Chipotle, Growth Slowing, Looks at Fast-Food Future

Photographer: Scott Eells/Bloomberg

The Chipotle Mexican Grill Inc. logo is displayed on a paper bag at a location in New York, U.S., on Wednesday, Oct. 17, 2012. Close

The Chipotle Mexican Grill Inc. logo is displayed on a paper bag at a location in New... Read More

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Photographer: Scott Eells/Bloomberg

The Chipotle Mexican Grill Inc. logo is displayed on a paper bag at a location in New York, U.S., on Wednesday, Oct. 17, 2012.

With growth stalling, Chipotle Mexican Grill Inc. (CMG) is mulling changes that threaten to turn the burrito chain into what founder Steve Ells said it would never be: another fast-food joint.

Ells, a classically trained chef, built a cult brand by wowing diners with a tightly edited menu of sustainably sourced food and helped pioneer the “fast casual” category.

Hewing to that vision is getting harder. Last week, the Denver-based company reported profit that trailed analysts’ estimates amid slowing same-store sales growth. After the results, Ells suggested strategic changes one might expect from his counterparts at McDonald’s Corp. (MCD) or Burger King Worldwide Inc. (BKW) They include running more commercials that drive traffic rather than celebrate the brand, and possibly adding breakfast items and installing drive-through windows.

The proposed changes recall what happened when Starbucks Corp. (SBUX) began brewing bagged coffee instead of grinding beans in front of customers in stores, losing the fresh coffee aroma, said Kevin Lane Keller, a marketing professor at the Tuck School of Business at Dartmouth College in Hanover, New Hampshire. Starbucks later returned to grinding.

“You have to be careful of the death by a thousand cuts, where you’re making a series of decisions that might have little compromises” and aren’t consistent with the brand, said Keller, who has written about Chipotle in a textbook.

While Chipotle’s new Mexican-themed food might work, Keller said a drive-through gets away from the chain’s signature production-line service, in which counter staff build burritos to customers’ specifications.

“You lose the experience,” he said.

Struggling Chains

In the wake of the U.S. recession, chains such as McDonald’s and Chipotle continued to boost sales. Now, restaurants including Chipotle are starting to struggle and some are stepping up advertising and adding new menu items. After last week reporting the slowest U.S. same-store sales increase in 11 quarters, McDonald’s said it would increase its Dollar Menu marketing to draw cash-crunched consumers.

While the Standard & Poor’s 500 Restaurant Index (S5REST) gained by at least 14 percent annually in the past three years, the index has slumped 6.2 percent this year as higher gas prices squeeze Americans’ paychecks and stall consumer spending.

Ells, who serves as co-chief executive officer, opened the first Chipotle store in 1993. McDonald’s, the world’s biggest restaurant chain by sales, began investing in Chipotle in 1998 and was the largest shareholder from 2000 until it spun off the chain in 2006. Chipotle, which sold shares in an initial public offering for $22 each in 2006, has since grown to more than 1,350 locations.

Not Pivoting

“We’ve always been very sort of focused on doing our marketing kind of different,” Alex Spong, Chipotle’s director of investor relations, said in an interview. “That model has allowed us to have consistent sales growth.

‘‘While we may tweak some things here or there, I think it’s important that the takeaway is, we’re not pivoting from our strategy,” Spong said.

Chipotle sales growth started to slow during the second quarter. Sales at stores open at least 13 months rose 8 percent in the second quarter and 4.8 percent in the third quarter as consumers pulled back spending.

On Oct. 2, hedge fund manager David Einhorn criticized the company, saying its valuation was too high and that it will face challenges from Yum! Brands Inc.’s (YUM) Taco Bell.

Beef Controversy

Taco Bell has moved past a controversy concerning the quality of its ground beef, and its recent higher-priced Cantina Bell menu has helped fuel sales. Still, the chain isn’t stealing many Chipotle diners, said Peter Saleh, a New York-based analyst at Telsey Advisory Group. Though there is some customer overlap, it’s not significant, he said.

