The Real Reason Chipotle Mexican Grill Is Raising Prices and Why You Should Care

Chipotle cites one valid reason, but there is another, bigger one.

Apr 28, 2014 at 6:02PM

Chipotle Mexican Grill (NYSE:CMG) has been threatening to raise prices for some time. Everything from beef to pork to avocados has been on the rise, yet the burrito chain hasn't hiked prices in nearly three years. While input costs partially justify a price bump for Chipotle Mexican Grill, that's only a part of the real story.

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Source:  Chipotle Mexican Grill

The freshly wrapped results
On April 17, Chipotle Mexican Grill reported its fiscal first-quarter results. Revenue popped 24.4% to $904 million. Same-store sales soared 13.4%. Net income rose 8.5% to $83.1 million or $2.64 per diluted share.

Steve Ells, founder and co-CEO, simply explained, "Our food culture has always been a defining characteristic of Chipotle and continues to set us apart from other restaurants." He added that Chipotle Mexican Grill's "unique and compelling people culture" has "a tremendous and growing impact."

Most of the gains stemmed from increased traffic, not so much from check size. That's not surprising because it's hard to imagine that the average guest is going to want much more to eat than a burrito which seems as large as a football. "Petite" is not exactly a good characteristic to describe anything on Chipotle Mexican Grill's menu.

Movin' on up (the prices)
During the conference call, Jack Hartung, Chipotle Mexican Grill's CFO, detailed all sorts of inflationary pressures that the company is seeing. Due to the drought, steak prices rose 11% in the first quarter and another 14% in April. Expectations call for the price of cheese to jump 10% this year. Expectations call for the avocado yield in California to be down 30% while demand rises even higher. Then there is the hog virus which is expected to make pork costs jump.

You know what we didn't hear about? Corn prices. That was probably because corn prices fell by 40% in 2013 for the biggest one-year drop since 1960 as the result of a massively successful worldwide harvest.

Prices for food rise and fall all of the time. This year avocados are in part to blame. In prior years Chipotle Mexican Grill actually said that avocados were deflationary. Food costs are up this year. Next year they may be down.

Slideshow

Source: Chipotle Mexican Grill

The price hike covers far more than food costs
Here's the deal. All in all, Chipotle expects its food costs to rise to a high of 36% of revenue over the next two quarters. This compares to a low swing to just 33% of revenue in the first quarter of 2013.

The average meal at Chipotle Mexican Grill costs around $9. This means at the low end of 33% of revenue or the high end of 36% of revenue, the food costs Chipotle between $2.97 and $3.24 per meal.

Chipotle Mexican Grill has targeted a "mid-single digit range" for the price hikes. Using the midpoint of 5%, that comes out to an average price increase of around $0.45 per meal. 

That $0.45 per meal hike covers much more than a $0.27 swing in costs from the low end of the spectrum to the high end.

There is nothing wrong with a successful business raising its prices in response to demand, which is the real reason why I believe that Chipotle is doing this. Regardless of its input costs, a business can only raise prices as much as the market will pay. Do you think your average steak house has hiked steak prices on the menu by 25% over the last four months? Of course not. Droughts and hog viruses are expected to be temporary.

The market dictates
Hartung seems to know that the market, not just input costs, determine demand. He stated, "We're currently reviewing our menu price on a market-by-market basis compared to competitors and based on our analysis."

Slideshow

Source: Chipotle Mexican Grill

Two other statements from Hartung during the conference call were also very telling. First he said, "If we focus on creating a wonderful restaurant experience and cooking and serving delicious food that we have the permission to raise prices." Permission is a nice way of saying demand.

Second he stated, "We believe we've got a lot of pricing power." In other words, perhaps the real reason why Chipotle Mexican Grill is raising its prices is simply because it can. And it should. Food inflation may just provide the catalyst and the excuse for doing it in a "friendly" manner.

Foolish final thoughts
To take it a step further, Chipotle Mexican Grill is not only raising its prices "because it can," perhaps it kind of has to. This is not so much because of food inflation, but because if it wants to grow its same-store sales any further it may not have much of a choice. A year ago analysts were talking about how they thought that Chipotle Mexican Grill had already maxed out its "order-processing capacity."

With a whopping 13.4% tacked on for this quarter alone, price increases may be the only thing left for Chipotle as a restaurant can only feed so many at one time. Yours truly, for example, was turned away several times because the lines were simply out of control. Look for the price hikes to increase same-store sales without lowering guest count.  This is a great position for the company and its shareholders to be in.

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Nickey Friedman has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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