of the conpan\''s stock on specific dates. Third quarter 2012 results showed a revenue increase oi 19.4 percent over the sante period in 201i and a net income increase oi 19.6 pg16sy11. Same-store sales increased bv .1.8 nercerrr in the qtrarte' conrparcd r" ll.3;.r.;;r-i,r tni,.a;,,;;r;'- 2011. Rer-enue gro\rth was attributed to both ne\r restau_ rant openings and ntenu pt'ice increases. The corTtlranv launched a s\-stem-wide nlenu price iltcrease in 1011 whose implementatiou \ras cor-npleted in third quarter 2012.r'

On October 2. 1012, Jeff Einhorn, u'ho headed a hedse fund, n.rade a presentation at the \hlue Inr-estors Cont-eret.ice in \err. \brk Citr'. In his ptesentatlon, Einhorn said that CllG n'as an attractive stock fbr short sellers because the conpan\- t-aced significat.rt compe- tition, principalh'from Taco Bell's Cantlna Bell nenu, and increased tbod costs, both dr-re to its sustainable sourcing practices and a elobal increase in food com_ modit\" prices. He said that a sur\-ev conducted br. l.ris tirm tbund that , 5 Lrercent of self-identitied Chipotle cLlstonrers also frequented Taco Beli and that Taco

411 ,096

(210,208)

(24,268)

Bell can.re out on top on both price aucl conveuience. Einhorn stated:

Tu'erttt, three percett o,f Chiitotle .u-stonte,r,( ltad ttlreath. tried Toco Bell's Carttina Bell ntenu - u'hiclt tettttLre s bur- ritos arrtl lntrrito bctu'ls ttradc rt'itlt .trtslt ingt ttlieuts -ortLl two-thirds o.f those custotners intlicnted thet. t,ottld re turn. I|httt\ rttore, tlte custotners tnost likel\, t() retlfftt to Toco Bell were also those rnost likely to eat Ltt Chipotlt, a dt'rtamic thot indicdtes to nte thttt Chipotte is ntost at risk o-f losirtg its ,freqtLent cttstorne rs.),

\\-ithin hours of Einhorn's presentation, CllG's stock began to fall. It fell br.- more than -1 percent br- the end oithe da1-, ar-rd stock analr-sts stared that CllG l-rad been "Einhorned."r"

In his cor-rf-erence call rvitl-r analvsts on October lg, 1012, Eils indirectlr.compared Cantina Bell rvith C\lG (rvith- out :rctuallr' naming his cornpetitor):

Tlte tat' Chipotle does i fs lrilsiiles.s is rtot ttrt cost' tlting to cctpt', ttntl though (r cotllpetit(ir ctrirlt/ tr//ii ,t sintilttr ite rrt, it's probabll, onll' on the xtr,fttce. Trrke d cornpant, tltnt sclls grilled clicken, -fctr instortce. \'et thctt conlp(inv tloes rtot Itote a grill, nor do the;'httye knit'es or cLttting &orl.r/-,i. So Itoll' rlo tltel' rnake real clticken ond art it tLp? ,\ntl in the ettd tlte customers rettlize the r/i_fterertce. Be cttre.fiLl ttf those :r'lto ltaye o loy'er cost opportlnlitt'. Tfu cl-slorilerli ilot e(ts- il;' iooled. Otu' itterttctit'e .fitrntat - tlte btrrittt ttssentlilt, lirte tltnt eleri, cLtstonler runs fhrottgh - is t'trt irrtporrttnt p,tt t

',.1 rr'/tat C/rrpol1,.drr..r.

