filings.toolsItem 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion together with Item 6. “Selected Financial Data” and our consolidated financial statements and related notes included in Item 8. “Financial Statements and Supplementary Data.” The discussion contains forward-looking statements involving risks, uncertainties and assumptions that could cause our results to differ materially from expectations. Factors that might cause such differences include those described in Item 1A. “Risk Factors” and elsewhere in this report.
Overview
Chipotle operates fresh Mexican food restaurants serving burritos, tacos, burrito bowls (a burrito without the tortilla) and salads. We began with a simple philosophy: demonstrate that food served fast doesn’t have to be a traditional “fast-food” experience. We do this by avoiding a formulaic approach when creating our restaurant experience, looking to fine dining restaurants for inspiration. We use high-quality raw ingredients, classic cooking methods and distinctive interior design, and have friendly people to take care of each customer—features that are more frequently found in the world of fine dining. Our approach is also guided by our belief in an idea we call “Food With Integrity.” Our objective is to find the highest quality, safest ingredients we can—ingredients that are grown or raised with respect for the environment, animals, and people who grow or raise the food. A similarly focused people culture, with an emphasis on identifying and empowering top-performing employees, enables us to develop future leaders from within. We believe that these fundamental principles can be adapted to other cuisines as well.
2015 Highlights and Trends
Food-Borne Illness Incidents. Beginning in the fourth quarter of 2015, significant publicity regarding a number of food-borne illness incidents associated with Chipotle restaurants in as many as 15 states had a severe adverse impact on our sales and profitability. As a result of these incidents, comparable restaurant sales declined 14.6% for the fourth quarter of 2015, including a decline of 30% for the month of December, and the decline worsened to over 36% in January 2016. Comparable restaurant sales represent the change in period-over-period sales for restaurants beginning in their 13th full calendar month of operation. We anticipate some improvement in sales trends as a result of the announcement on February 1, 2016 by the U.S. Centers for Disease Control and Prevention that it has closed its investigation into the E. coli incidents that first led to the significant decline in our comparable restaurant sales. However, due to the uncertainties created by the food-borne illness incidents, we are unable to provide estimates of any future movements in comparable restaurant sales. We plan to increase marketing and promotional spending considerably during the first half of 2016, including significant use of free and discounted food promotions, in an effort to attract customers back to our restaurants and reverse negative sales trends.
In addition to the impact on sales, the food-borne illness incidents resulted in non-recurring expenses in the fourth quarter of 2015 of approximately $16.0 million, which includes food waste, impairment charges for kitchen equipment that will no longer be used, insurance claim estimates, increased marketing expenses, lab analysis of food samples and environmental swabs, and retaining expert advisory services related to epidemiology and food safety.
As part of our response to the food-borne illness incidents, we are implementing enhanced food safety procedures in our supply chain and restaurants that we expect to increase our food costs as a percentage of revenue. Some of these changes are expected to result in fewer labor hours being required in our restaurants, but we do not expect to see the benefit until free and discounted food promotions return to normal levels. We expect the ongoing net impact of the enhanced food safety procedures on our food and labor costs as a percentage of revenue to be approximately 2% when fully implemented and after our operations are normalized. Additionally, we expect that our restaurant operating costs as a percentage of revenue will continue to be significantly impacted due to expected lower average restaurant sales, as well as increased costs to support marketing initiatives. As a result of the sales impact from the food-borne illness incidents and the additional costs described above, we believe that our net income will be at approximately break-even levels in the first quarter of 2016.
Sales. Average restaurant sales were $2.424 million as of December 31, 2015, decreasing from $2.472 million as of December 31, 2014. We define average restaurant sales as the average trailing 12-month sales for restaurants in operation for at least 12 full calendar months, and as a result, the foregoing average restaurant sales include approximately 10 months of operations prior to the adverse impact of the food-borne illness incidents described above. Accordingly, average restaurant sales will decrease further for as long as we continue to post comparable restaurant sales declines. Our comparable restaurant sales increases were 0.2% for the full year 2015. Comparable restaurant sales increases in 2015 were driven primarily by the impact of menu price increases taken nationwide in the second quarter of 2014 and in selected restaurants in the second half of 2015, offset by lower average number of transactions and group size, primarily in the fourth quarter. Menu price increases accounted for a 3.5% increase in our comparable restaurant sales increases for 2015.
