Chipotle May Have a Whole New Guacamole Problem

By Daniel B. Kline Markets Fool.com

A year after the CDC declared Chipotle's (NYSE: CMG) business-crushing E. coli outbreak over, the company is still trying to win back customers. Despite revamping its food safety program, creating a limited-time loyalty rewards program, and even adding a new meat to the chain's limited menu (chorizo sausage), diners remain wary. Chipotle has essentially pulled out all the stops, but people have not come back as fast as they have in similar situations with other brands.

Continue Reading Below

Overall revenue for the first three quarters of 2016 fell by 18.1%, driven by a 24.9% decrease in comparable-restaurant sales that the company blamed on "a decrease in the number of transactions in our restaurants, and to a lesser extent from a decline in average check."

These are disappointing numbers, especially as the company moves further away from when the actual outbreaks occurred. Still, numbers did inch up in Q3 compared to the first half of the year and there are signs that the company could eventually turn a corner in its recovery.

Unfortunately, an issue out of the chain's control may force it to raise prices on its most popular condiment: guacamole. If President Donald Trump goes forward with his proposed 20% tariff on anything imported from Mexico, that could raise the price of avocados (the main ingredient in guacamole) while also potentially increasing the cost of tomatoes, and other imported produce.

Chipotle has had trouble winning customers back since its food safety issues. Image source: Chipotle.

Why would this be bad for Chipotle?

Continue Reading Below

The Mexican chain has had trouble keeping avocados in stock, which in 2014 caused a panic among its customers, which many news outlets dubbed the "Guacapocalypse." Those concerns were raised by a paragraph in its annual report that year, which suggested what it might do in certain market conditions.

In the event of cost increases with respect to one or more of our raw ingredients, we may choose to temporarily suspend serving menu items, such as guacamole or one or more of our salsas, rather than paying the increased cost for the ingredients.

Those remarks were actually a "what if" scenario that never occurred on a widespread basis, but it does show how the chain might react if a tariff gets enacted. Chipotle does not detail what percentage of its avocados come from Mexico, but Instinet analyst Mark Kalinowski estimated that Chipotle gets 70%-90% of its avocados from Mexico, Nation's Restaurant News reported, quoting Kalinowski as saying that "the majority of its jalapenos, less than half of its tomatoes and small amounts of other items" come from Mexico.

A 20% increase in the price of avocados and other produce could force the chain to either raise prices or lower its margins. Through the first nine months of 2016, the company's food costs came in at 34.8% of revenue while restaurant level operating margin was 12.5%. That's a tight profit margin that suggests that a 20% increase on avocados would result in either the company passing the cost on to consumers or it keeping its beloved guacamole off the menu.

Chipotle has few choices

Before its E. coli issues, Chipotle marketed its brand around the idea that paying more for higher-quality food actually counts as value. That concept became harder to push after the food safety scandal made consumers doubt the pricier-equals-better formula. The chain has also been hurt by fast-food rivals returning to offering heavier discounts after a period where they had turned away from that.

A tax on goods from Mexico could hurt numerous chains, but Chipotle's need for avocados gives it greater exposure than its rivals. If this border tariff passes, the company will almost certainly have to raise prices or stop selling guacamole because it's unlikely it will be able to source avocados from other countries or domestically in the amounts it needs.

10 stocks we like better thanWal-Mart
When investing geniuses David and TomGardner have a stock tip, it can pay to listen. After all, the newsletter theyhave run for over a decade, the Motley Fool Stock Advisor, has tripled the market.*

David and Tomjust revealed what they believe are theten best stocksfor investors to buy right now... and Wal-Mart wasn't one of them! That's right -- theythink these 10 stocks are even better buys.

Click hereto learn about these picks!

*StockAdvisor returns as of December 12, 2016
The author(s) may have a position in any stocks mentioned.

Daniel Kline has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. The Motley Fool has a disclosure policy.