Why a Chipotle Mexican Grill Turnaround is All But Inevitable

Image source: Chipotle Instagram.

The reader is no doubt more than aware of the recent travails of Chipotle Mexican Grill (CMG -0.12%). Practically everyone who hasn't been living under a rock has caught whispers of the E. coli (and the even-less-pleasant Norovirus) born problems that sent Chipotle's same-store sales (the pride of the fast-casual industry) plummeting. The scandal's effects were harsh enough to force CMG's bottom line for the first quarter of FY 2016 into the red -- the first time this has happened since its inception. 

Fortunately, the pressure seems to have alleviated itself to an extent. The aforementioned loss reversed itself the very next quarter -- but to a level some 80% below the results from the year-ago quarter.

The obvious reason for this dynamic is trepidation mixed with burrito cravings on the part of Chipotle's patrons. However, as we shall soon see, a Chipotle turnaround is practically guaranteed thanks to the very same dynamic that led to its meteoric rise in the first place.  

How did we get here?

Chipotle's self-inflicted wounds are broadly known, but they bear repeating.

Beginning in early 2016, Chipotle patrons were subjected to a slew of food-poising incidents -- each one more difficult to cope with than the last. An isolated event can be put out of the mind. Two, perhaps. But when it happens again and again, over a period of months, in locations stretched across entire U.S., even the most ardent steak-bowl fan starts to wonder.

All told, over 500 people became ill after eating at various Chipotle locations. Perhaps the most damaging tale involved over 100 Boston College students, including half of BC's basketball team, becoming seriously ill.

As time progressed, it became clear that Chipotle had a serious problem on its hands. What was no doubt assumed to be a one-off stumbling block turned into a full-on predicament. A restaurant naturally suffers when there are even hints of uncleanliness at it locales. The problem is amplified when part of that restaurant operator's value proposition is cleanliness and quality. 

In Chipotle's defense, a CDC investigation concluded that there truly was no direct connection between the incidents. However, the damage had been done, not just to Chipotle's image. Not only were people scared to buy their favorite burrito, but it had become glaringly obvious that something was seriously wrong with CMG's supply chain and procedures. Drastic steps needed to be taken to stem the tide. 

The response

Chipotle's management, to its credit, owned up to the situation and sought to rectify it -- any way that it could. Perhaps most impressively, in addition to any and all apologetic statements that any restaurant would make in a similar situation, Chipotle took the unusual step of shutting down every location for a four-hour period while all of its some 60,000 employees participated in a company-wide meeting to discuss operational changes, answer questions, and to be thanked by the executive team for their hard work. For inconveniencing its loyal customers during this company-wide meeting,  Chipotle gave away free entrees to any and every one who claimed to have had their lunch plans derailed that day. You have to hand it to them: The move was brilliant. Chipotle knew countless thousands would take advantage of its generosity -- and it was fine with it. CMG wanted us to be reminded of something we should have known all along -- that our hearts skip a beat at the thought of a free Chipotle burrito.

Management didn't stop there. They offered loyalists a chance to enter nirvana, or more accurately, "Chiptopia." The reward program, and yes it is actually called Chiptopia, is simple enough. Go to Chipotle, order your favorite dish and hand them your rewards card, then earn free food. LOTS of free food. For the most hard-core of customers, a free catered party for up to 20 people was offered to every Chiptopia card holder willing to simply frequent their local Chipotle eleven times a month for three months in a row.

We don't know the full results of these initiatives just yet -- CMG reports Q3 results on Oct. 25 -- but those results will almost certainly show that this move was a step in the right direction. Despite all of the egregious errors over the past year, we all still love a good chicken bowl with guac. Chipotle's management knows this, which is exactly why they are incentivizing their most loyal customers visit their local Chipotle location even more than they typically do. 

The customers shall return

It won't happen immediately, but the customers will be back. Yes, some of Chipotle's luster has been tarnished. And yes, as was recently noted by market research company M Science, customers have yet to return in droves for their cilantro-infused meal fix. These are all very true, very real facts. But there are two sides to every story. Chipotle has gone above and beyond to fix the leaks in its supply chain, ensuring that these mistakes will never happen again. Its Chiptopia rewards program, which attracted 3.6 million participants, proved that customers are not inherently adverse to eating at their local Chipotle. If the American public truly feared for their health, the program would have been a flop. Sure, the company spent an estimated $20 million on Chiptopia, but that's a small price to pay to plant the seed that Chipotle is back as a high-quality purveyor of fast-casual Mexican cuisine. 

And that's just it. Until proven otherwise, shareholders should consider what Chipotle is currently doing to win customers back all part of a process to reboot its status as a fast-casual favorite of early adopters. That's how the chain came into being in the first place. It started with a spark, where only early adopters and adventurous eaters had even heard of Chipotle. Then these early adopters started telling their friends. Then their friends said, "You've got to try this place." The rest, as they say, is history:

Source: Wikimedia Commons. 

Think about how you, dear reader, first heard of Chipotle Mexican Grill. Where did you fall on the above chart? Essentially, this model seeks to break down a company's given customer base into segments based upon when a given portion of its customer base became a regular user of its product. Chipotle knows full well that it needs to earn back your trust -- and it's going about it the way it knows best. By getting die-hard loyalists in the door, Chipotle's management knows that eventually, the broad public will follow. It will be slow at first, as we saw in the company's Q2 FY 2016 results, but the majority of consumers will be back. Not only that, but they need to win back far fewer customers than one might think to regain the company's profitability footing.   

A crazy little thing called operating leverage

Chipotle is currently spending millions to win back its base. This is almost certainly the right move, but it won't do the company a lick of good if it won't lead to profits down the line. Fortunately, the picture here isn't as bad as one might expect. The drastic drop in Chipotle's profits over the past three quarters was the product of a noteworthy, but far less extreme, pullback in total sales: 

Data source: S&P Global Market Intelligence. 

Unsurprisingly, it's expensive to run a restaurant. Even ignoring Q1 of 2016's stunning quarterly loss, Q2 2016 accurately tells the tale. Year over year, revenues for the period fell 17%, whereas profits fell a whopping 81.7%. The inevitable conclusion of these results is simple: Chipotle doesn't have to win back as many burrito lovers as one might expect to generate strong profits once again. Restaurants have lots of costs like rent, supplies, wages, and utilities, but once those costs are surpassed, the profits roll in once again.  

Foolish bottom line

When Chipotle reports earnings on Oct. 25, investors are unlikely to see an explosive rebound. But make no mistake, there will be a marked improvement. Chipotle's "rebooting" is still in the early stages, somewhere between the "early adopters" and the "early majority" groups in the above chart. For patient, long-term investors, this makes Chipotle's shares an enticing buy. At its current quotation, shares trade for a relatively low valuation(at least compared to CMG's historic multiples), offering investors the chance to buy a fantastic business at a time when it is suffering from a likely short-term-but-manageable setback. Chipotle's management team has bet it all on CMG's strongest adherents. The odds are extremely good that this bet will pay off handsomely. 

If you enjoyed this article, be on the lookout for my next article focused on Chipotle Mexican Grill where I will not only describe Chipotle's "Chiptopia" rewards program and its likely affects on CMG's bottom line in detail, but also my first-hand experience with the reward program and the overall reaction to a catered party provided by Chipotle as part of its attempts to reboot customer loyalty.