Wednesday, February 3, 2016

Answers in Chipotle Report

The earnings report from U.S. restaurant chain Chipotle Mexican Grill hints at answers to two of the questions customers have been asking. The more important question of the two is why Chipotle can’t change its slapdash food preparation approach. Chipotle’s financial results point at the answer to this. Revenue at Chipotle was down 15 percent as customers stayed away following three highly publicized disease outbreaks originating in the restaurant chain. Profit, though, was down 45 percent. When a business’s profit falls faster than its revenue, this points to the fixed costs of the business. These are the costs the business must bear regardless of the number of customers. If profit falls three times as fast as revenue, this is a business that has an unusually high proportion of fixed costs for the restaurant sector. To make a profit at all, Chipotle must bring in as many customers as it can, regardless of its ability to handle the workload. To put it another way, Chipotle has to force its customers to wait in long lines and push its food-assembly workers to work an unnaturally fast pace to make a profit at all.

The unfortunate other side of this effect is that Chipotle will fail spectacularly when consumer tastes change, something that inevitably happens within a matter of years in the fickle restaurant business, all the more so in restaurants like Chipotle where the novelty factor is intrinsic to their appeal. A decline in traffic of one third would not be a drastic change from the customer’s point of view — you would be waiting in a shorter line, but still waiting in line — but it would have the restaurant chain operating at a loss. Any adjustments Chipotle might make at that point to return to profitability, such as raising prices, closing stores, or reducing the quality of the product, would further erode revenue in what would likely be a downward spiral. Chipotle’s suggestion that heavy spending on food safety will wipe out its profits in the current quarter suggests that this downward spiral may have already begun.

The other big question was whether any of the official investigations into Chipotle’s operations have turned up anything. A criminal investigation in California may have turned up something about actions in other states, because we now know that a California criminal investigation of a single location in Simi Valley has turned into a federal investigation by the Department of Justice. Chipotle says it received the first subpoena in the federal investigation last week. The documents sought by the subpoena hint that investigators suspect a company policy directed toward covering up problems with food quality.

Chipotle ultimately probably cannot fix its quality problems because slowing down food assembly enough to fully control the process would mean giving up the high volume that it requires to turn a profit. I believe Chipotle can fix all its other quality problems, but it is easy to see why management turns a blind eye to the actual problem that it faces. There may not be a solution that allows the company to stay in business.