Chipotle Mexican Grill (NYSE:CMG), a recent spin-off of McDonald's (NYSE:MCD), has been the talk of Wall Street in recent months. Last week, following the release of its fourth-quarter results, Fool contributor Steven Mallas asserted, "Chipotle looks like it could be a very rewarding long-term investment." All of the chatter certainly has me interested in taking a closer look.
Following our recent Folly Volley of another concept in the restaurant biz, Texas Roadhouse (NASDAQ:TXRH), my colleagues and I are going to stick with a subject near and dear to our hearts -- food. To add to the Chipotle discussion, Bodhi Zappa, Hank Schofield, and I will once again spar over the company's recent conference call, for the purpose of developing a more informed understanding of the core strategies that have helped it become such a successful concept. Without further ado, Bodhi, kick us off with your opening observations.
On better-quality ingredients:
Bodhi: It's interesting -- what gets all of the press in regard to this cool concept is its high-flying financial results. What is often totally missed by the media are those characteristics that make it all possible -- good, quality food and professional-minded restaurant management. Chipotle executives spent the better part of their opening remarks on these less-advertised qualities of its operation.
Right from the outset, CEO Steve Ells gave considerable attention to what he referred to as "food with integrity." He added that understanding how the animals it uses are raised and how the produce it provides to customers is grown "directly relates to serving the very best possible food." One step toward this end is that it strives to use only naturally raised meat that is free of added hormones and antibiotics, and served a vegetarian diet. It has been a work in progress, but as of the conference call. 100% of its pork, half of its chicken, and a third of its beef are naturally raised. Ells states that Chipotle is at the "forefront" of this movement and as the company continues to expand, the market for naturally raised animals will expand with it, making these better-quality ingredients available to everyone.
Jeremy: Interesting business strategy. If you've noticed, many Chipotle sites are located near college campuses, populations that are often more conscious to the ethical debates on the treatment of animals. Naturally, advertising its naturally raised meats not only appeals to the students' minds, but also to their wallets. For Ells, this is a winning strategy, as he asserts, "Quite simply, better raw ingredients mean better quality food, more customers, and better financial performance ultimately."
Hank: Let me tip my sombrero to you -- all of this talk about naturally raised hogs and cattle just about won this old cowboy over. Just about. But for this investor, profits rule the day, and anything taking away from margins I have to question the logic of. For instance, Fool contributor Vitaliy Katsenelson just wrote up an extensive report on the chicken industry, indicating that many chicken-producing stocks have recently hit lows in response to falling commodity prices for chickens.
My point is that when one analyst questioned Chipotle executives on its ability to capitalize on falling chicken prices, CFO Jack Hartung's response was less than convincing. Essentially, since only about half of its chicken comes from commodity-based sources, it is not able to fully capitalize on the recent weakening of prices. Put simply, all of this talk of using naturally raised meats doesn't come without a cost. My bet is that its profitability would improve without using this ethically inclined strategy.
Bodhi: Well, old cowboy, allow me take a six-shooter to your argument. You are going to question management's decision to sacrifice a percentage point or two on profits for the sake of higher-quality ingredients? Consumers are going gangbusters over its product, leading the company to post a 36% increase in sales. Besides, margins are actually improving as a result of several factors, including lower prices for cheese, tomatoes, and green peppers, as well as higher average sales from menu-price increases. And remember, management indicated that each introduction of an organic product gives it the ability to raise prices, since consumers are willing to pay up for quality. The net effect was a staggering 400% jump in operating income.
Jeremy: I don't expect the "food with integrity" trend to end any time soon. Management suggested later on in the call that it is concentrating on meats right now, but the beans it uses are already 20% to 25% grown organically. And it has plans to move toward organic lettuce, tomatoes, corn, and even flour. The same organic craze that Whole Foods (NASDAQ:WFMI) is benefiting from is one that Chipotle is also capitalizing on -- people are concerned about where their food comes from and how that product comes to the market.
While we have some time, let us turn our attention to the other topic Chipotle's conference call addressed in depth -- management hiring and training.
On management hiring and training:
Bodhi: Dude, I was floored when President and COO Monty Moran said he and Steve personally interview each candidate for their new restaurateur program. I mean, how far out is that? As busy as these two are, they actually take time away from their schedule to make sure they are hiring the right people for long-term careers at their restaurants.
Hank: It has to do something to keep its top managers around. As it stands, management turnover for the company is just average, with the industry at around 43% for 2005.
Bodhi: A fair point -- and that's what this incentives-based program is all about. It rewards top managers not only with performance bonuses, but also for their ability to successfully train future managers. Hank, name another company where the CEO and COO of such a large corporation actually takes the time to interview its top-performing restaurant managers for the purpose of keeping them around for the long haul. Can't name any? Neither can I.
Foolish bottom line:
Jeremy: This is the kind of thing that prospective investors need to be aware of in the companies in which they invest -- the quality of management and innovative business models. Just as Tom Gardner takes the time to interview the CEOs of those companies he picks in his Motley Fool Hidden Gems newsletter, for the purpose of identifying enterprises led by high-quality management, so too is it important for us to be aware of the kinds of individuals that are overseeing our investments.
The headlines will read that Chipotle management expects to increase income from operations at a rate of around 25% a year over the next few years and that its potential unit growth is off the charts, but what you won't hear is how the Chipotle leadership actually pulls it off -- and that's by bringing in the highest quality ingredients and keeping their best managers around. It is this attention to detail that sets Chipotle apart from a lot of other concepts.
It is important to note that identifying good quality management is just one criterion for finding strong candidates for long-term investments. Prospective investors will also want to watch other metrics like free cash flow and return on invested capital. But as far as identifying strong leadership, I think we may have found that in Chipotle Mexican Grill.
Take a bite into more Foolishness:
- Investors are going bonkers for Sonic (NASDAQ:SONC).
- Does Famous Dave's (NASDAQ:DAVE) still offer hope for long-term investors?
- Wendy's (NYSE:WEN) serves up soggy figures.
Whole Foods is a Motley Fool Stock Advisor recommendation. Fool contributor Jeremy MacNealy does not own shares of any companies mentioned.
