Why Chipotle Mexican Grill Could Be the Next Whole Foods

There wasn't much to like about Whole Foods Market's(NASDAQ: WFM) latest quarterly report. Comparable sales slumped 2.4%, driven by a 3.9% drop in transactions. Net income contracted, with gross margin slumping and operating costs rising. The long-held goal of reaching a store count of 1,200 wasn't mentioned, though management said nine stores would be closing. And the company's outlook for 2017 doesn't call for much improvement.

Whole Foods has run into the problem that is guaranteed to eventually beset any trendsetter: intensifying competition. For many years, the company had the market for natural and organic groceries largely to itself, and it rode that wave to become a major player in the grocery business. But Whole Foods' success was also its undoing. As consumer preferences shifted toward healthy and organic fare, the large supermarket chains eventually took notice.

Image source: Whole Foods.

Whole Foods CEO John Mackey says that mainstream supermarkets have upped their game, carrying many of the same products that Whole Foods sells but at lower prices. The company has no interest in competing on price, according to Mackey, so returning to growth will require a new strategy to drive customers to its stores.

So what does this have to do with Chipotle?

There are certainly major differences between the problems facing Whole Foods and those plaguing Chipotle Mexican Grill(NYSE: CMG), but I think the restaurant chain is going to be facing a similar issue as it attempts to recover. Chipotle suffered a string of E. coli and norovirus outbreaks at its restaurants in 2015, which prompted a dramatic decline in sales that sent the company reeling. Comparable sales are expected to return to growth in 2017, but sales will remain far below peak levels.

Like Whole Foods, Chipotle built its business by focusing on quality. The company sources ingredients locally when possible, buying only non-GMO ingredients and pasture-raised animal products free from antibiotics. Whenever conventionally raised meat is used due to shortages, a sign is posted in restaurants to explain the temporary situation to customers.

This strategy worked for a long time. The health crisis of 2015 was a major setback, tarnishing the brand in the eyes of consumers and undercutting the company's message. But those events will eventually be forgotten.

Image source: Chipotle.

The bigger problem for Chipotle may be competition. In the same way that mainstream supermarkets have put pressure on Whole Foods, big restaurant chains have started to come around to consumer demand for natural ingredients. Pizza chain Papa John's began eliminating all artificial ingredients from its menu in 2015. Subway is doing the same, reformulating its menu in North America to exclude artificial flavors, colors, and preservatives.

Even McDonald's, the poster child for cheap food of questionable quality, is jumping on the bandwagon. The fast food chain announced last year that it was taking various steps, including removing artificial preservatives from Chicken McNuggets and its breakfast sandwiches, introducing buns free of high-fructose corn syrup, moving toward antibiotic-free chicken, and transitioning to cage-free eggs.

The comeback won't be easy

The collective result of the entire restaurant industry shifting toward natural ingredients is to minimize the advantage Chipotle has long enjoyed. Just like Whole Foods now faces intense competition from the mainstream supermarket industry, Chipotle faces intense competition from other restaurant chains. Chipotle blazed a trail, but that trail is starting to get crowded.

As the company attempts to recover from its health crisis, it will need to steal customers away from the competition. That prospect becomes more daunting in a world where natural ingredients are becoming the norm. The quality gap between Chipotle and the rest of the industry is rapidly shrinking.

This isn't to say that Chipotle can't recover and return to growth. But in the same way that Whole Foods became big enough to attract attention from the rest of the industry, Chipotle's success has triggered a shift among other major restaurant chains. Whether Chipotle can truly ever recover remains to be seen.

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John Mackey, CEO of Whole Foods Market, is a member of The Motley Fools board of directors. Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill and Whole Foods Market. The Motley Fool owns shares of Papa John's International. The Motley Fool has a disclosure policy.