Disaster Strikes Chipotle Again

| About: Chipotle Mexican (CMG)

Summary

Chipotle is struggling to recover from major failures that damaged revenues and margins.

Management is tackling the problem from precisely the wrong angle.

The emphasis on marketing is incorrect. The marketing emphasized food, but service is the issue.

Chipotle’s major food safety issues are already behind them, but the company’s focus has not changed.

Chipotle Mexican Grill (NYSE:CMG) is a great restaurant that suffered from a terrible breakdown in quality control. Since then, management has been racing to put out the fires. Food safety is very important, but it is not the central issue for Chipotle. For Chipotle to recover, they need to fix the consumer experience. The commentary on the earnings call demonstrated that management was aware of the problem, but they were not tackling it the right way.

Start Crossing Problems off the List

Management still believes they have several problems. Among those problems was the need to convince consumers to trust Chipotle again. I do not believe this is a major issue. If consumers simply did not trust Chipotle, you would see empty stores. I visited Chipotle repeatedly over the last few weeks and checked traffic volume and line movement. These were not long tests and they will not meet any scientific criteria. Consequently, I appeal to readers on simpler measures. Evaluate the argument and come to your own conclusion.

What I Witnessed

By visiting the store on multiple occasions, each during dinner timer, I was able to assess the operations management. Here is what I saw:

The sitting area for eating food was largely empty on each visit.

The assembly area was packed.

The line of customers stretched from the register, past the assembly area, around some barriers, then back across the restaurant to the door.

The customers were, on average, scowling.

Implications

Redesigning a restaurant is a substantial amount of work, but most customers were taking their orders to-go. Removing a small fraction of the seating would allow for a longer assembly area, which could include a duplication of ingredient spaces. Essentially this would put production areas side by side. The normal employee volume on my visits was about 1 employee running the register, 1 employee handling random tasks, and 5 employees preparing orders as quickly as they could. Packing the 5 employees into the one area for food preparation caused it to be packed so tightly that adding another employee would not have increased production materially.

Many orders are "to go". Therefore, seating areas should be smaller. The only reason so many tables would be necessary is if there were customers filling all the tables. This was not a problem. Customers could not get through the line to buy food, so they did not need a place to sit. This is the first major issue to tackle. In operations management, increasing the bottleneck is the critical step towards higher production. The bottleneck was not seating area; it was production.

An inability to recognize the impact of this bottleneck and a discounting program that fails to address it create a new disaster for earnings. In the next section, I'll discuss how this problem could be avoided.

Simple Fix

There are a couple other ways to improve the system. These are dramatically simpler than redesigning the restaurant. The first is to ditch the focus on the Chiptopia. The idea behind Chiptopia is to increase the number of visits from key customers in each month. That should rebuild the habit of going to Chipotle for food. It does not seem like a terrible plan, but it was far from the best plan. This piece will focus on describing the best plan.

The first trip I had planned to Chipotle for the month involved simply driving there to order food. Upon arriving, I looked through the windows and saw the line was already to the door and starting to snake around even further. I ordered a pizza from my phone and left.

Subsequent purchases from Chipotle came through the app. The visits were pleasant and food was ready. However, the lines were still going to the door each time. There were 0 other online orders waiting for pickup, despite these trips deliberately being made near prime dinner time. On the most recent trip, the 1 employee "handling random tasks" was going through the line trying to sign people up for Chiptopia. This was a terrible strategy because it misrepresents the problem. Customers had different levels of displeasure, but "happy" was not a good word to describe the mood. They did not want Chiptopia, even though it came with free chips and guacamole.

The answer here was simple. The "free reward" (rewards for actions are not free) should have been conditioned upon installing the Chipotle app. The app is incredibly easy to use. To verify this, I took my phone to a friend that had never ordered Chipotle. I gave him the phone, with the app open, and said dinner was on me. It took no instruction and less than 2 minutes.

For Chipotle, this would be a much better process. Offer free chips and guacamole, a free drink, or even a free entrée the first time, or the second time, a customer orders an entrée through the application. Without the application, I would not bother buying food from Chipotle. The food quality was good, but the value was not even remotely worth standing in that line. The lost time from standing in line would easily have cost as much as the food.

Why is the Application Faster?

The reason customers should use the application is not simply so they can skip ahead of the line. The application makes the process of ordering materially better. There is a painful delay in waiting for a customer to recite what they want to eat. If a customer fails to speak clearly, it slows the line even further. This is a material increase in production time. Whether the customers are slow because they are new or because they have not decided, the result is still a slow customer. The speed of the employee is limited by waiting for responses.

The main reason for customers deciding not to eat at Chipotle is not a lack of trust for the brand. It is a negative experience from waiting in line. The line is long because of a bottleneck in the preparation process. Taking orders through the app provides the employees with a clear formula for each item. This process should make each employee more efficient in the process.

Conclusion

Chipotle sees a problem in lower revenues levels, but a program to encourage repeat visits will not solve that. The long line created by customers waiting for food will prevent other customers from entering the store. Providing discounts to customers for waiting in line does not improve revenue materially when other customers, who may not require a discount, choose to drive on rather than enter the store.

I believe management has chosen the wrong strategy to handle their revenue problem. By failing to emphasize the bottleneck, their potential for increased revenue is limited. Increases in revenue from the program will come at the cost of stronger margins. Offering customers free food as a reward is a fine promotion. However, it should be a reward for helping with their bottleneck.

Chipotle's stock has fallen hard. Due to the dramatic decline, I am coming out with a neutral rating initially. If the stock had not fallen dramatically or had already bounced back, I would be negative. If management were to change the strategy to emphasize the bottleneck, I would expect revenue and EBITDA to exceed prior figures and would raise my rating. For now, the rating starts at neutral.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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