Dear Chipotle Mexican Grill Investors: Do Not Fear Margin Compression

Chipotle Mexican Grill released a great earnings report last quarter, but investors have begun to worry about margin compression after rising food costs ate into profits. That's not a problem, however.

May 26, 2014 at 9:00AM

When Chipotle Mexican Grill (NYSE:CMG) released its first-quarter earnings report in mid-Apirl  and the results looked good at first. Although the company missed the estimates on earnings per share, it still managed to grow revenue 24.4% on a year-over-year basis and reported comparable-store growth of 13.4%, an almost unheard-of figure. 

However, the earnings per share miss had investors wondering what went wrong. Well, the answer was easy to spot going through the numbers: Margins.

Food prices increased during the quarter for beef, avocados, and cheese and this ate into profits, literally. However, this is not a reason for investors to fret, because Chipotle can solve this problem by simply raising prices. 

Chipotle's customers are different
Ordinarily, a price hike coincides with a drop in sales volume. This makes sense, as when the price goes up naturally less buyers exist. 

However, I believe that Chipotle has a different set of buyers. Allow me to explain by using an example:

Consumers who shop at Wal-Mart are generally doing so for value, buying things at the absolute lowest prices. Some of these items, such as food, may not be all-natural or organic. Therefore, prices are lower. 

Now consider the typical shopper at Whole Foods Market. This shopper realizes that the items in the store are more expensive. The food is all-natural and organic, and people are willing to pay a premium for it. 

So goes the case for Chipotle. Sure, some people just stop in to grab a burrito and that's it. They don't care about the all-natural food. They just wanted a burrito and heard it was a good place to eat.

However, a majority of the customers, I would suspect, are there because of the integrity of its food. At a time when healthy eating and natural foods is not a fad, but rather a secular trend, Chipotle may be the best fast-casual restaurant for customers in terms of getting the most bang for their buck. 

Chipotle is undervaluing its product
Below is a picture I took just last week in a local Chipotle restaurant near Birmingham, MI. Those familiar with the area would know that this it's a high-end location within the state, despite the broader public's perception of Michigan's southeastern city of Detroit. 

With that being said, here are the menu prices at my local eatery:

Img

At just $6.25 for a huge chicken burrito or burrito bowl with all-natural food, this meal is truly dirt cheap. I don't consider myself a lightweight eater, but I can easily split either the burrito bowl or the burrito with my significant other and be plenty full when we're done eating. 

For essentially less than $8, (guacamole costs extra!), the two of us can split a great-tasting, healthy meal. I think more and more people are realizing that Chipotle offers incredible value. That's why I think it has room to raise its prices. 

I also think that the typical customer who eats there is doing so, at least partly, for the health-conscious aspect. As we discussed above, those customers are usually willing to pay a premium for food with integrity. 

Customers can absorb a price hike
So for investors who are worried about margins or the effects of a price hike, rest assured, Chipotle's customer base can handle the increase. Consider that a price boost of 10% would still only leave customers paying $6.88 for a huge, all-natural chicken burrito. 

Even a price hike of 20% would make that same chicken burrito $7.50. That might seem like a lot for a burrito, but I think Chipotle's is different, both in size and quality. (For the record, I don't think the company would, or should, raise prices by that amount. It's just an example).

Some customers will likely not be very happy about the price hike. That can be expected. However, I think the vast majority will be understanding. I know that each time I go to Chipotle, I'm pretty surprised the cost is so low and I leave feeling like I received a really good deal. 

Higher prices will not only boost margins, they will also increase earnings per share, which should send the price of the stock higher.

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John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Bret Kenwell has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill and Whole Foods Market. The Motley Fool owns shares of Chipotle Mexican Grill and Whole Foods Market. 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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