“Chipotle’s core customer is more young professional, late 20s, early 30s, the person who is looking to eat a little bit healthier,” Saleh said. “The Taco Bell customer is definitely a younger, high-school or young, college student” who wants to spend a little less, he said.

Chipotle also has fast-casual rivals that may be poaching some customers. So-called better-burger chains have been expanding in the U.S. -- sales at Smashburger jumped 72 percent last year, while Five Guys Burgers and Fries revenue rose 33 percent, according to data from Chicago-based researcher Technomic Inc.

Einhorn Criticism

Since Einhorn criticized the burrito maker, its shares have dropped 23 percent and on Oct. 22 traded at the lowest premium to the Standard & Poor’s 500 Index in more than two years. Chipotle has become less valuable to investors and trades at about twice the price-to-earnings ratio of the S&P 500 Index, compared with 4.3 times in April. Still, the company’s stock is up more than 11-fold since its IPO.

With sales growth slowing, the burrito chain seems prepared to try more conventional fast-food advertising.

“Chipotle hasn’t been a traditional advertiser,” David Tarantino, a Milwaukee-based analyst at Robert W. Baird & Co., said in an interview. “They’ve chosen to allow their brand to grow with more word-of-mouth communication.”

The company has used emotional advertising to connect with Americans and push an environmentally conscious image -- it’s “Back to the Start” animated video shows a hog farmer returning to his small, family-run business roots after experimenting with large, industrial production. In the ad, which aired during the Grammy Awards, Willie Nelson sings “The Scientist.” Chipotle has also given out free burritos on Earth Day to customers carrying recycled lunch bags.

Offbeat Ads

Burger King has recently gone the way of traffic-driving ads. Instead of offbeat ads featuring the so-called King character, the company began using close-up product shots and touting special deals, such $1 chicken wraps and 50-cent soft- serve ice cream cones.

While Chipotle has spent less on marketing than its peers in the past, that may be changing. To spur sales the company will continue its signature emotional marketing and also will “add on traffic-driving parts to that marketing,” Ells said during an Oct. 18 conference call with analysts. Chipotle will spend about 1.4 percent of sales on marketing this year, while McDonald’s ad expenses were $768.6 million in 2011, or about 2.8 percent of revenue, which doesn’t include “significant” costs incurred by franchisees at the local level, according to a company filing.

“I haven’t really seen anything from Chipotle that shows anyone biting into a burrito,” said Bob Dorfman, executive creative director at Baker Street Advertising in San Francisco, who has worked on Taco Bell marketing.

How Cheap

Many restaurant commercials “show the product and talk about how cheap it is” and Chipotle hasn’t done that, Dorfman said. “If they’re having some issues with sales, generally the trend is you move into that direction.”

Along with more advertising, the company would consider testing breakfast foods, new menu items and adding drive-through windows to some restaurants, Ells said during the call. Other fast-food chains, including Wendy’s Co. (WEN) and Taco Bell, have recently added breakfast items, such as biscuit sandwiches, sausage and egg burritos and home-style potatoes, to attract consumers. Some Panera Bread Co. (PNRA) units have drive-throughs.

Americans like drive-throughs: U.S. fast-food chains generated 24 percent of their sales that way in the 12 months ended in August, data from NPD Group Inc. show. Breakfast made up about 10 percent of U.S. restaurant sales in the year ended in August, according to the Port Washington, New York-based researcher.

“I would lean probably more toward something like breakfast if we were looking at expanding the menu,” Ells said. “None of these things are off the table by any means.”

Chipotle should proceed with caution because adding new menu items and window service may complicate and slow down their stores, Tarantino said.

“One of the things that makes Chipotle so successful is how simple the operating model is,” he said.

To contact the reporter on this story: Leslie Patton in Chicago at lpatton5@bloomberg.net

To contact the editor responsible for this story: Robin Ajello at rajello@bloomberg.net

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