Chipotle Mexican Grill (NYSE:CMG) is scheduled to release its second quarter earnings report on July 21, 2014. The Mexican cuisine specialist has been performing well in the fast-casual dining segment, due to a growing outlet count, loyal customer base and healthy organic food freshly prepared in an up-scaled and inviting ambiance. In the first quarter, Chipotle excelled with 13.4% comparable sales growth, driven primarily by higher customer traffic and performance of new restaurants eventually leading to 2% increase in the average receipt. 
The company considers the second quarter as the busiest period of the year and expects to continue, as well as build further on the momentum that has been developed during the last few quarters. The company’s catering services, menu expansion, and also diversification into other cuisines through ShopHouse and Pizzeria Locale have been the key factors in its excellent top-line performance over the past couple of years. However, inflationary pressure on food items has forced leading restaurant brands including Chipotle to raise the menu prices. This might boost the comparable sales but company might also witness a decrease in customer traffic, if the price hike does not go well with the customers.
We have a $574 price estimate for Chipotle, which is about 2% lower than the current market price.
Menu Price Hike To Boost Revenue Growth
Since the onset of this year, food inflation has been a constant threat to the restaurant industry. Fast-casual chains and Quick service restaurants such McDonald’s (NYSE: MCD), Subway and Burger King (NYSE: BKW) have been facing rising beef costs, given the reductions in U.S. cattle inventory in recent years. The prices of beef, avocados and cheese have increased significantly over the last few months. The price of Ground Chuck 100% beef rose to $3.85 per pound in May 2014, up 11% year-over-year, whereas the price of cheese rose 28% in a 5-months period when it peaked at $2.36 per pound in May.  In comparison to this, overall inflation is reported to be around 2% for a wide range of food products. Two years of drought conditions in some parts of the U.S. were the main reasons for this significant increase in prices. 
Threatened by the vigorous inflation, Chipotle widened the price gap between its steak burritos and chicken burritos in early May. The price hike was 4%-6%, or 32-48 cents for a burrito costing $8. Many feared that the price hike would affect the company’s customer traffic, but it had minimal impact on them.  People are willing to pay 4-5% extra for hygienic and better quality food. Furthermore, according to the Bureau of Labor Statistics, U.S. consumers paid 2.6% more at eateries (food away from home) in 2013 over the last year, while food prices were 6.2% higher at supermarkets or retail stores.  Therefore, consumers get a wide idea of price inflation for the core items and they are less likely to react against rising menu prices at restaurants. As a result, restaurants can raise prices as long as they do not exceed prices for food-at-home items.
Moreover, the price hike at the start of second quarter might help in driving the revenue at previously existing stores. Chipotle has been seeing increasing sales even during times when its competitors are struggling with flat or marginally rising sales. Hence, considering that inflation is affecting everyone in the restaurant industry, we don’t expect menu price hikes to have a major impact on Chipotle’s sales in particular. In the first quarter, Chipotle did not raise menu prices despite the escalating food costs, which led to a dip in operating margin by 40 basis points to 25.9%. The overall margins also declined by 150 basis points to 15%. However, the margins could grow this quarter after the company raised prices of some of the high-volume food products.
If the unsuitable conditions continue to prevail, the company might further raise menu prices later this year, giving a further boost to average ticket per visit. On the other hand, there is a constant threat that the price hike might keep the customers away from restaurants. Trefis has already taken these factors into account and estimates the average spend per visit to rise 3% in 2014.
Catering Services And Expanded Menu Might Aid Sales Growth
Incremental sales due to catering services, launched by Chipotle in January last year, continue to approach 1% of the company’s total sales. By the end of 2013, the company had introduced catering services in all its restaurants, except those in New York City. Its plans to start catering services in NYC in 2014 could boost sales further. The company believes that with the graduation season approaching, catering services might significantly drive the revenues in the second quarter.
Chipotle has always been known for its organic and hygienic food items and its popularity does not seem to be fading away. Over the last few years, the fast-casual segment has witnessed tremendous growth due to its wide variety of food items. Chipotle’s recent addition to the menu was its Tofu Sofritas, which proved to be quite a success among its customers.  The company has always been successful in providing its customers with an unusual dining experience and continuous expansion of its menu with new and innovative items.
Higher Marketing Costs Might Hinder Top-line Growth
In its guidance for the fiscal year 2014, Chipotle mentioned that it expects the marketing expense for the year to be around 1.7% of sales. In the first quarter, the marketing expense was 1.3% of the sales, and the company expects it to be relatively higher for the second and third quarter, as the company has planned its ‘better ingredients’ advertising campaign in over 30 markets and over 1,000 restaurants. The extra expense might lower down the operating profit.
Focus On Expansion
For the past couple of years, Chipotle’s recorded revenue has been driven significantly by new store openings. As of December 31, 2013, there are 1,595 restaurants operated by the company, most of which are in the U.S. The company has a lot of scope to expand in the U.S as well as internationally where the company has only 16 restaurants. Chipotle added 44 new restaurants in the first quarter, a slower pace as compared to similar period last year. In Q2 of fiscal 2013, Chipotle opened 44 new restaurants and we might expect a similar figure this year too, as the company aims to open 180-195 total restaurants by the end of 2014.
Chipotle’s continually rising sales and its expansion plans are reassuring to its investors. If the expansion rate persists and the company carries on attracting customers after hiking its prices, Chipotle could surely go on performing above expectations. Effectively, we might witness excellent performance figures by the company in the second quarter.