He also indicated that CtrlG n-ould consider taising its menu prices in 2013 to make up ior expected higher iood costs. As he cor.rf-erred n-itl-r co-CEO -\loran tblloll.ins the

91

call, both r.nen listened in on Chief Financial OtTicer Jack Hartunq talkiire to a reporter:

The contpant u'ill be patient tt,ith its pricing r/eci,siori-s, ,so .r-i /tor to dcter cLtstoLners. I\te cotiltl ntot'e t1uickll,, btrt .r'e'r"e going to choose not to be in too muclt of u hLtrrv. I\-e r1()/t1 rr',1/i/ l,r 1,, t/ic.17i-sl oirts ,ttrl tt.t lhe 1,o.r rlll/i lr.r,.. lncred-ss-s. \\-c'd rother see n,httt happens y,ith tlrc e(.otlotltr., see t,lnt hoppetls tt,ith consunter spending, see trhat other cotltpetitors tlo ond hot, constLrners respontl.-:

CllG taced a l'rost of challenges. \\'hile the deprrg55.6 econonl\' fhr-ored quick serr.ice and t-ast casual I estauranls oler tuli serr-ice restaurants because oflorr'er check prices. consumer sentimeltt indicated that the ntajoritr- of theln uor-ild either curtail their spr.nding on eating or at best maintain it at current levels. h-r addition, Taco Bell rvas pror-ing to be a iormidable corlpetitor rvith its 5,670 U.S. restaurants pushine the higher margin Cantina Bell mer.ru thror-rgh ageressir-e and large-scale advertisir.rg. Finallr, the espectecl increase in tbod costs \\.as bound to .ittect CIIG both in its margins trnd in its quest to increzrse its usage of sust:rinable inputs. Both men recalied a sr.tre- ment lnade bv Arnold to an inter.n-ierver a ferr vears ago:

Cltipotle is tt good exantple o.f wltat cart httppert ttlrcn t,otr buck cont'ertiorrnl t,isLlom. I{e\,e built a chctin o,f .tttst,tbotl restnurdtlts shirking rrton;, o,f the things the indrLstrt' r''tts Lttrilt ott - v'e sperrd more on food, not ie.s-s; rlc ott n oLtr restouratts rather thott -frnnchisittg; anLi we don't :nnrket tr,slrig 1of-s o.i price prottrotions antl other gimnicks. Gttirrg thot route, n,e'ye built one o-f tlrc rtost srcddsr-/i tl resttun'ttrtt contp ntti es in t,e ors. "

\\ere sustainabiiitv and the "Food l.ith Integritr] cant- paien luxr,rries that C\lG could i1l afford in these difti- cult economic times? Could CNIG cor.rtinue to use qual- itr- and sustainablr- sourced inpr-its as differentiators to justiti-a higher priced menu?

Yahoo Finance, accessed Octolrer 18, 2012. Unless otheru/ise indicated, the rformation in this section is based on Standard & Poor's ndustry Surveys: Restaurants .)une 7, 2012. National Restaurant Association, 'Restaurants by the Numbers, u.,wrv. restaurant.org, accessed October 10, 2012. John T. Barone, "Commodity Outlook 2012 Nationa Restaurant Association, \vww. restaurant.org, accessed October 10, 2012. Thomas O..lones and W. Ear Sasser, lr., "Why Satisfied Customers Defect.' H d tvo rd

Btsi ness Revlew, November December :995, pp.88 99. lack in the Box,2011 t0-K. Da- 5eb. r Cood Fat,: t3r i s-. ,co Style Hits Huntington w th Qdoba, \.1..,i/!v.hera d dispatch.corn'enierta nment x]543286410,' San'Franc sco-style h ts-Nuntington !vith- Qdoba?l=0, accessed October 11, 2012. lack n the Box.20ll 10-K. Yum Brands, nc.20ll l0-K. Taco Bell Takes on Chipotle !,r'ith

Nelv i\'lenu, rvrv,"v.brandchanne . com home post 2012 01 24,

Taco Bell-vs-Cl' oor'e-Ol2/ 2 dsp.. ac:e))ed October 11, 20]2. Yum Brands, Inc. Press Release. October 9 2012

I\4argaret Heffernan, "Dreamersi Chipot e Founder Steve E s," urwrv.rd.com aov ce work careerldreamers chlpot efouncler- steve ells/, accessed October 12,2012. bid.

Chipot e website, "About Us, w,u",yr.cnroorre com,/en-us/company/about us aspx accessed October 1'1, 2012.

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