How Chipotle Mexican Grill Serves Up Its "Food With Integrity"

On this episode of Industry Focus: Consumer Goods, Vincent Shen welcomes Motley Fool contributor Asit Sharma to discuss the lifecycle of a Chipotle (CMG 6.33%) burrito -- ingredients, suppliers, and all.

Learn about a few of the surprisingly far off locations Chipotle's ingredients come from, how recent safety concerns have put pressure on smaller suppliers, changes in food preparation at the restaurants, and more. 

A full transcript follows the video.

This podcast was recorded on May 24, 2016. 

Vincent Shen: Hey, Fools, welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Tuesday May 24th, so today we'll be covering the consumer goods and retail sector. I'm your host, Vincent Shen, and for newer listeners this is my first moving into the host seat and I have a great discussion in store for you to kick things off proper. I'm joined today by Fool.com contributor Asit Sharma, who's Skyping in remotely from Raleigh, North Carolina. Hey, Asit, really excited to have you on the show, how are you doing?

Asit Sharma: Hi, Vince, likewise. I'm excited to be here.

Shen: This week, we're trying to tie together each sector of Industry Focus to look at product life cycles. For example Kristine is going to be covering the life cycle of a prescription drug for the healthcare show tomorrow. For consumer goods today, I wanted to cover something near and dear to my heart, or at least to my belly, a Chipotle burrito, what do you think about that?

Sharma: Sounds great, and very near and dear to my belly as well.

Shen: Glad to have a fellow Chipotle fan here, even with some of the food safety issues they've run into. I've been happily enjoying some of the shorter lines in previous months and I'm rooting for the stock here. But we know that this is a company now about 23 years old, pioneered the fast-casual restaurant movement. Started I think when McDonald's first made their investment in 1996 and had about 15 or 16 locations. Now it's grown to over 2,000; much of its success has stemmed from its focus on fresh quality ingredients. The company's mission statement actually reads, "Food with integrity is our commitment to finding the very best ingredients raised with respect for the animals, the environment and the farmers."

If we're looking at the life cycle here of the Chipotle burrito, going from the farm to our table, it's exactly some of those animals and farmers that I think we're going to be discussing today, looking at these ingredients. Let's dive right into it. What do you think, Asit?

Sharma: Yeah, sure. Let's talk about that mission statement for just a second. Chipotle often shortens that mission statement on its websites, you come across any promotional materials, because it's a mouthful. They shorten it to, "Food with integrity," and that is an awesome mission statement when you condense it down. It's concise, it's evocative, it makes you believe, or want to believe in the product. But there's this other thing going on too, and that's actually a business model. It's got this marketing pull and it's got a certain cost structure underneath it. When you communicate to the customer, "This is food with integrity," you're differentiating yourself from the quick service restaurants, the McDonald's and Wendy's of the world, so you're setting a very high bar to begin with.

What we've seen with Chipotle is that that business model's worked so well for them for so many years because there weren't many incremental costs associated with that model, they went about their business sourced with great suppliers, had a great product, but didn't have to come to terms with any kind of food scares that we've seen recently. This is the first instance that we're seeing Chipotle is having to pay whatever it takes to make that one word in the mission statement, integrity, come true for its customers.

Diving from there into the supply chain, what's really interesting when you walk into your local Chipotle, you see. Vince, I know we talked about this recently, you see the ingredients and you want to think they're very low or very close to you. I'm sure this is your take, correct?

Shen: Yes, absolutely.

Sharma: Yeah, mine too. I'm also a fan of Chipotle, a fan of the stock, a fan of the food. But the reality is that your burrito or your burrito bowl has a variety of far flung ingredients coming with it. Your pork may be coming from England, because Chipotle has a few food scares and before that had issues with hormones, they've really reached out and branched overseas to some suppliers. They have two, one is called Karro, the other is Tulip. These suppliers sent carnitas, that is pork, over the ocean to Chipotle because Chipotle ran into some issues with hormones in the pork here domestically.

That doesn't mean that they don't have domestic suppliers, it's just they're branching out. Your pork and your burrito bowl might come from overseas. The avocados come from California, for the most part. One of Chipotle's big tortilla suppliers is called Don Pancho and they're based in Oregon. You might think, "Hey, I happen to know that there is this farm close by that supplies lettuce to Chipotle," and again this is very interesting. Before that lettuce gets to you, because of the norovirus scares, E.coli scares, that lettuce is now being shipped to a central kitchen, which may be hundreds of miles away, where it's prepped and then sent back to be distributed to the restaurants. This burrito bowl ought to come with its own passport, it's a really cosmopolitan batch of ingredients that's traveling hundreds and in some case thousands of miles to get to the line where you pick up that order.

