Chipotle Mexican Grill (CMG -1.11%) has been thriving in recent years as management skillfully adapted the company's operations to maintain performance during a pandemic. The fast-casual restaurant chain's sales and earnings soared in 2021. But rapidly rising inflation in 2022 is threatening to halt its momentum. 

Chipotle's fiscal 2022 second-quarter earnings report is scheduled to come out Tuesday, July 26, after the markets close. Analysts and other interested parties will be watching the results closely to see how well the company is handling this new headwind.

Here's what investors should look for from Chipotle heading into this upcoming release. 

Inflation is pushing Chipotle's production costs up by double-digit percentages

Chipotle's fiscal 2021 was a banner year for the company. Sales surged by 26.1%, the highest since they grew by 27.8% in 2014. 2021 earnings soared by 83% to $22.90 per share, its highest in the previous decade. Some of this performance boost can be attributed to management moving quickly at the pandemic's onset to emphasize online orders for delivery and pickup. With restaurants temporarily closing dining rooms to address the coronavirus pandemic, Chipotle knew that to sustain or grow sales, it had to pivot.

In its most recent quarter (which ended on March 31), Chipotle's revenue jumped by 16% year over year to $2 billion. Customers have returned to restaurants, but online sales have maintained their growth with 42% of Chipotle's sales coming thru digital channels.

As with most other businesses in 2022, the company's biggest challenge is rising costs. Supply chains are still disrupted and fuel costs are up significantly, which is leading to rising costs of produce, meats, and other materials Chipotle needs to operate. On the workforce side, it's still difficult finding enough employees to staff adequately, which is driving up wages to attract and keep employees. Adding to the employment problem is the coronavirus is still an issue and outbreaks send infected workers home for days or weeks, further aggravating staffing levels.

All together, Chipotle is dealing with the highest inflation rate in its operational existence. That inflationary pressure helped lower its restaurant-level operating margin by 160 basis points in Q1 despite rising sales. Chipotle CFO John Hartung said in the Q1 conference call that production costs rose by 12% to 13% year over year. Additionally, Chipotle increased employee wages by 15% in the second quarter of 2021.

US Consumer Price Index YoY Chart

U.S. Consumer Price Index YoY data by YCharts

To help offset those increases, Chipotle raised the prices of its menu items by 4% in the first quarter. Management is hopeful the price increase will return its restaurant-level operating margin to around 25% in Q2 from 20.7% in Q1. Interestingly, management forecasted revenue would increase by 11% at the midpoint for Q2. Given that estimate, management appears confident the price increases will not repel customers.

What this could mean for Chipotle investors

Analysts on Wall Street expect Chipotle to report revenue of $2.24 billion and earnings per share (EPS) of $9.07. If the company meets those projections, it would be increases of 19.3% and 21.6%, respectively, from the same period the year prior.

CMG Price to Free Cash Flow Chart

CMG Price to Free Cash Flow data by YCharts

So far, it would seem that Chipotle is effectively grappling with inflation. But it also appears the market has made note of this and it is reflected in the stock price. Now may not be the best time to buy the stock. Chipotle's stock is expensive when trading at a price-to-earnings ratio of 55 and a price-to-free cash flow ratio of 46.5. Those levels are well down from highs in 2021, but still relatively high in general. This upcoming earnings report may help drop the levels a bit further and make for a better entry point for long-term investors.