Along the banks of the Hudson River sits the little village of Highland Falls, New York. This village isn't the kind of place a high-volume restaurant chain would typically set up shop. And yet, that's exactly where Chipotle Mexican Grill (CMG -1.34%) just opened its newest location.
There's something different about the Highland Falls Chipotle: You can't eat inside. There's no dining room or front-line food prep either. The location, just a stone's throw from West Point Military Academy, is called The Digital Kitchen. It will only receive to-go orders digitally through its website, its app, or a third-party delivery app like DoorDash.
Image source: Chipotle Mexican Grill.
The digital sales trend
Generally speaking, once the COVID-19 pandemic started, dining rooms closed and restaurant sales plummeted worldwide. There were only a handful of resilient operations, and Chipotle was among them. The company was already adequately prepared for to-go options with its digital channels, and once the coronavirus motivated diners to use them, digital sales really took off.
| Metric | Q1 2020 | Q2 2020 | Q3 2020 |
|---|---|---|---|
| Digital sales YoY growth | 81% | 216% | 202% |
| Digital sales percentage of total sales | 26.3% | 61% | 49% |
Data source: Chipotle Mexican Grill. YoY = year-over-year.
Digital sales are advantageous for restaurants for a variety of reasons. For example, if someone uses Chipotle's app, the company can collect certain data points on a customer (menu preferences, order frequency, and the like) that it couldn't otherwise. From a pure business perspective, you can better serve a customer when you better understand a customer.
Chipotle was able to keep business going when many customers were sheltering at home, and the company was sure glad it was equipped to do this beforehand.
But then something interesting happened: By the end of the third quarter, 85% of Chipotle restaurants were returning to pre-pandemic normal by offering at least some seating. Nevertheless, almost half of sales were still coming in through digital channels.
In other words, digitally ordering ahead rather than placing an order at the counter upon arrival is a consumer behavior that's sticking. And if people are going to order their Chipotle digitally, it opens the door to new possibilities.
Image source: Chipotle Mexican Grill.
The rise of delivery-only operations
This brings us back to Chipotle's new Digital Kitchen prototype. Management says the new store will experiment in "urban areas that wouldn't support a full-size restaurant and allows for flexibility with future locations." Traditionally, filling a development pipeline isn't easy. Each location needs to facilitate enough sales to make sense; no management team wants to shut underperforming locations down the line.
While many places could support a lot of restaurant sales, not all of them make a great spot to place a traditional restaurant design. But if consumers are going to order digitally and take it to go, then perhaps your standard-format Chipotle could be replaced by a small-format digital operation. Therefore, Chipotle might be able to operate more locations long term than it previously thought.
In the past, Chipotle has gained operating leverage (leading to profits) with high sales volume. Average unit volume (AUV) in the third quarter was around $2.2 million. If the company chooses to open a lot of small-format digital stores, one would expect AUV to fall some. An average location only does about $1 million in digital sales right now, and it seems to me that a to-go-only location would struggle to approach the volume of a regular store.
That said, I would expect Chipotle's profit margin to remain strong despite the lower sales volume because a digital-only location could have a better cost structure. The smaller piece of real estate would theoretically be more affordable. Furthermore, almost all labor would be used directly in food preparation, with the app handling the transaction. This is a good example of how a company can leverage technology to boost profits even when it's not a technology stock.
An illustrative takeaway
The pandemic pushed the adoption of Chipotle's digital channels and opened the door to digital-only locations. The company is experimenting with the format and could soon begin seriously incorporating it into its restaurant development pipeline. While it's too early to say the pandemic changed Chipotle's business model forever, this is an unexpected result of the coronavirus.
While unexpected, this lesson from Chipotle is illustrative. This is why many investors approach past stock winners with the presumption they can continue winning into the future. Considering Chipotle already owns over 2,700 locations, it was fair to wonder just how much more room there was for new locations. But with digital-only locations, the company is expanding its possibilities, which is what successful companies tend to do.