Restaurant Development. As of December 31, 2015, we had 2,010 restaurants in operation, including 1,971 Chipotle restaurants throughout the United States, with an additional 11 in Canada, seven in England, four in France, and one in Germany. Our restaurants include 13 ShopHouse Southeast Asian Kitchen restaurants, serving Asian-inspired cuisine, and we are an investor in a consolidated entity that owns and operates three Pizzeria Locale restaurants, a fast casual pizza concept. New restaurants have contributed substantially to our restaurant sales growth and we opened 229 restaurants in 2015, and expect to open between 220 and 235 restaurants in 2016, including a small number of Chipotle restaurants outside of the U.S. and ShopHouse and Pizzeria Locale restaurants within the U.S.
Food With Integrity. In all of our restaurants, we endeavor to serve only meats that were raised without the use of non-therapeutic antibiotics or added hormones, and in accordance with criteria we’ve established in an effort to improve sustainability and promote animal welfare. We brand these meats as “Responsibly Raised TM.” In addition, a portion of some of the produce items we served was organically grown, and/or sourced locally when in season (by which we mean within 350 miles of the restaurant where it was served). A portion of the beans we serve is organically grown and a portion is grown using conservation tillage methods that improve soil conditions, reduce erosion and help preserve the environment in which they are grown. The sour cream and cheese we buy is made with milk that comes from cows that are not given rBGH. Milk used to make much of our cheese and sour cream is sourced from pasture-based dairies that provide an even higher standard of animal welfare by providing outdoor access for their cows. Further, we have achieved our goal of eliminating (as further described on our website) genetically modified organisms, or GMOs, from the ingredients in our food (not including beverages) in U.S. Chipotle restaurants, as well as ShopHouse Southeast Asian Kitchen. While the meat and poultry we serve is not genetically modified, the animals are likely fed a diet containing GMOs. We will continue to search for quality ingredients that not only taste delicious, but also benefit local farmers or the environment, or otherwise benefit or improve the sustainability of our supply chain.
One of our primary goals is for all of our restaurants to continue serving meats that are raised to meet our standards, but we have and will continue to face challenges in doing so. In January 2015, through an ongoing audit of our suppliers, we identified a pork supplier that was not meeting our standards related to the size and condition of the housing offered to some of the pigs, so we suspended our purchases from this supplier. Without this supply, we were unable to get enough pork to meet our standards for all of our restaurants, and were not able to serve carnitas in many of our U.S. restaurants for a portion of the year. During the third quarter of 2015, we began introducing carnitas from a new pork supplier in the United Kingdom, and this new pork supply allowed us to serve carnitas in all of our restaurants by the end of 2015. Additionally, some of our restaurants may periodically serve conventionally raised beef or chicken or stop serving one or more menu items in the future due to supply constraints. When we become aware that one or more of our restaurants will serve conventionally raised meat, we clearly and specifically disclose this temporary change on signage in each affected restaurant, so that customers can avoid those meats if they choose to do so.
Stock Repurchases. In accordance with stock repurchases authorized by our Board of Directors, we purchased shares of our common stock during 2015 with an aggregate total repurchase price of $485.8 million. As of December 31, 2015, $116.4 million was available for stock repurchases under the authorization announced on December 4, 2015. We also announced authorizations by our Board of Directors of up to an additional $300 million in common stock repurchases on January 6, 2016 and up to another additional $300 million on February 2, 2016. We have purchased $270.0 million of our common stock under these authorizations from January 1, 2016 through February 3, 2016. We have entered into an agreement with a broker under SEC rule 10b5-1(c), authorizing the broker to make open market purchases of common stock from time to time, subject to market conditions. The existing repurchase agreement and the Board’s authorizations of the repurchases may be modified, suspended, or discontinued at any time.
