Hitting the Road
By: Ryan McCrea & Matt Nesvadba
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
Over the past three years, Chipotle Mexican Grill (Chipotle) has baffled investors, delivering more than 140% share price accretion. Through its 1,600 restaurant locations from Frankfurt to Vancouver, the chain exceeded analyst expectations for Q4 2013, increasing net income by 30% and same store sales by 9.3% over Q4 2012. Chipotle has become the star of the up-and-coming ‘fast-casual’ segment, defined by the quick delivery typical of fast food but made with higher quality ingredients.
Despite its well-timed entrance into fast-casual, Chipotle faces new entrants that have taken notice of this segment’s growth. With a price-to-earnings ratio twice that of the industry average, Chipotle will need to deliver on investor expectations by maintaining their market-leading position and growing the bottom line.
Somewhere Between Fast Food and Premium-Casual
Chipotle is well-positioned in the fast-casual industry, which has been experiencing rapid growth in recent years. As a relatively new segment dating back to the early 1990s, the fast- casual industry experienced a surge of popularity following the 2008 financial crisis as consumers began to substitute more expensive premium-casual restaurants for relatively cheaper fast-casual restaurants. The industry is now one of the fastest growing in North America. At $17 billion in annual revenue, it has been growing at a compound annual growth rate (CAGR) of 10% since 2007.
Fast-casual consumers demand what can be described as a hybrid between fast food and full-service restaurants. They crave a quick meal, but want some of the amenities offered by full-service restaurants; more restaurant space and a more interactive service experience overall. Firms that aim to be successful in the fast-casual industry must place an emphasis on atmosphere and decor, provide strong customer service, and ensure high quality ingredients. Fast-casual customers are willing to pay higher prices at roughly $9 to $12 per meal for comparatively higher quality food over their limited-service counterparts, which average $5 to $7 per meal. Key differentiators for Chipotle are the consumer-oriented restaurant designs and customizable menu, using ingredients that are produced with consideration for the environment, animals, and farmers. Furthermore, all of Chipotle’s locations are company-owned to offer a consistent eating experience and to ensure stringent quality control. Chipotle believes this draws a socially-conscious customer profile by offering “Food With Integrity,” but at a significant cost; Chipotle pays a comparatively higher cost of goods sold (COGS)/Sales at 33%, while the industry average sits below 29%.
Fast-moving Competition
The greatest threat to Chipotle’s continued success comes from fast food chains like Taco Bell. In 2012, the Mexican eatery launched the “Cantina Bell” menu in hopes of emulating Chipotle’s success. A recent survey by hedge fund Greenlight Capital illustrated the significance of this threat by noting over 23% of Chipotle customers reported they had already tried the Cantina Bell menu, and from those, two-thirds stated they would return to Cantina Bell. In the face of growing competition, Chipotle needs to look at diversifying strategic initiatives that will spotlight its competitive advantages of high quality food and quick service.
Companies like McDonalds have also attempted to move into the higher-end restaurant space. The mega-chain changed its restaurant decor and product offerings over the past few years in order to better position itself to capture customers in the ‘fast-casual’ segment. Given the stronger supply chains, lower COGS, and larger marketing budgets of these fast food chains, the management team of Chipotle faces a significant threat to their company’s market share.
Finding an Alternate Route
Chipotle has historically been limited to serving customers willing to pay a premium for both higher quality food and a pleasant environment. If Chipotle were able to eliminate its occupancy costs, it would find itself in a more competitive position. In order to maintain its growth in the face of increased competition, Chipotle should implement a sub-brand of premium food trucks. In this way, Chipotle could offer high quality food to a new range of customers without harming its brand image in the eyes of its core customer base.
Similar to the fast-casual industry, food trucks have taken off since the 2008 recession, growing sales at a CAGR of 12.4% into 2014, with total sales approaching $1 billion. Food chains that have considered adopting a food truck method have primarily done so with the intent of using it as a marketing tool, rather than as a distribution method. Although many chains rely on their brand to attract potential customers, the inherent value of Chipotle is actually the food quality and its unparalleled customer operations. By offering a similar value proposition through a premium food truck, Chipotle can take market share from its fast-food competition without compromising its own position.
Chipotle should continue with its ingredient sourcing and food quality practices. However, maintaining an efficient customer processing service would require some changes. First, Chipotle should allow customers to place their orders over a mobile device for pick-up through an express window. For non-app orders, Chipotle could have sales associates take customer orders outside of the food truck and send the information wirelessly through a point of sale device. Also, limiting the menu to just the Chipotle staple burrito would allow the fast delivery process to be maintained.
Rolling Out
The potential to achieve strong profitability is high, as these trucks would need to sell less than half the number of burritos per location. This works out to 290 burritos per day versus 600 in brick-and-mortar locations, assuming Chipotle reduces its price for the food truck from $9 to $6.50 per burrito. This falls just above the $6.33 average price of a food truck entrée.
The lower initial investment required for food trucks versus a traditional storefront location equates to less than $200,000 per truck compared to the $800,000 required for a storefront. Furthermore, the lower operating costs in managing a truck result in a profit margin of 40%, much higher than the 17% typically achieved in-store. Clearly, food trucks present an opportunity to make a meaningful contribution to Chipotle’s bottom line while simultaneously diversifying revenues.
Beware of Hazards
There are some risks for Chipotle in pursuing this strategy. First, the sales cannibalization figure may be higher than accounted for in the projections. This concern is highlighted by the fact that cannibalization decreases by approximately 30% for every mile between fast food locations. As such, if these food trucks are situated more than three miles away from Chipotle’s existing stores, there should be a cannibalization rate of approximately 10%. Other potential issues, such as the effect that truck breakdowns and seasonality will have on profitability, were also accounted for and were found not to have a significant effect on the overall internal rate of return. As such, effective location management for the food trucks, both in relation to Chipotle’s stores and in relatively warm climates, will be essential to the success of this venture.
The Perfect Destination
The best US cities to target for premium food trucks could be identified using several criteria. Extrapolating demographic data from New York City illustrates that one Chipotle restaurant services a market size of approximately 200,000 consumers. Currently, standard food trucks in US cities serve market sizes from 75,000 to well over 200,000. Assuming a typical Chipotle market size of 200,000 can be served by a Chipotle food truck, over 100 cities in the US could provide the customer base for at least one truck. Additional factors need to be considered to narrow down the list of cities.
First, recent studies suggest that fast food consumption is positively correlated with increases from low to middle-income brackets. In addition, population density in the area (Chipotle requires a population density of 30,000 in a two-mile radius ) and the rate of urbanization need to be taken into account. Using all of these considerations, 89 cities can be used for the initial rollout of the food trucks.
While these cities can support the customer base required to validate investment in a food truck, one of the greatest concerns to food truck owners is municipal government regulations. However, the cities proposed are relatively urbanized, where public demand is leading to deregulation. Nearly half of these cities are in the southern US, where a comparatively warmer year-round climate will extend the operating season of food trucks. Of the remaining cities, roughly 15% are located in the Midwest, 31% in western states, and 7% in the Northeast.
Conclusion
Chipotle Mexican Grill still has substantial room to expand its bottom line and diversify the sources of its top-line revenue. Launching a series of premium food trucks will allow Chipotle to compete directly with fast food chains that are encroaching on its traditional market share. This will steer the company towards continually exceeding analyst expectations and delivering significant shareholder value for years to come.
