Chipotle's Uniqueness Is Its Biggest Weakness, As E. Coli Fears Resurface

  • Chipotle's unparalleled focus on quality and freshness has allowed the company to experience significant brand recognition and rampant growth.
  • To sustain this focus as Chipotle increases its foot-print throughout the U.S., the company has had to partner with a lot of small farms that adhere to its strict principles.
  • However, although this focus has allowed the company to enjoy success, it might also lead to its demise in light of the on-going E. Coli outbreak.

Chipotle Mexican Grill's stance and dedication towards quality is unmatched. That is why it is no surprise that the company's tab on 'Food With Integrity' says, "We source from farms rather than factories, and spend a lot more on our ingredients than many other restaurants. We wouldn't have it any other way." To achieve this goal, Chipotle Mexican Grill (NYSE:CMG) has created a vast network of small farm suppliers throughout the country.

Having small farms as suppliers comes at a huge cost. The most obvious example is the on-going E-Coli problem that has affected the restaurant chain for the last few weeks. Small farms become a problem amidst emotionally driven, time-sensitive issues such as the E. Coli outbreak for four main reasons:

  1. Headline risks take-time to be solved: It is time consuming to go through each supplier (there are many of them) to assess the root cause of such a time-sensitive, brand-damaging headline risk as an E. Coli outbreak.
  2. It is not optimal for suppliers to cooperate: The small farms might be less inclined to admit making a mistake especially if Chipotle is their sole client.  Because that would definitely put them out of business. This might make it hard for the company to get to the bottom of the problem in a timely manner.
  3. Lack of economies of scale encourage suppliers to take short-cuts: The bigger a supplier is, the riskier it is for the supplier to compromise on quality. Bigger suppliers have brand names to preserve and hence they are more likely to take extra caution to prevent problems like the current E- Coli outbreak. In addition, industrial suppliers have a cost advantage and have systematic processes for many (if not all) of their farms. Meaning it is easier for them to get to the root cause of the problem faster.  But small farms might compromise to cut cost and maximize on margins since they do not have the luxury of cost-cutting through economies of scale.
  4. Lack of experienced employees: Experience preventing diseases and taking precautions might not be there among all small suppliers and they might not even know what mistakes they are making.

The aforementioned challenges of Chipotle's suppliers might prolong the 'E Coli' headline risk for longer than necessary. The implications for Chipotle, of this prolonged problem would be:

  • Chipotle earnings are likely to miss estimates next quarter: Revenues are a function of the number of stores and traffic.  For instance, 43 Chipotle restaurants were closed across Oregon and Washington state were closed after the E. Coli outbreak was linked. The sudden, unplanned closing of stores will negatively interfere with the company's revenue estimates and actual results this quarter.
  • Increased threat of a further stock decline: Threat of the company adjusting FY 2016 expectations to below estimates are high. Such news is likely and has the potential to push the stock price further down.
  • Brand damage which might lead to reduced traffic: People do not play around with their health, the damage to the brand will be bigger and it will be detrimental to the company's revenues moving forward.
  • Loss in market share to competitors: There is an imminent threat of Chipotle loosing clients to competitors. Loyal customers who are concerned about their health are likely to explore other options. Options that increases the chances of them discovering other choices in other restaurants.

The E. Coli outbreak was just the beginning. Chipotle is now under a microscope and it is likely going to be scrutinized more. For instance, after the outbreak, Seattle health officials closed the South Lake Union Chipotle restaurant for repeated food-safety violations amid the current nationwide problems the chain is experiencing. This came after 120 students at Boston College were sickened by norovirus after eating at a single Chipotle restaurant. Although, based on their history and stipulated principles, Chipotle adheres to strict safety rules, it will not matter moving forward. That is the problem of headline risk. Logic is thrown out of the window and emotions take the drivers seat. Some long-term Chipotle customers will not risk going to a Chipotle because of the fear of getting sick. We have seen this before. KFC China experienced the same problems in China. In December of 2012, KFC China was accused of cramming extra antibiotics into their chickens. The news shook consumer confidence and led to margin contractions. Chipotle is not an exception. Although Chipotle is a great business, the headline risk is still on-going. This risk increases the chances of seeing margin contractions this quarter which might lead to a further decline in the company's stock price.

 

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