Restaurant Openings, Relocations and Closures
The following table details restaurant unit data for the years indicated.
| 2015 | 2014 | 2013 | |||
| Beginning of year | 1,783 | 1,595 | 1,410 | ||
| Openings | 229 | 192 | 185 | ||
| Relocations | (2) | (4) | - | ||
| Total restaurants at end of year | 2,010 | 1,783 | 1,595 |
Results of Operations
Our results of operations as a percentage of revenue and period-over-period variances are discussed in the following section. As we open more restaurants and hire more employees, our restaurant operating costs and depreciation and amortization increase.
Revenue
| Year ended December 31, | % increase (decrease) | % increase | ||||||||||
| 2015 | 2014 | 2013 | 2015 over 2014 | 2014 over 2013 | ||||||||
| (dollars in millions) | ||||||||||||
| Revenue | $ | 4,501.2 | $ | 4,108.3 | $ | 3,214.6 | 9.6% | 27.8% | ||||
| Average restaurant sales | $ | 2.424 | $ | 2.472 | $ | 2.169 | (1.9%) | 14.0% | ||||
| Comparable restaurant sales increases | 0.2% | 16.8% | 5.6% | |||||||||
| Number of restaurants as of the end of the period | 2,010 | 1,783 | 1,595 | 12.7% | 11.8% | |||||||
| Number of restaurants opened in the period, net of relocations | 227 | 188 | 185 |
In 2015, increased revenue was primarily driven by new restaurant openings. Revenue from restaurants not yet in the comparable base contributed $390.4 million of the increase in sales in 2015, of which $183.6 million was attributable to restaurants opened during the year.
In 2014, the significant factors contributing to our increases in revenue were comparable restaurant sales and new restaurant openings. Comparable revenue increases contributed $530.0 million of the increase in restaurant sales, due primarily to increases in customer visits, and an increase in average check amount, including the benefit from menu price increases. Restaurant sales from restaurants not yet in the comparable base contributed $364.7 million of the increase in sales in 2014, of which $173.9 million was attributable to restaurants opened during the year.
Food, Beverage and Packaging Costs
| Year ended December 31, | % increase | % increase | ||||||||||
| 2015 | 2014 | 2013 | 2015 over 2014 | 2014 over 2013 | ||||||||
| (dollars in millions) | ||||||||||||
| Food, beverage and packaging | $ | 1,503.8 | $ | 1,421.0 | $ | 1,073.5 | 5.8% | 32.4% | ||||
| As a percentage of revenue | 33.4% | 34.6% | 33.4% |
Food, beverage and packaging costs decreased as a percentage of revenue in 2015 primarily due to the benefit of the nation-wide menu price increases taken in the second quarter of 2014 and relief in dairy and avocado costs. The decrease was partially offset by inflation on beef costs.
Food, beverage and packaging costs increased as a percentage of revenue in 2014 due to inflation on many food items, primarily beef, avocados, and dairy. The increase was partially offset by the impact of menu price increases.
Labor Costs
| Year ended December 31, | % increase | % increase | ||||||||||
| 2015 | 2014 | 2013 | 2015 over 2014 | 2014 over 2013 | ||||||||
| (dollars in millions) | ||||||||||||
| Labor costs | $ | 1,045.7 | $ | 904.4 | $ | 739.8 | 15.6% | 22.3% | ||||
| As a percentage of revenue | 23.2% | 22.0% | 23.0% |
Labor costs as a percentage of revenue increased in 2015 due primarily to wage inflation and an increased number of crew and managers in each of our restaurants caused by scheduling inefficiencies occurring earlier in the year. Based on expected lower average restaurant sales, we expect labor costs as a percentage of revenue to increase for 2016.
Labor costs as a percentage of revenue decreased in 2014 due primarily to the benefit of higher average restaurant sales, including the impact of menu price increases, partially offset by an increased number of managers and crew in our restaurants and normal wage inflation.
Occupancy Costs
| Year ended December 31, | % increase | % increase | ||||||||||
| 2015 | 2014 | 2013 | 2015 over 2014 | 2014 over 2013 | ||||||||
| (dollars in millions) | ||||||||||||
| Occupancy costs | $ | 262.4 | $ | 230.9 | $ | 199.1 | 13.7% | 16.0% | ||||
| As a percentage of revenue | 5.8% | 5.6% | 6.2% |
Occupancy costs as a percentage of revenue increased in 2015 primarily due to higher average rents for new locations. Occupancy costs are expected to increase as a percentage of revenue during 2016 as a result of expected lower average restaurant sales.