Shen: OK, OK. Doubling back a little bit, you mentioned the carnitas for example coming from those two U.K. suppliers. Funny enough, Sarah Priestley who joined me in the editorial bureau recently on the tech team, she's heard of Tulip. They're a major meat -- pork and beef -- supplier in that region. She's heard of them, quite famous in her home country. From my understanding, some of that... this was also tied when Chipotle connected with these suppliers across the Atlantic to the shortage that happened in early 2015.

Part of the company's efforts, especially around animal welfare, they send auditors out to their suppliers to make sure that they're essentially adhering to the policies that the company's put in place. They found some issues with those standards, like as you mentioned with the hormones as well. When they cut those ties they lost supply to about one-third of their restaurants. You can see how I feel committed the company is to their mission statement in this case, when they're willing to go that far with the added cost of course, of bringing those ingredients across an ocean to resupply. I think a lot of the Karro Foods, or even the Tulip went to, for example, locations in Florida to bolster their carnita supply there.

Sharma: Yeah. This is case of whammy and double whammy, because a company like Chipotle can take a whammy. What I mean by that is it worked for Chipotle to get out in front of that shortage and to post signs in their restaurants saying, "Hey we've got a carnita shortage. You may not see the carnitas for a while," and customers really responded to that. Instead of going away and going to a competitor, they were willing to wait. It reinforced the image that we have a Chipotle interested in sustainability, interested in socially conscious food and willing to stand by those values.

But then the double whammy came in late 2015, where suddenly the cost to procure and prep food, to make it safe, really increased. That became a double whammy. In incurred cost in the first wave, that worked out for them, they were actually able to raise beef prices in 2015, to raise pork prices. What then ensued was an unexpected wave of safety violations, of people getting sick, bad publicity, and now the company posted -- as many of our listeners know -- a $26 million loss in the first quarter of this year.

If Chipotle is going to really appeal to its core customer, it's going to have to spend more millions, and it's willing to do that. We've seen that despite everything the company is still enforcing those small suppliers to incur more cost. As you and I were chatting about Vince, they have this $10 million program to help defray some of those cost for the smaller suppliers.

Shen: Yes. That $10 million if I recall, it was the local grower support initiative. That's money it seems that the company understands basically that... Keeping in mind that actually for their produce, I think in 2015 about 10% or 12% of their produce was actually considered locally sourced. Still just a smaller portion, a pretty small portion of the ingredients that they bring into the restaurant. But even then, at their scale and size it makes it really hard for some of these smaller growers to adhere to the very strict new safety standards that they've set after the scandal outbreaks last year.

With those added costs, with the DNA testing and testing before the crops could even be harvested. Basically can you tell us a little bit more about the $10 million? Maybe a little bit how they're spending it, about education, the assistance and things along those lines?

Sharma: Yeah. You mentioned the testing in the field, and that's something that's important for these small suppliers, because now they have this process of high resolution testing. It sounds really fancy. It sounds like you're taking some kind of highly sophisticated instruments and going into the field, but what high resolution really means is that, if you've got a sample size of stuff you're testing in the field, of small farmers' crops, you're going to test more of a small sample. Whatever the sample size is, you're going to test more of it. I sometimes wonder, is there any product left after you put high resolution testing through a small supplier. But that's exactly what that is, and that's labor intensive actually.

If you think of a small farmer who wants to grow into a midsize farm, the opportunity to do business with Chipotle is awesome, but if you've got these unexpected labor costs where you're paying somebody to physically go out, and not just someone who's maybe not related to the food industry, but a person with qualifications, or maybe an internal person that you had to train, that's a high cost. Consider the margins on a crop like cilantro, they're not very high. It's a business where you scale, you try to sell more and more each year and you're making on volume.

This is something of a setback to any small supplier who wants to conduct business with Chipotle. These programs should help in making the testing more efficient. I think they're setting aside actually some money to defray some of the cost of people being in the field to test these ingredients.

Shen: OK. Before I wanted to dive into a little bit more of the safety initiatives specifically and how it's changing, we talked about some of the ingredients, where they're coming from, and then also how the preparation process is changing in the restaurant and also at these central preparation centers. The thing is, Chipotle actually has kept their supplier list really pretty close to the chest, so a few other names to keep in mind that we discovered during our research. There's another one that's called Niman Ranch, they're a source of beef and pork and network from hundreds of independent farmers. As of last year, they were actually the largest pork supplier to Chipotle.

For example, during that carnitas shortage where the company decided to cease taking pork from one of their vendors that they found was not adhering to their animal welfare standards, Niman Ranch tried to step in but they can only do so much on short notice. Interestingly enough actually toward the end of last year in September, Perdue Farms actually bought out Niman Ranch and there was quite a bit of controversy among Chipotle fans and fans of Niman Ranch themselves, basically saying, "This is going to change everything, Perdue takes much more of a large scale approach to growing food," and that they're not going to be as concerned with animal welfare.

