The rise of Chipotle (NYSE:CMG) has been driven by the vision of its management, which includes environmental sustainability. So Chipotle issued a challenge to technology industry teams at the Food + Tech Connect event Hack // Dining NYC.
The challenge description included a wide variety of areas in which restaurants could improve that included more use of natural light, the reduction of food packaging, and operational throughput. Throughput has been an issue for Chipotle's competitor Panera Bread (NASDAQ:PNRA.DL), which is why Panera has rolled out upgraded and customized ordering through a mobile app with its Panera 2.0 initiative.
One team, Just Right, discovered that most of Chipotle's customers don't eat their entire burritos. This makes sense, because these burritos are very large and that's been one of the chain's selling points in the past. Specifically, the team learned that 57% of the customers in their survey didn't finish their burritos. While Chipotle could just shrink the size of its burritos in response to this, it needs a way to ensure that customers still feel like they're getting a good deal.
Just Right came up with a suggestion for an app that would reward Chipotle customers for ordering burritos that contained fewer ingredients. A customer who cut back would receive loyalty points, which the team called peppers. In the proposal, the team suggested rewarding a customer with a free burrito for 50 peppers. Chipotle liked this proposal so much that the Just Right team won the contest and received a reward from the burrito maker.
The team performed a financial calculation at the end of its presentation that showed that implementing this project could have a very large impact on Chipotle's financials. Specifically, using Chipotle's 2013 numbers, the chain would cut costs by $107 million on $3.21 billion in sales, or 10% of its food, beverage, and packaging costs. Chipotle reported $327 million in total income that year, so if this project had been in place then and the projection came true, Chipotle would have reported 33% more income for the year.
Chipotle hasn't said anything about whether it actually plans to implement this project yet. However, its margins did come into focus with its last earnings report. Food, beverage, and packaging costs came in at 34.5% versus 33% in the first quarter of 2013, and as a result operating margin dropped from 16.5% in the prior quarter to 15%. The stock sold off after Chipotle announced that it would raise prices in response to this, but its stock price recovered later and is now over $600 versus $552 on the day before the release.
Panera Bread has also seen higher costs recently. Food and paper costs rose from 26% of sales in the first quarter of 2013 to 26.3% of sales in the first quarter of 2014. Panera is investing in its Panera 2.0 project so its margins should see continued pressure over the short term; however, the Panera 2.0 upgrades should pay off over the long run in more efficient restaurants. Panera also adjusted its menu to offer greater portion control by allowing customers to order half-sized portions.
In addition to price competitiveness, the chain thinks that portion size flexibility could also bring in customers for snacks as well. Bringing in customers outside of the lunch hour can help any fast-casual restaurant, but it's especially important for Panera because of its throughput issues. If Chipotle decides to roll out smaller burritos, that might bring in customers for snacks at other times of the day as well, although anecdotally Chipotle restaurants have customers in line at any time of day.
The results that came out last quarter showed that Chipotle had to either increase its prices or cut its costs to defend its margins. At the time, Chipotle seemed like it had selected price hikes, and after a temporary panic investors seem to be OK with that now.
However, that doesn't mean that Chipotle can't cut costs as well. The chain now has a way to cut costs without sacrificing food quality that might even allow it to reward its customers, and thus increase their loyalty, at the same time.
While there's no evidence that Chipotle will put this plan into effect thus far, if it does happen it could lead to a massive EPS boost for Chipotle that would provide more justification for its high valuation.