Chipotle Mexican Grill (CMG 0.47%) has had an impressive year so far. The company's stock is up nearly 33% this year, versus the S&P 500's 19% gain. One of the leading causes for the outstanding performance is management's quick adoption of digital ordering at the pandemic's onset. The decision offset any loss of sales as a result of in-person dining being temporarily disallowed. The move allowed the company to grow sales in fiscal 2020 without which the results would've been disastrous.
Additionally, management believes that these digital capabilities will have additional pay-offs over the longer term. Specifically, CEO Brian Niccol believes each store can now bring in annual sales of $3 million. While that's great news, investors probably would need to take this view with a pinch of salt under the current economic circumstances. Let's look at the challenges of achieving the target and why it's an important goal.
Digital sales fueling growth for Chipotle
Interestingly, the previous high-water mark for adjusted unit volume, or store unit sales, was $2.5 million; so the increase to $3 million is a 20% jump. That's a significant number, especially when you consider the company has 2,850 stores with plans to expand to 6,000 in North America alone.
The proliferation of its digital business is undoubtedly helping the cause. In its most recent quarter ended June 30, digital sales totaled $916 million and comprised 49% of overall sales. The figure as a percentage of overall sales will likely decrease as economic reopenings gain more steam. However, the absolute value of sales could continue higher.
To fulfill the expected increase in store-level sales, management has started equipping restaurants with Chipotlanes. These are dedicated areas where staff make orders that come through the digital channel. That way, orders made for delivery or pickup are not interrupting the flow of in-store business. Although it is still early in its development, stores with Chipotlanes are outperforming their counterparts without them.
Moreover, if each store is now expected to produce 20% more in annual sales, that should improve profit margins. Indeed, management has said there is room for the company to grow operating profit margin by several hundred basis points from the current store-level operating margin of 24% to 25%. And perhaps most importantly, as the company progresses toward $3 million in annual store-level sales, it could improve cash-on-cash returns from the current range of 60% to 65% up to nearly 100%.
Challenges in hitting the target
Importantly, just because management set the target of hitting $3 million in sales per store does not mean the company will achieve that goal. Raising sales by 20% per store is not an easy task, and several challenges, including labor shortages and rising costs, could hamper those ambitions.
A supply and demand imbalance between open jobs and people willing to fill those jobs is widely reported in the U.S. Chipotle has nearly all its restaurants. If Chipotle cannot get enough staff to fulfill customer demand, it may lose out on sales. For instance, imagine walking into a Chipotle and seeing a line so long it is spilling over outside. In that case, it is easy to see customers leave the line and walk over to the next closest restaurant.
Moreover, the coronavirus pandemic is causing disruptions in the supply chain worldwide. An outbreak at a manufacturing facility can stall production for several weeks, which hurts the next step in the supply chain that relies on those products as inputs, and so on. These occurrences are frequent, with the deadly virus still in circulation.
Longstanding economic relationships are holding (prices increase when supplies decrease), raising ingredient and labor costs for Chipotle. The company has implemented modest price increases to offset those costs, and so far, customers have not decreased spending. However, Chipotle cannot expect customers to absorb higher prices without reducing purchases or visits to some degree. Therein lies the challenge for Chipotle -- to increase sales, it may have to absorb higher costs and accept lower profit margins.
Chipotle stock is a market favorite
There is a lot to like about Chipotle's prospects over the next several years. The only problem is that its good prospects are widely agreed upon in the market. The stock isn't exactly cheap, trading at a forward price-to-earnings ratio of 53.
To make matters worse, the near-term challenges could persist longer than expected and put a damper on Chipotle's excellent operating performance.
Still, Chipotle has returned 346% for shareholders over the last five years. Its growth in new restaurants and increases in sales per restaurant could keep the good times rolling for shareholders even longer, especially if the company hits the $3 million in annual store-level sales sooner rather than later. That's why it could be Chipotle's most important number right now.