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
Steve Ells, our founder, Chairman and CEO, started Chipotle with the idea that food served fast did not have to be a typical fast food experience. Today, we continue to offer a focused menu of burritos, tacos, burrito bowls, and salads made from fresh, high-quality raw ingredients, prepared using classic cooking methods and served in an interactive style allowing people to get what they want. We seek out extraordinary ingredients that are not only fresh, but that are raised responsibly, with respect for the animals, land, and people who produce them. We prepare our food using real, wholesome ingredients and without the use of artificial colors or flavors typically found in fast food. Chipotle opened with a single restaurant in Denver in 1993 and as of December 31, 2017, we operated 2,408 restaurants.
Sales. Our sales and profitability improved during 2017 as compared to 2016. Comparable restaurant sales increased 6.4% as a result of an increase in the average check, including a 1.2% benefit from menu price increases implemented in about 500 restaurants during the second quarter of 2017 and 900 restaurants during the fourth quarter of 2017. Comparable restaurant sales represent the change in period-over-period sales for restaurants beginning in their 13th full calendar month of operation. Average restaurant sales were $1.940 million as of December 31, 2017, increasing from $1.868 million as of December 31, 2016. We define average restaurant sales as the average trailing 12-month sales for restaurants in operation for at least 12 full calendar months. We expect comparable restaurant sales increases in the low single digits for the full year 2018, including the benefit from extending menu price increases to almost 950 additional restaurants in January 2018. Sales growth from new restaurant openings, however, will be lower in 2018 than in the past due to our planned decrease in new restaurant openings during the year, as discussed below under “Restaurant Development.”
During 2017, we invested in improving our digital platforms, including significant improvements to our mobile application and online ordering platform, and equipping select restaurants with an upgraded second make line dedicated to fulfilling out-of-restaurant orders. Sales from out-of-restaurant orders represented 8.3% of our revenue during the year ended December 31, 2017, up from 6.4% of revenue during the year ended December 31, 2016. Additionally, in September 2017 we introduced an all-natural queso, which was ordered in approximately 10% of our transactions in January 2018.
Restaurant Operating Costs. During the full year 2017, our restaurant operating costs (food, beverage and packaging; labor; occupancy; and other operating costs) as a percent of revenue decreased 4.1% compared to the full year 2016. The decrease was attributable to sales leverage, including the benefit of the menu price increases, lower marketing and promotional spend as a percent of revenue, and labor efficiencies, partially offset by higher wages paid to crew and managers.
Restaurant Development. As of December 31, 2017, we had 2,408 restaurants in operation, including 2,363 Chipotle restaurants throughout the United States, with an additional 37 international Chipotle restaurants and eight non-Chipotle restaurants that were consolidated into our financial results. We opened 183 restaurants in 2017, including two relocations, and closed 23 additional restaurants (including 15 ShopHouse Southeast Asian Kitchen restaurants). We intend to open between 130 and 150 restaurants for the full year 2018, as we focus our resources on improving our operations and delivering an outstanding experience to every one of our guests. Most of our 2018 restaurant openings are planned in markets that already have a Chipotle presence established.
Tax Law Changes. In December 2017, the Tax Cuts and Jobs Act was signed into law, and among other changes, the Act lowered the U.S. corporate income tax rate from 35% to 21% beginning in 2018. As a result, we recognized a $6.0 million benefit in our provision for income taxes related to the remeasurement of our deferred tax position at the lower rate.
We expect our 2018 annual effective tax rate to be in the range of 30% to 31%, which includes an underlying effective tax rate of 27% to 28%, and around 3% to 4% related to stock awards. As discussed in Note 1. “Description of Business and Summary of Significant Accounting Policies” included in Item 8. “Financial Statements and Supplementary Data,” the adoption of ASU No. 2016-09, “Compensation-Stock Compensation (Topic 718)” will subject our tax rate to quarterly volatility from the effect of stock award exercise and vesting activities. Additionally, we have deferred tax assets related to outstanding non-vested stock awards that contain market conditions. If market conditions are not achieved, then we may not realize the benefit of these deferred tax assets, which would result in a higher effective tax rate in future periods. We believe the stock awards granted in 2015 and 2016 that contain market conditions will increase our tax rate in the first and fourth quarters of 2018, respectively.