But it seems like I think all parties involved are interested in maintaining that relationship and the reputation that the Ranch has developed over the years. Then also a few other ones that we discovered were OSI Group, [...] and Golden State Foods. These are also commissaries that help with the food preparation, so I think the pork and beef is braised by OSI according to Bloomberg, and then Ready Food also cooks some of their beans, makes red ingredient sauces. Is there anything that you found out about these suppliers as well?

Sharma: Yeah, sure. Niman Ranch is extremely well respected in the food industry. They sort of grew up with Whole Foods. They have, or hold, Whole Foods' highest supplier rating. They have scaled up with that company. It's a natural fit for Chipotle to do business with them. We know that Golden State supplies to some very large companies, even in the fast food industry, such as McDonald's. These are well known large suppliers. Even though Niman was bought out by Perdue, my thought is that they probably will be able to keep their practices and Perdue understands that revenue stream has a certain buyer, so they're not going to mess with it too much.

But I'd like to move on to actually talking about how this food is prepped in these central kitchens and some of the techniques that have changed for Chipotle. It's pretty fascinating. When you think about the tomatoes that go into your burrito -- and some other of these vegetables -- they're actually now, the vegetables are blanched. If you don't know what blanching is, it's basically dropping the vegetables into boiling water for two to three seconds. You might thing that this kills the taste. If you were to take that same tomato and taste it, yeah, maybe you would see the difference. But what executives at Chipotle said when they came up with this is, "Hey, I challenge you to taste the difference in a burrito when everything else is in there, including the cheese and the sour cream, whatever else you have."

I tried that, I went to Chipotle and I said, "I know I'm going to be able to taste the difference because I'm a serious fan. I consider myself a borderline foodie. I don't have immense food knowledge, but I'm going to be able to taste the difference." I went, I ate the burrito and I could not tell the difference on that side. But some of the other procedures that they're using, you can tell a little bit of a difference.

One is definitely for the positive. With the chicken, Chipotle used to marinate their chicken through the day and now they only do it at night. Anyone who's ever cooked at home, unwrapped a bit of chicken, you see the warnings on the food labels, "Don't let this chicken get all over your counter," you've got to handle this stuff very carefully. What they do know is they marinate the chicken overnight, so there's very little chance of contamination of surfaces and other food items. I think that's actually improved the taste of the chickens, because in some cases it results in a longer marinade process.

But the beef is a whole different story. Bear with me here, I'm going to go into a little bit of detail, you foodies out there perk up your ears, because you probably are familiar with this technique. If you remember when Chipotle first came around, for me -- and Vince you mentioned this when we were talking for you as well -- seeing how they used to throw the raw beef onto their grill and sear that on a commercial oven, a gas oven, that was pretty exciting and new. Then they would slice it up, and it had a very classic American seared on the outside, medium texture on the inside, and it was delicious.

Along comes this food scare and now what Chipotle is doing is preparing the beef sous vide. What that means is it's a vacuum process; basically, they take their beef and put it in plastic bags, vacuumed, and they put this into a water bath, a warm water bath, and they let it sit there for hours. This is a really slow way to cook the meat, and what it does is it breaks down the collagens and the connective tissue and it increases the succulence of the meat. Basically, you should be getting what's an even tastier product.

Now there's a slight catch there, which is when you walk into a Chipotle, you really don't see that beautiful seared beef any longer. You see something that looks appetizing but it's brownish, and our brains are hard wired so that our senses combine. We need to see what we're eating. We need to smell it, we need to feel the texture on our tongue. If something's different, our brains tell us, "This isn't quite the same, and maybe it's not quite as good." You may think, "How important is that?"

It's so important that on Chipotle most recent conference call the analysts were asking about this sous-vide preparation technique. They were saying, "Hey, how are customers reacting to this?" Because if you and I don't take to that beef any longer, guess what's going to happen to one of Chipotle's most popular meats and to their sales in general. Monty Moran, co-CEO, was very careful to say, "Hey, at first customers didn't seem to be taking to this, but now their satisfaction is improving." I think by and large that's true. Try this at home, next time you go to Chipotle and order a steak burrito, try the taste, it's different but it's not bad, it's actually juicy meat and I think it passes muster.

Shen: OK, OK. Yeah, I did notice that. Honestly I have to say, Chipotle's beef was what originally pulled me away from Qdoba, I loved the way they grilled it right then and there. I love grilling out and seeing those grill marks on it even. It was I felt like another level in terms of the quality and really won me over and made me a regular at Chipotle restaurants. It seems like the company's trying to strike a balance here of finding the preparation techniques that they're launching at these restaurants to avoid these food safety issues, and at the same time work with their supply chain but also their preparation process overall and keep customers satisfied, especially at a very pivotal, sensitive time when I think they are under this extra scrutiny essentially due to the issues they ran into recently.

