Three Weaknesses for Chipotle Investors to Monitor in 2014

Chipotle had a tremendous 2013, but the company is still far from perfect and faces strong competition from the likes of Jack In the Box Inc. and Panera Bread.

Jan 6, 2014 at 5:00PM

Chipotle Mexican Grill (NYSE:CMG) had an outstanding 2013 thanks in large part to the the company's key strengths.  Despite all of the company's success it is important for investors to be vigilant and understand that no company is perfect. With a diverse set of fast casual competitors including burrito specialist Qdoba (owned by Jack In The Box Inc. (NASDAQ:JACK)) and food quality-centered restaurants like Panera Bread (NASDAQ:PNRA) competing for the same customers as Chipotle, differences in the operations of each company are important to recognize.

"Food with integrity" comes at a price
A key to Chipotle's growth and popularity is its unique "food with integrity" message. While customers rave about the quality and taste of the ingredients that Chipotle uses, these ingredients come at an elevated cost. In the most recent quarter, food costs represented 33.6% of Chipotle's revenue. This figure does not compare favorably with other fast casual competitors as noted below:

RestaurantFood Cost as a % of Revenue-Q3 2013
Chipotle 33.6%
Qdoba 30%
Panera 29.8%
Potbelly 29.5%
Noodles & Company 26.3%

In the most recent quarter's earnings call, Chipotle management attributed elevated food costs to adverse weather disrupting local suppliers, higher prices of California avocados, and the beginning of Chipotle's conversion away from oils containing GMOs. This last piece is an important consideration, since the company expects its efforts to move away from food ingredients with GMOs to continue to drive costs upward. Going forward, Chipotle expects food costs to continue to be within the range of 33.5%-34% of revenue.

Chipotle CEO Steve Ells acknowledges the fact that Chipotle spends more on ingredients than the competition and is not troubled by this given the high sales volumes of Chipotle locations. However, these costs have forced Chipotle's management to acknowledge that the company will have to raises prices during 2014.  

Limited menu
Chipotle has a range of ingredient options that customers can choose to make thousands of variations of burritos and tacos. However, the company's menu is limited to burritos and tacos. In contrast, Qdoba has a comparable selection of burrito and taco options as well as quesadillas, nachos, and taco salads. Perhaps more importantly, Qdoba adds additional variety through "signature flavors" that include queso and ancho chile barbecue that can't be found at Chipotle.

Other fast casual chains have even more variety than Chipotle and Qdoba. For example, Panera's menu features sandwiches, soups, salads, pastas, bakery items, and a rotation of seasonal specialties throughout the year. Noodles & Company (NASDAQ:NDLS) provides customers with pasta dishes with Italian, Asian, and American influences as well as a growing selection of sandwiches, soups, and salads. This additional variety is especially important when people with varying tastes determine where to eat together.

Chipotle has made an effort to expand variety through its unique tofu-based sofritas. While sofritas could provide a boost to Chipotle's revenue through its appeal to vegan and vegetarian customers, sofritas are only available in a quarter of Chipotle's locations and remain a largely unproven concept at this time.

With the exception of the sofrita rollout, Chipotle has done less than the competition in terms of introducing new menu items.

Chipotle's slow international growth
Last quarter, Chipotle heralded the opening of its first location in Germany. However, the new restaurant in Frankfurt is just the 14th international Chipotle location. Considering that the company opened its first international location in 2008, the international growth rate has not been impressive thus far.

When asked about whether this growth rate would be more meaningful in 2014, Chipotle's CEO responded as follows:

"I would still expect over the next year or so that international won't be a very large part of our growth. We are still in the brand building phase. There is still the vast majority of people in the markets we are in, in outside the US are not yet aware of Chipotle."

Based on this commentary, it is hard to imagine an aggressive growth initiative internationally in the near term.

Role within the overall investment thesis
High food costs and limited menu selection relative to the competition are significant considerations for investors, since both have a direct impact on margins and the ability to drive same store sales increases going forward. Likewise, the lackluster international growth to date must be considered in determining whether Chipotle can continue to outperform the market; if Chipotle is destined to be a one-concept, domestic-only company it will be hard to justify the premium valuation currently placed on the company's shares.

While weighing these considerations against Chipotle's numerous strengths is up to each investor, the rate and consistency of Chipotle's revenue growth over the past five years indicates that these issues are more than offset by Chipotle's core strengths.

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Brian Shaw owns shares of Chipotle Mexican Grill and Panera Bread. The Motley Fool recommends Chipotle Mexican Grill and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill and Panera Bread. 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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