During 2018, we expect to use a portion of the savings from the lower federal corporate income tax rate to provide enhanced benefits to our employees, including by making all restaurant managers and crew eligible for a one-time cash bonus, awarding one-time stock bonuses to a broad group of staff employees, and enhancing a number of other benefits such as parental leave and short-term disability. Additionally, we will use a portion of the savings by investing in our existing restaurants. We expect these initiatives to increase labor, other operating, and general and administrative expenses, and to result in higher capital expenditures than we have typically incurred.
Management and Governance. During the second quarter of 2017, we announced that we hired Scott Boatwright as Chief Restaurant Officer, and Scott has assumed oversight of operations for all North American Chipotle restaurants. In the fourth quarter of 2017, we announced that Steve Ells, our Chairman and CEO, will become Executive Chairman following the completion of a search to identify a new CEO. For risks associated with our planned installation of a new CEO, see “Risks Related to our Unique Business Strategy – Our success may depend on the continued service and availability of key personnel, and upcoming changes in our management team may not provide the benefits we expect” in Item 1A. “Risk Factors.”
Data Security Incident. In April 2017, we detected malware on the network that supports payment processing for our restaurants, and subsequently determined that the malware searched for track data, which may include cardholder name, card number, expiration date, and internal verification codes. We removed the malware from our systems and continue to evaluate ways to enhance our security measures. See “General Business Risks—We may be harmed by security risks we face in connection with our electronic processing and transmission of confidential customer and employee information” in Item 1A. “Risk Factors,” as well as Note 10. “Commitments and Contingencies” in Item 8. “Financial Statements and Supplementary Data,” for further discussion of the payment card security incident and related legal proceedings.
During the year ended December 31, 2017, we recorded a liability of $30.0 million ($18.2 million after tax), or $0.64 per basic and diluted earnings per share, as an estimate of potential losses associated with anticipated claims and assessments by payment card networks. We may ultimately be subject to liabilities greater or less than the amount accrued.
Restaurant Openings, Relocations and Closures
The following table details restaurant unit data for the years indicated.
| Year ended December 31, | |||||
| 2017 | 2016 | 2015 | |||
| Beginning of period | 2,250 | 2,010 | 1,783 | ||
| Openings | 183 | 243 | 229 | ||
| Relocations/closures | (10) | (3) | (2) | ||
| ShopHouse closures | (15) | - | |||
| Total restaurants at end of period | 2,408 | 2,250 | 2,010 |
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 aggregate restaurant operating costs and depreciation and amortization generally increase.
Revenue
| Year ended December 31, | % increase | % increase/ (decrease) | ||||||||||
| 2017 | 2016 | 2015 | 2017 over 2016 | 2016 over 2015 | ||||||||
| (dollars in millions) | ||||||||||||
| Revenue | $ | 4,476.4 | $ | 3,904.4 | $ | 4,501.2 | 14.7% | (13.3%) | ||||
| Average restaurant sales | $ | 1.940 | $ | 1.868 | $ | 2.424 | 3.9% | (22.9%) | ||||
| Comparable restaurant sales increases (decreases) | 6.4% | (20.4%) | 0.2% | |||||||||
| Number of restaurants as of the end of the year | 2,408 | 2,250 | 2,010 | 7.0% | 11.9% | |||||||
| Number of restaurants opened in the year | 183 | 243 | 229 |
The significant factors contributing to the increase in revenue in 2017 were new restaurant openings and comparable restaurant sales increases. Revenue from restaurants not yet in the comparable restaurant base contributed $338.8 million to the revenue increase, of which $149.1 million was attributable to restaurants opened in 2017, and comparable restaurant sales increased $233.2 million. The increase in comparable restaurant sales was attributable to an increase in average check, including a 1.2% benefit from menu price increases.