In 2014, occupancy costs decreased as a percentage of revenue primarily due to the benefit of higher average restaurant sales on a partially fixed-cost base.
Other Operating Costs
| Year ended December 31, | % increase | % increase | ||||||||||
| 2015 | 2014 | 2013 | 2015 over 2014 | 2014 over 2013 | ||||||||
| (dollars in millions) | ||||||||||||
| Other operating costs | $ | 515.0 | $ | 434.2 | $ | 347.4 | 18.6% | 25.0% | ||||
| As a percentage of revenue | 11.4% | 10.6% | 10.8% |
Other operating costs include, among other items, marketing and promotional costs, bank and credit card fees, and restaurant utilities and maintenance costs. Other operating costs increased in 2015 due primarily to a change in the classification of kitchen gloves out of food, beverage, and packaging costs beginning in 2015, and higher marketing and promotional costs. We expect other operating costs to increase significantly as a percentage of revenue for 2016 as we pursue a marketing campaign, including an increase in free food promotions, to regain customers after the recent food-borne illness incidents and due to expected lower average restaurant sales as a result of those incidents.
Other operating costs decreased as a percentage of revenue in 2014 due primarily to the benefit of higher average restaurant sales on a partially fixed-cost base.
General and Administrative Expenses
| Year ended December 31, | % decrease | % increase | ||||||||||
| 2015 | 2014 | 2013 | 2015 over 2014 | 2014 over 2013 | ||||||||
| (dollars in millions) | ||||||||||||
| General and administrative expense | $ | 250.2 | $ | 273.9 | $ | 203.7 | (8.6%) | 34.4% | ||||
| As a percentage of revenue | 5.6% | 6.7% | 6.3% |
The decrease in general and administrative expenses in dollar terms for 2015 primarily resulted from decreased non-cash stock-based compensation expense, lower bonus expense, and decreased expense associated with our biennial All Managers’ Conference, or AMC, held in the third quarter of 2014. Stock-based compensation expense decreased $39.4 million. The decrease was primarily due to a change in the structure of our executive compensation, as well as a decrease in our estimate of non-vested performance stock awards that we expect to vest, resulting in a cumulative adjustment during the fourth quarter of 2015 reducing expense by $12.2 million. The total decrease was partially offset by higher payroll costs as we grew. We expect general and administrative expenses in dollar terms for 2016 to increase due, in part, to additional stock-based compensation expense, payroll costs as we grow, and costs associated with our 2016 AMC scheduled for the third quarter of 2016.
The increase in general and administrative expenses in dollar terms in 2014 primarily resulted from increased non-cash stock-based compensation expense, higher payroll and bonus costs as we grew, as well as costs from our AMC held in the third quarter of 2014.
Depreciation and Amortization
| Year ended December 31, | % increase | % increase | ||||||||||
| 2015 | 2014 | 2013 | 2015 over 2014 | 2014 over 2013 | ||||||||
| (dollars in millions) | ||||||||||||
| Depreciation and amortization | $ | 130.4 | $ | 110.5 | $ | 96.1 | 18.0% | 15.0% | ||||
| As a percentage of revenue | 2.9% | 2.7% | 3.0% |
Depreciation and amortization increased as a percentage of revenue in 2015 due to reinvestment costs for our restaurants as they age.
In 2014, depreciation and amortization decreased as a percentage of revenue as a result of the benefit of higher average restaurant sales on a partially fixed-cost base.
Loss on Disposal of Assets
| Year ended December 31, | % increase | % increase | ||||||||||
| 2015 | 2014 | 2013 | 2015 over 2014 | 2014 over 2013 | ||||||||
| (dollars in millions) | ||||||||||||
| Loss on disposal of assets | $ | 13.2 | $ | 7.0 | $ | 6.8 | 89.1% | 3.3% | ||||
| As a percentage of revenue | 0.3% | 0.2% | 0.2% |
Loss on disposal of assets increased in 2015 due to impairment charges resulting from an internally developed software program that we chose not to implement and related hardware, the discontinued use of certain kitchen equipment as we move more food preparation to central kitchens, as well as restaurant relocations. Loss on disposal of assets remained relatively consistent in 2014.
