Quality Food Is The Future Of Chipotle Mexican Grill

Summary

• Chipotle’s last quarter was another success as the comparable sales figure grew with more visits despite the menu price increase.
• Quality is the main selling point and importing beef from Australia is likely to help Chipotle uphold its standard.
• Marketing efforts are effective given the awards the company has received.

Shares of Chipotle Mexican Grill Inc. (NYSE:CMG) reached a new 52-week high of $667 this week, the day after the company announced its second quarter results. Chipotle continues to be one of the restaurant industry's leading businesses, delivering incomparable sales growth and beating its peers' margins. When the company first opened its first store in 1993, the simple business model preached that food served fast didn't necessary have to be "fast-food". This way of life continues to contribute towards Chipotle's success. Complementing this success is the high-quality raw ingredients, classic cooking methods and unique restaurant design that have helped the company to gain ground and steal market share from big chains like McDonald's (MCD).

In this article I will be discussing Chipotle's recent quarterly results before proceeding to discuss the future potential of this fast-growing restaurant chain.

Second Quarter

In its latest period, Chipotle's revenue increased 28.6% to $1.05 billion with the comparable figure rising by a smaller but still important, 17.3%. Despite raising its menu prices in April, this comparable rate of growth which grew 390 bps year over year strengthened the company's foothold in the industry and was the reason behind its pricing power as consumer visits grew together with higher average check.

Operating expenses rose 29.8% to $870 million due to higher food, beverage, and packaging and other operating expenses. Food costs, as a percentage of revenues, increased 150 bps to 34.6% due to higher beef, avocado, and cheese costs. Marketing expenses are also rising. The only reduction was seen in labour costs which declined as a percentage of revenues to 21.8%. The net result of cost movement was the restaurant level operating margin declining 30 bps to 27.3%.

Chipotle provided diluted earnings per share of $3.5 during the last quarter. This was an increase of 24% compared to 2013's figure. Theses earnings would have been higher had higher foods costs not prevailed. These expenses form a major chunk of total expenditure for the company and won't be reduced any time soon. This is because Chipotle recently struggled to get the ample supply of beef it needs from cattle raised without the use of antibiotics or added hormones. Since the company uses organic and natural ingredients which are a key driver for its demand, it cannot use conventional meat. Domestic beef supply is presently at a 60-year low while demand continues to rise. Therefore Chipotle temporarily filled that gap with conventionally-raised beef and posted notices in its restaurants so that customers were aware of the change.

I brought this point up because quality, especially of meat, has been a major global concern. A great example is the latest Chinese scandal which exposed the meat suppliers of McDonald's and KFC, a subsidiary of YUM Brands (YUM) who were using sub-standard meat and processing procedures. Chipotle is exclusively known for its high-quality organic ingredients and any blow to that image could cost the company a fortune since that's their primary selling point. However, the issue now seems to be resolved as the company is obtaining its chief ingredient from Australia. The decision may increase costs, but these expenses are crucial to sustaining its advantaged position and top line growth rate.

Moving forward, these efforts need to be marketed and Chipotle has been doing this by holding day-long food and music festivals called Cultivate. The company just held the first of three Cultivate festivals planned for this year in San Francisco with the remaining scheduled to take place in Minneapolis and Dallas. Additionally, two of the company's most recent marketing programs called "Farmed and Dangerous" and Scarecrow were recently awarded 12 Lion awards at the Cannes Lions International Festival of Creativity. While the programs were not produced to win awards the awards demonstrate the effectiveness of the company's advertising policy.

There isn't much technical analysis to do for Chipotle. The simple strategy of quality food and effective advertising are enough to ensure profitability in the future. A more qualitative example is the peak hours' sales growth. Chipotle has been able to drive a 9.4% transaction comparable growth rate during its peak lunch hour and a 13.3% transaction growth at its peak dinner hour. If one visits the restaurant at these times, they will often find a long queue of customers. These people can turn to other places as an alternative, but the company's effort to promote healthier products is so effective that customers would rather wait than eat poor quality food at another fast food restaurant.

Bottom Line

Chipotle is still in its expansion phase. The company plans to open 180-195 restaurants this year. While investors worry over McDonald's and other typical fast food chains that previously gained profits by selling unhealthy products, Chipotle is doing the opposite by expanding and offering a premium and safe fast food experience. This probably explains why revenue growth has stood at 20% over three years when the industry has only reported 12% growth. There is no material defect in the company's strategy and I believe the 65% one-year price return should continue in the future. Therefore, I recommend buying the stock.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.