In 2016, the decrease in revenue was attributable to a decline in comparable restaurant sales, which we attribute primarily to the impact of food safety incidents beginning in late 2015, partially offset by new restaurant openings. Comparable restaurant sales decreased $914.7 million while revenue from restaurants not yet in the comparable restaurant base contributed $323.9 million, of which $156.2 million was attributable to restaurants opened in 2016.
Food, Beverage and Packaging Costs
| Year ended December 31, | % increase | % decrease | ||||||||||
| 2017 | 2016 | 2015 | 2017 over 2016 | 2016 over 2015 | ||||||||
| (dollars in millions) | ||||||||||||
| Food, beverage and packaging | $ | 1,535.4 | $ | 1,365.6 | $ | 1,503.8 | 12.4% | (9.2%) | ||||
| As a percentage of revenue | 34.3% | 35.0% | 33.4% |
Food, beverage and packaging costs decreased as a percentage of revenue in 2017 primarily due to the benefit of the menu price increases taken in select restaurants during the second and fourth quarters of 2017. Food, beverage and packaging costs also benefitted from bringing the preparation of lettuce and bell peppers back into our restaurants after using pre-cut produce during portions of 2016, and cost savings initiatives resulting in lower prices and usage of paper and packaging products. These decreases were partially offset by higher avocado prices. We expect food, beverage and packaging costs as a percentage of revenue in 2018 to be lower than 2017 due to the benefit of menu price increases, and our expectations for stable commodity prices.
Food, beverage and packaging costs increased as a percentage of revenue in 2016 primarily due to increased waste and costs related to new food safety procedures as well as higher avocado prices, partially offset by relief in beef prices. In dollar terms, food, beverage and packaging costs decreased in 2016 due to lower sales.
Labor Costs
| Year ended December 31, | % increase | % increase | ||||||||||
| 2017 | 2016 | 2015 | 2017 over 2016 | 2016 over 2015 | ||||||||
| (dollars in millions) | ||||||||||||
| Labor costs | $ | 1,206.0 | $ | 1,105.0 | $ | 1,045.7 | 9.1% | 5.7% | ||||
| As a percentage of revenue | 26.9% | 28.3% | 23.2% |
Labor costs as a percentage of revenue decreased during the year ended December 31, 2017 due primarily to increased crew efficiency, including the benefit of lower promotional activity during the year, improved manager deployment, and sales leverage, including the impact of menu price increases. The decrease was partially offset by wage inflation. We expect labor costs as a percentage of revenue to be higher in 2018 than 2017 due to labor inflation and the enhanced benefits described above under “Overview – Tax Law Changes.”
Labor costs as a percentage of revenue increased in 2016 due primarily to sales deleveraging and wage inflation, partially offset by labor efficiencies resulting from fewer managers and crew in each of our restaurants. Labor costs increased in dollar terms for the year ended December 31, 2016 due to staffing needs for new restaurants.
Occupancy Costs
| Year ended December 31, | % increase | % increase | ||||||||||
| 2017 | 2016 | 2015 | 2017 over 2016 | 2016 over 2015 | ||||||||
| (dollars in millions) | ||||||||||||
| Occupancy costs | $ | 327.1 | $ | 293.6 | $ | 262.4 | 11.4% | 11.9% | ||||
| As a percentage of revenue | 7.3% | 7.5% | 5.8% |
Occupancy costs as a percentage of revenue decreased in 2017 primarily due to sales leverage on a largely fixed-cost base.
Occupancy costs as a percentage of revenue increased in 2016 primarily due to lower average restaurant sales on a largely fixed-cost base. Occupancy costs increased in dollar terms for the year ended December 31, 2016, primarily due to costs associated with new restaurants.