Income Tax Provision
| Year ended December 31, | % increase | % increase | ||||||||||
| 2015 | 2014 | 2013 | 2015 over 2014 | 2014 over 2013 | ||||||||
| (dollars in millions) | ||||||||||||
| Provision for income taxes | $ | 294.3 | $ | 268.9 | $ | 207.0 | 9.4% | 29.9% | ||||
| Effective tax rate | 38.2% | 37.6% | 38.7% |
In 2015 and 2014, the effective tax rate was lower than 2013 because there was a decrease in the state tax rate. Additionally, 2014 included a benefit from filing the 2013 tax returns, which included a non-recurring change in the estimate of usable employer credits. For 2016, we expect the effective tax rate to be 39.0% due to expected lower income before income taxes.
Quarterly Financial Data/Seasonality
The following table presents data from the consolidated statement of income and comprehensive income for each of the eight quarters in the period ended December 31, 2015. The operating results for any quarter are not necessarily indicative of the results for any subsequent quarter. Results from the quarter ended December 31, 2015 include the impact of the food-borne illness incidents described elsewhere in this report, and these incidents are likely to impact our results in future quarters.
| 2015 Quarters Ended | ||||||||||||
| March 31 | June 30 | September 30 | December 31 | |||||||||
| Revenue | $ | 1,089.0 | $ | 1,197.8 | $ | 1,216.9 | $ | 997.5 | ||||
| Operating income | $ | 197.8 | $ | 227.4 | $ | 234.8 | $ | 103.6 | ||||
| Net income | $ | 122.6 | $ | 140.2 | $ | 144.9 | $ | 67.9 | ||||
| Number of restaurants opened in quarter | 49 | 48 | 53 | 79 | ||||||||
| Comparable restaurant sales increase (decrease) | 10.4% | 4.3% | 2.6% | (14.6%) | ||||||||
| 2014 Quarters Ended | ||||||||||||
| March 31 | June 30 | September 30 | December 31 | |||||||||
| Revenue | $ | 904.2 | $ | 1,050.1 | $ | 1,084.2 | $ | 1,069.8 | ||||
| Operating income | $ | 135.7 | $ | 179.8 | $ | 207.4 | $ | 187.9 | ||||
| Net income | $ | 83.1 | $ | 110.3 | $ | 130.8 | $ | 121.2 | ||||
| Number of restaurants opened in quarter | 44 | 45 | 43 | 60 | ||||||||
| Comparable restaurant sales increase | 13.4% | 17.3% | 19.8% | 16.1% |
Seasonal factors cause our profitability to fluctuate from quarter to quarter. Historically, our average daily restaurant sales and net income are lower in the first and fourth quarters due, in part, to the holiday season and because fewer people eat out during periods of inclement weather (the winter months) than during periods of mild or warm weather (the spring, summer and fall months). Other factors also have a seasonal effect on our results. For example, restaurants located near colleges and universities generally do more business during the academic year. Seasonal factors, however, might be moderated or outweighed by other factors that may influence our quarterly results, such as the adverse publicity that we saw during 2015 around food-borne illness incidents associated with our restaurants, as well as fluctuations in food or packaging costs or the timing of menu price increases. The number of trading days in a quarter can also affect our results, although, on an overall annual basis, changes in trading dates do not have a significant impact.
Our quarterly results are also affected by other factors such as the amount and timing of non-cash stock-based compensation expense, the number of new restaurants opened in a quarter and unanticipated events. New restaurants typically have lower margins following opening as a result of the expenses associated with opening new restaurants and their operating inefficiencies in the months immediately following opening. In addition, unanticipated events also impact our results. Accordingly, results for a particular quarter are not necessarily indicative of results to be expected for any other quarter or for any year.
