In April, Chipotle Mexican Grill, (CMG 6.33%) reported that sales in restaurants open for at least a year had jumped 13.4% during Q1. This represented Chipotle's best comparable restaurant sales performance in almost a decade. Yet investors didn't seem pleased, as they sent the stock plummeting from more than $600 in March to well below $500 by late April.
Chipotle YTD Stock Chart, data by YCharts
The main cause of investors' worries was apparently soaring commodity costs. Food costs increased from 33% to 34.5% of revenue last quarter, and Chipotle CFO Jack Hartung stated that food costs could exceed 36% of sales for the next two quarters based on the prevailing trends.
However, Chipotle announced at the same time that it planned to increase menu prices in order to get ahead of the cost increases. Now that Chipotle has started the process of raising prices, investors are finally beginning to realize just how much this will boost earnings.
Enter menu price increases
On the Q1 conference call, Chipotle suggested that it would implement a companywide mid-single digit price increase this spring. That was a slight increase from the informal guidance provided earlier this year that Chipotle would likely increase prices 3%-5% this summer.
Theoretically, menu price increases could hurt traffic, if customers are turned off by the price changes. However, Chipotle has not implemented a broad price increase in 3 years. Consumers will also see food price increases wherever they go, due to beef and pork supply issues. Lastly, Chipotle customers have generally been very accepting of price increases. As a result, Chipotle's price increase represents pure upside for investors.
Most Chipotle customers are willing to pay higher prices
At an investor conference last week, Chipotle's management stated that the company has already increased prices in 500-600 restaurants: about one-third of the chain. Chipotle now expects the average increase to be near 6%. So far, customer traffic remains strong.
Tweaking the sales mix
While Chipotle is raising prices across the chain, it is not raising prices equally. For example, Chipotle is incentivizing customers to choose lower-cost proteins by raising the price for steak more than the price for chicken.
Historically, Chipotle has only charged $0.30-$0.40 more for steak than for chicken. However, that does not fully cover the additional cost of steak relative to chicken, particularly after the rapid rise in beef prices in the last few months. Going forward, Chipotle plans to charge $0.70-$0.80 more for steak than for chicken.
In the restaurants where this change has already occurred, Chipotle is seeing some customers trade down from steak to chicken -- which is good for Chipotle's profit margin. This tactic also allows Chipotle to keep chicken as a more affordable option for value-conscious customers.
Margin growth coming
Chipotle's menu price increases will provide a significant boost to the company's profit margin in the back half of the year. With a 6% price increase and stable commodity costs, food costs would drop from 36% of revenue to 34% of revenue. (The benefit could be bigger if enough people switch from steak to chicken.) The price increase will also help Chipotle leverage labor, occupancy, and overhead expenses.
Chipotle's price increase will help the company return to margin growth next quarter
In fact, the 6% of incremental revenue is essentially pure profit for Chipotle, relative to the status quo. On an annual basis, this is worth more than $200 million before tax. That should more than offset food and wage cost increases, allowing Chipotle to return to record profit margins within a few quarters.
Foolish final thoughts
Chipotle analysts are starting to recognize the margin and earnings growth potential created by Chipotle's menu price increase. However, the average EPS estimates of $12.51 for this year and $15.95 for 2015 still seem too conservative. They incorporate relatively little margin growth in the second half of 2014 and the first half of 2015, despite the beneficial impact of the price increase.
Thus, Chipotle investors are likely to get a very pleasant surprise in the next few quarters as earnings growth accelerates. The company's revenue is on pace to grow more than 20% this year, and EPS should be able to increase at least that quickly. Chipotle shares may seem a little pricey at more than $540, but they're well worth the money: just like Chipotle's food.