Other Operating Costs
| Year ended December 31, | % increase | % increase | ||||||||||
| 2017 | 2016 | 2015 | 2017 over 2016 | 2016 over 2015 | ||||||||
| (dollars in millions) | ||||||||||||
| Other operating costs | $ | 651.6 | $ | 642.0 | $ | 515.0 | 1.5% | 24.7% | ||||
| As a percentage of revenue | 14.6% | 16.4% | 11.4% |
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 decreased as a percentage of revenue in 2017 due primarily to decreased marketing and promotional spend, sales leverage including the benefit of menu price increases, and decreased kitchen supplies expense. Marketing and promotional spend decreased to 3.5% of revenue in 2017, as compared to 5.1% of revenue in 2016. We expect other operating costs as a percentage of revenue in 2018 to remain consistent with 2017 as planned lower marketing and promotional spend is offset by expected higher maintenance costs from investments in our existing restaurants.
Other operating costs increased as a percentage of revenue in 2016 due primarily to higher marketing and promotional expense as well as sales deleveraging. We increased our marketing and promotional spend in an effort to regain customers, which contributed $98.2 million to the increase.
General and Administrative Expenses
| Year ended December 31, | % increase | % increase | ||||||||||
| 2017 | 2016 | 2015 | 2017 over 2016 | 2016 over 2015 | ||||||||
| (dollars in millions) | ||||||||||||
| General and administrative expense | $ | 296.4 | $ | 276.2 | $ | 250.2 | 7.3% | 10.4% | ||||
| As a percentage of revenue | 6.6% | 7.1% | 5.6% |
General and administrative expenses increased in dollar terms in 2017, due to recording a liability of $30.0 million as an estimate of potential losses associated with anticipated claims and assessments by payment card networks for the data security incident that occurred in 2017. Increased bonus costs and higher non-cash stock-based compensation expense also contributed to the increase. The increase was partially offset by lower legal costs, and decreased meeting costs because of the biennial All Managers Conference held in September 2016. The increase in stock-based compensation expense during 2017 was primarily a result of a cumulative reduction of expense in 2016 for performance share awards that were no longer expected to vest. We expect that general and administrative expenses will increase in dollar terms in 2018 due to increased wages and benefits, the biennial All Managers’ Conference planned for the third quarter of 2018, and an increase in stock-based compensation expense.
The increase in general and administrative expenses in dollar terms for 2016 primarily resulted from increased legal expense, higher payroll costs as we grew, and expenses associated with our biennial All Managers’ Conference held during 2016, partially offset by lower bonus expense and travel costs.
Depreciation and Amortization
| Year ended December 31, | % increase | % increase | ||||||||||
| 2017 | 2016 | 2015 | 2017 over 2016 | 2016 over 2015 | ||||||||
| (dollars in millions) | ||||||||||||
| Depreciation and amortization | $ | 163.3 | $ | 146.4 | $ | 130.4 | 11.6% | 12.3% | ||||
| As a percentage of revenue | 3.6% | 3.7% | 2.9% |
Depreciation and amortization decreased as a percentage of revenue in 2017 due to sales leverage on a partially fixed-cost base.
Depreciation and amortization increased as a percentage of revenue in 2016 due to sales deleveraging. The increase in dollar terms was due primarily to depreciation and amortization costs associated with new restaurants.
Loss on Disposal and Impairment of Assets
| Year ended December 31, | % decrease | % increase | ||||||||||
| 2017 | 2016 | 2015 | 2017 over 2016 | 2016 over 2015 | ||||||||
| (dollars in millions) | ||||||||||||
| Loss on disposal and impairment of assets | $ | 13.3 | $ | 23.9 | $ | 13.2 | (44.1%) | 81.0% | ||||
| As a percentage of revenue | 0.3% | 0.6% | 0.3% |
Loss on disposal and impairment of assets during the year ended December 31, 2017 consisted primarily of charges related to the closure of underperforming Chipotle restaurants and the replacement of certain kitchen equipment.
