When people started complaining about portion sizes at Chipotle Mexican Grill (CMG -0.12%) earlier this year, Wells Fargo analyst Zachary Fedam took matters into his own hands. In the name of scientific discovery, Fedam and his team ordered a whopping 75 identical burrito bowls from various locations of the restaurant chain, meticulously weighing every single one. And what they found was shocking.
The difference between Fedam's heaviest and lightest bowls was 13 ounces -- one was roughly twice as big as the other one. And bowls fell anywhere across this entire spectrum. It turns out that the people complaining on social media about portions being variable had a valid point after all.
That's unfortunate for Chipotle Mexican Grill because its initial response to the social-media backlash wasn't great. CEO Brian Niccol jumped on TikTok to push back on the trend when it started. And he started his video by saying, "First, I can tell you the portions have not gotten smaller." But Fedam's delicious research later proved otherwise.
That research was too thorough and eye-opening to ignore. In the earnings call to discuss financial results for the second quarter of 2024, Niccol addressed the issue early on and outlined some changes coming for Chipotle Mexican Grill. It's a green flag for the business but might be a red flag for the stock.
Damage control for Chipotle's brand image
Chipotle now has more than 3,500 locations, and each does over $3.1 million in annual sales volume. This doesn't just happen. Consumers clearly love this brand. According to management, "generous portions" are part of the brand image it's going for. But the image got tarnished.
Now, Chipotle is moving quickly to fix things. Niccol said, "There was never a directive to provide less to our customers." But the company is circling back to low-ranked restaurants in its systems to retrain workers on appropriate portions.
In other words, Chipotle quickly went from denying a portion problem to actively correcting it.
The company could even be going a step beyond just retraining workers. Niccol went on to say, "We have also leaned in and reemphasized generous portions across all of our restaurants." This makes it sound like the company isn't simply making sure everyone is getting the prescribed portion, but it's also making portions a little bigger, in general.
Maybe Fedam can do a second round of research later and let investors know.
According to management, Chipotle's traffic trends were strong in April but started decelerating thereafter. The timing of the slowdown coincides with the social media trend that alleged smaller portions.
Therefore, it suggests some damage was done, and now, Chipotle is addressing this issue -- specifically, with better portions. That's a good move for the business but might not be for the stock -- at least not yet.
The red flag for investors
Chipotle's management didn't beat around the bush for what investors should expect: In the upcoming third quarter, management expects its restaurant-level operating-profit margin to fall to 25%. For perspective, it was nearly 29% in Q2 and over 26% in the third quarter of 2023.
To be clear, I believe this move is necessary. For starters, in less than three years, the restaurant chain has raised menu prices four times, according to USA Today. The speed of the price hikes naturally carries an expectation from consumers that they'll get their money's worth. If they don't feel that way, the company has to do something about it.
Moreover, Chipotle says its portions haven't gotten smaller, at least not intentionally. But the numbers don't entirely reflect that. Before the pandemic in 2019, 59.5% of revenue covered food and labor expenses. In the first half of 2024, by comparison, only 53.3% of revenue went to cover these expenses.
In other words, Chipotle's margins have expanded during the inflationary period that started when the pandemic began. But this suggests menu prices went up slightly more than necessary.
CMG Gross Profit Margin data by YCharts.
Investors should expect Chipotle's margins to take a step back as it actively tries to restore any lost brand luster. That's the right move for the business. But stocks tend to rise when profits increase, and if margins modestly go down, the stock likely won't perform as well as it has lately.
The bright side is that if Chipotle can repair any damage that's been done to its brand, investors should continue expecting strong top-line growth. The company can open new locations, and sales per location will increase. And over the long term, revenue growth can lead to higher profits, even if margins are slightly lower than what they've been lately. But it underscores the need for shareholders to be patient.