Liquidity and Capital Resources
Our primary liquidity and capital requirements are for new restaurant construction, working capital and general corporate needs. We have a cash and short-term investment balance of $663.2 million that we expect to utilize, along with cash flow from operations, to provide capital to support the growth of our business (primarily through opening restaurants), to repurchase additional shares of our common stock subject to market conditions, to maintain our existing restaurants and for general corporate purposes. As of December 31, 2015, there was $116.4 million remaining available under repurchase authorizations previously approved by our Board of Directors. We announced authorizations by our Board of Directors of up to an additional $300 million in common stock repurchases on January 6, 2016, and up to another additional $300 million on February 2, 2016. We also have a long term investments balance of $622.9 million, which consists of U.S. treasury notes with maturities of 13 months to approximately 2 years. We believe that cash from operations, together with our cash and investment balances, will be enough to meet ongoing capital expenditures, working capital requirements and other cash needs for the foreseeable future.
We haven’t required significant working capital because customers generally pay using cash or credit and debit cards and because our operations do not require significant receivables, nor do they require significant inventories due, in part, to our use of various fresh ingredients. In addition, we generally have the right to pay for the purchase of food, beverage and supplies some time after the receipt of those items, generally within ten days, thereby reducing the need for incremental working capital to support our growth.
One of our primary uses of cash is in new restaurant development. Our total capital expenditures for 2015 were $257.4 million, and we expect to incur capital expenditures of about $260 million in 2016, of which about $200 million relates to our construction of new restaurants before any reductions for landlord reimbursements, and the remainder primarily relates to restaurant reinvestments, information technology and infrastructure initiatives as well as food safety initiatives. In 2015, we spent on average about $805,000 in development and construction costs per restaurant, net of landlord reimbursements of approximately $77,000. For new restaurants to be opened in 2016, we anticipate average development costs will remain generally consistent with 2015.
Contractual Obligations
Our contractual obligations as of December 31, 2015 were as follows:
| 2015 | |||||||||||||||
| Total | 1 year | 2-3 years | 4-5 years | After 5 years | |||||||||||
| (in thousands) | |||||||||||||||
| Operating leases | $ | 3,468,012 | $ | 239,683 | $ | 486,064 | $ | 485,184 | $ | 2,257,081 | |||||
| Deemed landlord financing | $ | 4,316 | $ | 421 | $ | 846 | $ | 855 | $ | 2,194 | |||||
| Other contractual obligations(1) | $ | 286,281 | $ | 285,850 | $ | 431 | $ | - | $ | - | |||||
| Total contractual cash obligations | $ | 3,758,609 | $ | 525,954 | $ | 487,341 | $ | 486,039 | $ | 2,259,275 |
(1)We enter into various purchase obligations in the ordinary course of business. Those that are binding primarily relate to amounts owed for orders related to produce and other ingredients and supplies, construction contractor and subcontractor agreements, orders submitted for equipment for restaurants under construction, and marketing initiatives and corporate sponsorships.
The majority of our restaurants and administrative office leases are non-cancelable obligations. Our leases generally have initial terms of either five to ten years with two or more five-year extensions, for end-cap and in-line restaurants, or 10 to 15 years with several five-year extensions, for free-standing restaurants. Our leases generally require us to pay a proportionate share of real estate taxes, insurance, common charges and other operating costs. Some restaurant leases provide for contingent rental payments based on sales thresholds, although we generally do not expect to pay significant contingent rent on these properties based on the thresholds in those leases.
Off-Balance Sheet Arrangements
As of December 31, 2015 and 2014, we had no off-balance sheet arrangements or obligations.
Inflation
The primary areas of our operations affected by inflation are food, healthcare costs, labor, fuel, utility costs, materials used in the construction of our restaurants, and insurance. Although almost all of our crew members make more than the federal and applicable state and local minimum wage, increases in the applicable federal or state minimum wage may have an impact on our labor costs by causing wage inflation above the minimum wage level. Additionally, many of our leases require us to pay property taxes, maintenance, utilities and insurance, all of which are generally subject to inflationary increases. In the past we have largely been able to offset inflationary increases with menu price increases. There have been, and there may be in the future, delays in implementing such menu price increases, and we do not expect to increase menu prices while our sales are depressed due to the food safety incidents discussed elsewhere in this report. If we do raise menu prices in the future, general competitive pressures may limit our ability to completely recover cost increases attributable to inflation.