Loss on disposal and impairment of assets increased in 2016 primarily due to a non-cash impairment charge of $14.5 million to write-down substantially all of the value of the long-lived assets of our 15 ShopHouse restaurants.
Income Tax Provision
| Year ended December 31, | % increase | % decrease | ||||||||||
| 2017 | 2016 | 2015 | 2017 over 2016 | 2016 over 2015 | ||||||||
| (dollars in millions) | ||||||||||||
| Provision for income taxes | $ | 99.5 | $ | 15.8 | $ | 294.3 | 529.6% | (94.6%) | ||||
| Effective tax rate | 36.1% | 40.8% | 38.2% |
The 2017 annual effective tax rate was lower than the 2016 rate due to the enactment of the Tax Cuts and Jobs Act, resulting in our recording a benefit for the remeasurement of our deferred tax liability, as well as from a lower state tax rate. The decrease in our effective tax rate was partially offset by federal credits on overall higher pre-tax operating income.
The 2016 effective tax rate was higher than 2015 due to a higher state tax rate, not qualifying for the federal research and development tax credit in 2016 whereas we did qualify for the credit in 2015, and other federal credits on overall lower pre-tax operating income.
Quarterly Financial Data/Seasonality
The following table presents data from the consolidated statement of income for each of the eight quarters in the period ended December 31, 2017. The operating results for any quarter are not necessarily indicative of the results for any subsequent quarter.
| 2017 Quarters Ended | ||||||||||||
| March 31 | June 30 | September 30 | December 31 | |||||||||
| Revenue | $ | 1,068.8 | $ | 1,169.4 | $ | 1,128.1 | $ | 1,110.1 | ||||
| Operating income | $ | 73.2 | $ | 106.7 | $ | 30.9 | $ | 60.0 | ||||
| Net income | $ | 46.1 | $ | 66.7 | $ | 19.6 | $ | 43.8 | ||||
| Number of restaurants opened in the quarter, net of relocations/closures | 41 | 48 | 35 | 34 | ||||||||
| Comparable restaurant sales increase | 17.8% | 8.1% | 1.0% | 0.9% | ||||||||
| 2016 Quarters Ended | ||||||||||||
| March 31 | June 30 | September 30 | December 31 | |||||||||
| Revenue | $ | 834.5 | $ | 998.4 | $ | 1,037.0 | $ | 1,034.6 | ||||
| Operating income (loss) | $ | (46.6) | $ | 40.9 | $ | 9.7 | $ | 30.6 | ||||
| Net income (loss) | $ | (26.4) | $ | 25.6 | $ | 7.8 | $ | 16.0 | ||||
| Number of restaurants opened in the quarter, net of relocations/closures | 56 | 58 | 54 | 72 | ||||||||
| Comparable restaurant sales increase (decrease) | (29.7%) | (23.6%) | (21.9%) | (4.8%) |
Seasonal factors cause our profitability to fluctuate from quarter to quarter. Historically our average daily restaurant sales are lower, and net income has generally been 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 unexpected publicity impacting our business in a positive or negative way, 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 days do not have a significant impact.
Our quarterly results are also affected by other factors such as the number of new restaurants opened in a quarter, the amount and timing of non-cash stock-based compensation expense, and anticipated 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. 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, initiatives to improve the guest experience in our restaurants, working capital, and general corporate needs. As of December 31, 2017, we had a cash and short-term investment balance of $509.0 million that we expect to utilize, along with cash flow from operations, to provide capital to support the growth of our business, to invest in, maintain and refurbish our existing restaurants, to repurchase additional shares of our common stock subject to market conditions, and for general corporate purposes. As of December 31, 2017, there was $118.3 million remaining available under repurchase authorizations previously approved by our Board of Directors. Under the remaining repurchase authorizations, shares may be purchased from time to time in open market transactions, subject to market conditions. 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.