Sharma: Yeah. I think there's a big-picture takeaway here. Kudos to Chipotle because they're spending the money, they are working very hard to change their processes, and what looks like a lot of stumbling and fumbling today and trying to react, if you look carefully they're putting in new procedures for the long term. Let's go back to this idea of food with integrity. What they're doing is creating a new way. They understand that that original vision isn't going to work, it's just not possible, so they're recreating food with integrity and they're building a model that other restaurants that are interested in the same type of business model can follow in the future. It looks different, but at the end of the day if you can promise food safety and get close to what Chipotle had before, you've got a sustainable business.

For me, that's something essential that ties back to the stock, its valuation, Chipotle's future comps, their comparable sales, and the ability of this company to bounce back. I think by investing this time and this effort with suppliers, with procedures, spending these millions of dollars, they're building themselves to be that long-term company that they always purported to be. Personally, I think that's what they need to do, avoiding the issue and slapping some marketing on this would have been the utmost wrong move, totally wrong move, but they avoided that. They're acting with integrity, in my opinion.

Shen: OK, OK. I guess going off of that long-term view that you mentioned, and it's something that struck me as well, was the idea, last week we talked a little bit about inventory, how companies try and minimize the time they hold inventory on hand, convert that in cash or revenue as quickly as possible so they can invest it into other projects and get better returns. A process here that with a lot of these new safety initiatives, it seems like there's some added hand-offs for their inventory, essentially their ingredients for their burritos and their other menu offerings. How much do you feel like that is potentially adding to longer-term cost and affecting their margins, or do you think that this is something where longer term they need to get people back in their restaurants, to stay loyal to that mission and then the rest will sort itself out?

Sharma: Chipotle's always been very good at handling food costs. They used to be good at handling labor costs. I'm ribbing them a little bit, they still are very good at handling labor costs. The problem is that now you have a fully staffed restaurant that's waiting for customers to come in. When you look at Chipotle's restaurants margins, that's the direct cost they incur, the biggest portion of that is the labor cost. The food cost has suffered as well, so we're seeing that inventory moving a little more slowly because, number one, it's waiting for customers to come in and take it away. But number two, there are these hand-offs that you mentioned, and if you picture a funnel, inventory as a funnel, any time you have a bottleneck you're building cost in your system.

These food kitchens, if you look at it as a finance thing or an accounting thing, these food preps, multiple food preps, the central kitchens, they represent bottlenecks in Chipotle's system. Chipotle is trying to move those as quickly as possible, as efficiently as possible, but at the end of the day what they need is for that throughput to return, for the lines going out the door and for them to be focused on how fast we move a customer once they come in through our door, move them through the line, get them paid and let them get on with their day. That's something that will take care of itself. If they could get back to that, the inventory will move. But it's not a huge issue for them because as I said they're pretty good at handling the inventory, they can allow some of that to build on their balance sheet. It won't be too much of an issue.

Now there's a caveat here. That's, which every stockholder fears, if there's another food scare that will hurt them in terms of inventory, because their food waste will sky rocket in that instance. Whenever you have an incident like this, forget about what's called shrinkage, which is minimal food waste. They'll have a lot of food waste, because they'll have to go back to the drawing board. It will be terrible for their inventory balance on their balance sheet. I think they're behind that, but you never know, and that's the risk in holding the stock. We still won't know until time passes, that there's not one more scare in 2016. Those prospects are diminishing, but they're still there.

Shen: Yeah, absolutely, absolutely. You know for any restaurant at this scale, any of the companies out there, even for the larger ones that don't run into some of the same risks where they do more central processing for the ingredients, think of the traditional fast food companies, they still have their scandals. Overall, I think I'm with you, in that the company's focus' on the right place here. Overall I'm definitely rooting for them and will continue to be a regular at Chipotle.

Sharma: Yeah, as will I continue to patronize them. I feel safe eating the food, I think it tastes pretty good still, so I'm going to be going back for sure.

Shen: OK. All right, thank you very much Asit. We have to wrap up this episode, but life-cycle week continues tomorrow, as Kristine covers the journey of a prescription drug as I mentioned for healthcare. Sean will cover the origins of a barrel of oil on Thursday's energy and industrials show. Dylan will be looking at how the iPhone goes from individual components to everyday companion for tech on Friday. Thanks again, Asit. It was awesome having you on here!

Sharma: Thanks Vince it was a lot of fun.

Shen: Of course, we are always happy to keep the discussion going and encourage you to hit us up on Twitter @MFIndustryFocus, or shoot us an email with any questions or comments to [email protected]. You can also discover other podcasts from Motley Fool by checking out www.fool.com/podcasts. As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!