Chipotle Mexican Grill (NYSE:CMG) fell by almost 6% on Thursday after investors reacted negatively to the news that it will be raising prices to compensate for increased food costs. However, Chipotle is firing on all cylinders and materially outgrowing traditional fast-food competitors such as Yum! Brands (NYSE:YUM) as well as fast-casual players like Panera Bread (NASDAQ:PNRA.DL). Demand seems to be strong enough to tolerate a reasonable price increase, so the dip in Chipotle Mexican Grill could create a buying opportunity in an extraordinary growth company.
Chipotle is doing remarkably well when it comes to sales: Revenues during the first quarter of 2014 grew by an impressive 24.4% to $904.2 million. Comparable-stores sales increased 13.4% during the quarter, and management mentioned increased traffic as the main reason for this extraordinary performance.
These kinds of numbers are fairly unique in the industry. Yum! Brands is doing better at Taco Bell than at Pizza Hut and KFC, but Yum! Brands and its Taco Bell concept are no match to Chipotle.
Yum! Brands is scheduled to report earnings for the first quarter of 2014 on Tuesday, but financial reports for the fourth quarter of 2013 are painting an uninspiring picture for the company in the U.S. Yum! Brands announced a decline of 2% in total comparable-store sales during the fourth quarter of last year, as the increase of only 1% at Taco Bell was not enough to compensate for declines of 4% at Pizza Hut and 5% at KFC.
The fast-casual niche is materially outgrowing traditional fast-food restaurants lately, and Panera Bread was once thought to be a considerable competitive risk for Chipotle in that category. However, Panera has faced a slowdown over the last several quarters, and the company is having problems in areas such as guest experience and service efficiency.
Panera Bread forecasts company-owned comparable net bakery-cafe sales to increase between 2% and 4% during fiscal 2014. This is clearly better than the kind of growth produced by big fast-food companies such as Yum! Brands, but no big threat to Chipotle and its spicy performance.
Rising costs and falling stock price
On the other hand, rising food costs have been a considerable drag on profit margins for Chipotle lately. Avocado production in California is expected to decline by 30% in 2014, which means declining supply and rising prices. Both beef and steak prices are at historical highs, and cheese prices are expected to increase by 10% this year.
Food costs were 34.5% of revenues during the last quarter, an increase of 150 basis points versus the first quarter of 2013. Management also said in the earnings press conference that food costs in April were already above 36% of sales and rising, so cost pressures are a considerable headwind for Chipotle.
The company is planning to raise prices "somewhere in the mid-single digits" over the coming months to compensate for falling margins, and this is generating concerns among investors. Shares of Chipotle Mexican Grill were up by nearly 5% on Thursday morning after the company announced earnings, but they ended the day down by almost 6% as investors focused their attention on falling margins and the risks implied by rising prices in such a competitive industry.
Pricing power and the future of Chipotle
Does Chipotle have enough pricing power to raise prices without suffering a big decline in sales or will price increases send customers away to competing alternatives?
This is not only a relevant question when analyzing Chipotle in the current context. Pricing power is enormously important when it comes to evaluating a company's competitive strengths and fundamental soundness. In the words of Warren Buffett himself:
The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you've got a terrible business.
It's important to consider that this will be Chipotle's first price increase in the last three years, so the company is not raising prices too much above food inflation rates. Besides, a 5% price increase in an $8 burrito means an extra $0.40 for clients. Consumers who are price-sensitive enough to be affected by such an increase are probably already buying from Taco Bell or some other lower-priced alternative to Chipotle.
The company's proposition is based on superior ingredients for higher prices than traditional fast-food chains. Demand has been booming over the years based on this business model, so a moderate price increase should not be a game changer for Chipotle Mexican Grill in terms of customer demand.
If the stock continues to fall because of fears over the possible effects of a price increase, chances are this will be a buying opportunity for investors.
Cost pressures are an important variable to watch. But Chipotle Mexican Grill is generating extraordinary growth rates thanks to a customer proposition offering superior ingredients in exchange for higher prices. A reasonable price increase is unlikely to derail Chipotle from its long-term growth trajectory, so any dip in the stock could provide the chance to buy a remarkable growth name at a discounted valuation.