Our total capital expenditures for 2017 were $216.8 million. In 2017, we spent on average about $835,000 in development and construction costs per new restaurant, or about $735,000 net of landlord reimbursements of $100,000. In 2018, we expect to incur about $300 million in total capital expenditures. We expect the majority of our capital expenditures to consist of investments in existing restaurants, including remodeling and similar improvements, and upgrading our second make lines and other restaurant equipment. We also expect about $120 million in capital expenditures related to our construction of new restaurants, before any reductions for landlord reimbursements. For new restaurants to be opened in 2018, we anticipate average development costs will increase due to initiatives planned in most of our new restaurants such as the addition of the upgraded second make line. Finally, we expect a portion of our capital expenditures for the year to be incurred for additional corporate initiatives.
Contractual Obligations
Our contractual obligations as of December 31, 2017 were as follows:
| Payments Due by Fiscal Year | |||||||||||||||
| Total | 2018 | 2019-2020 | 2021-2022 | Thereafter | |||||||||||
| (in thousands) | |||||||||||||||
| Operating leases(1) | $ | 3,906,253 | $ | 281,461 | $ | 569,198 | $ | 558,431 | $ | 2,497,163 | |||||
| Purchase obligations(2) | $ | 929,242 | $ | 409,568 | $ | 323,906 | $ | 177,408 | $ | 18,360 | |||||
| Deemed landlord financing(1) | $ | 3,472 | $ | 423 | $ | 855 | $ | 908 | $ | 1,286 | |||||
| Total | $ | 4,838,967 | $ | 691,452 | $ | 893,959 | $ | 736,747 | $ | 2,516,809 |
| (1) | See Note 8. “Leases” of our consolidated financial statements included in Item 8. “Financial Statements and Supplementary Data.” |
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| (2) | Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms. We have excluded agreements that are cancelable without penalty. The majority of our purchase 36 |
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| obligations relate to amounts owed for chicken, produce, and other ingredients and supplies, construction contractor agreements, orders submitted for equipment for restaurants under construction and planned remodels, and marketing initiatives and corporate sponsorships. |
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The above table does not include income tax liabilities for uncertain tax positions for which we are not able to make a reasonably reliable estimate of the amount and period of related future payments. Additionally, we have excluded our estimated loss contingencies related to the data security incident described elsewhere, due to uncertainty regarding the timing and amount of payment. See Note 10. “Commitments and Contingencies” of our consolidated financial statements included in Item 8. “Financial Statements and Supplementary Data.”
Off-Balance Sheet Arrangements
As of December 31, 2017 and 2016, we had no off-balance sheet arrangements or obligations.
Inflation
The primary areas of our operations affected by inflation are food, labor, healthcare costs, fuel, utility costs, and materials used in the construction of our restaurants. Although a significant majority 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, and utilities, 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. 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. “Description of Business and Summary of Significant Accounting Policies” 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 that of our critical accounting estimates, the following involve a higher degree of judgement and subjectivity.
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. Certain awards that contain service, performance and market conditions have vesting criteria based on Chipotle’s relative performance versus a restaurant industry peer group in annual average 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 that involve a high degree of subjectivity. If we had arrived at different assumptions for revenue growth or net income for Chipotle or the peer group, our stock-based compensation expense and results of operations could have been different.
Insurance Liability
We are self-insured for a significant portion of our risks and associated liabilities with respect to workers’ compensation, general liability, employee health, property and auto damage, 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. Our history of claims experience is relatively short and our significant growth during most of our operating history could affect the accuracy of estimates based on historical experience. If a greater amount of claims occurs compared to what we have estimated, or if medical costs increase beyond what we expected, our accrued liabilities might not be sufficient and we may be required to record additional expense. 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, 2017 were $52.0 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 estimate the ultimate aggregate amount of monetary liability or financial impact with respect to these matters as of December 31, 2017. 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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