Critical Accounting Estimates
We describe our significant accounting policies in Note 1 and Note 6 of our consolidated financial statements included in Item 8. “Financial Statements and Supplementary Data.” Critical accounting estimates are those that we believe are both significant and that require us to make difficult, subjective or complex judgments, often because we need to estimate the effect of inherently uncertain matters. We base our estimates and judgments on historical experiences and various other factors that we believe to be appropriate under the circumstances. Actual results may differ from these estimates, and we might obtain different estimates if we used different assumptions or factors. We believe the following critical accounting estimates affect our more significant judgments and estimates used in the preparation of our financial statements:
Leases
We lease nearly all of our restaurant locations. Our leases typically contain escalating rentals over the lease term as well as optional renewal periods. We have estimated that our lease term, including reasonably assured renewal periods, is the lesser of the
lease term or 20 years. We account for our leases by recognizing rent expense on a straight-line basis over the reasonably assured lease term. The majority of our leasehold improvements are also depreciated over the reasonably assured lease term. If the estimate of our reasonably assured lease term was changed, our depreciation and rent expense could differ materially.
Stock-based Compensation
We recognize compensation expense for equity awards over the vesting period based on the award’s fair value. We use the Black-Scholes valuation model to determine the fair value of our stock-only stock appreciation rights, or SOSARs, and we use the Monte Carlo simulation model to determine the fair value of stock awards that contain market conditions. Both of these models require assumptions to be made regarding our stock price volatility, the expected life of the award and expected dividend rates. The volatility assumption was based on our historical data and implied volatility, and the expected life assumptions were based on our historical data. Similarly, the compensation expense of performance share awards, and SOSARs with performance-based vesting conditions is based in part on the estimated probability of our achieving levels of performance associated with particular levels of payout for performance shares and with vesting for performance SOSARs. We determine the probability of achievement of future levels of performance by comparing the relevant performance level with our internal estimates of future performance. Those estimates are based on a number of assumptions, and different assumptions may have resulted in different conclusions regarding the probability of our achieving future levels of performance relevant to the payout levels for the awards. Had we arrived at different assumptions of stock price volatility or expected lives of our SOSARs, or different assumptions regarding the probability of our achieving future levels of performance with respect to performance share awards and performance SOSARs, our stock-based compensation expense and results of operations could have been different. Awards that contain service, performance and market conditions ultimately vest based on Chipotle’s relative performance versus a restaurant industry peer group in the annual averages of revenue growth, net income growth, and total shareholder return. Our estimates of Chipotle’s future performance and the future performance of the restaurant industry peer group are assumptions. If we had arrived at difference assumptions for revenue growth, net income, or total shareholder return for Chipotle or the peer group, our stock-based compensation expense and results of operations could have been different.
Insurance Liability
We maintain various insurance policies for workers’ compensation, general liability and auto damage with varying deductibles as high as $1 million, and for property which generally has a $1.5 million deductible. We are self-insured for employee health but have third party insurance coverage to limit exposure to these claims. We record a liability that represents our estimated cost of claims incurred and unpaid as of the balance sheet date. Our estimated liability is not discounted and is based on a number of assumptions and factors, including historical trends, actuarial assumptions and economic conditions, and is closely monitored and adjusted when warranted by changing circumstances. In addition, our history of claims experience is short and our significant growth rate could affect the accuracy of estimates based on historical experience. Should a greater amount of claims occur compared to what was estimated or medical costs increase beyond what was expected, our accrued liabilities might not be sufficient and additional expenses may be recorded. Actual claims experience could also be more favorable than estimated, which would result in expense reductions. Unanticipated changes may produce materially different amounts of expense than that reported under these programs. The total estimated insurance liabilities as of December 31, 2015 were $40.3 million.
Reserves/Contingencies for Litigation and Other Matters
We are involved in various claims and legal actions that arise in the ordinary course of business. These actions are subject to many uncertainties, and we cannot predict the outcomes with any degree of certainty. Consequently, we were unable to ascertain the ultimate aggregate amount of monetary liability or financial impact with respect to these matters as of December 31, 2015. Although we have recorded liabilities related to a number of legal actions, our estimates used to determine the amount of these liabilities may not be accurate, and there are other legal actions for which we have not recorded a liability. As a result, in the event legal actions for which we have not accrued a liability or for which our accrued liabilities are not accurate are resolved, such resolution may affect our operating results and cash flows.
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