A Game of Inches and Portion Sizes

Michael is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

At the pro level, an inch can be the deciding factor in whether you get drafted or you go on to be pro at something other than sports. When it comes to electronics, inches are just as important. They can push electronic gadgets in and out of specific product distinctions and can launch companies past the competition. When it comes to the restaurant industry, portion sizes sometimes are the source of all problems related to the bottom line.

The Garmin Story

Just 5-6 years ago, having a standalone GPS was a necessity. At the top of that necessity was having the market leader Garmin (NASDAQ: GRMN) for your car, which consequently helped push the stock well past $100/share. Today, the stock is near a 52 week low, dropping 27% the past year, and since its peak in 2007 the stock has dropped by over two-thirds. The healthy 5.2%+ dividend the company currently yields and zero debt potentially hide the gloomy future many investors believe is in store for Garmin.

While people see competition from smartphone makers like Apple’s (NASDAQ: AAPL) iPhone or the Samsung Galaxy as the beginning of the end for standalone GPS makers like Garmin, I think people don’t realize the trends are positive for Garmin in the long run. Is Garmin really in trouble because smartphones are able to provide GPS, often for free? I would say not completely. It really comes down to a game of inches. How big of a screen is really too big for a cell phone? If the recent announcement from Samsung is correct, 6+ inches is coming soon to top their Galaxy S4, which is 5 inches while Apple’s iPhone 5 is 4 inches. Unless portability is no longer a goal in smartphones and people are willing to carry either a bag or wear clothes with extremely large pockets, I think the market will pull in Garmin’s favor – unless satchels become popular.

Garmin has the edge in this game of inches in many ways. First, I see 6-8” as a very doable and realistic screen size for a standalone portable GPS for the car. With vendors creating various mounting options for today’s automobiles and with displays being lighter and thinner than predecessors, this is a real opportunity to stay relevant in the auto space. Even if earnings continue to drop like they did last quarter for Garmin with net sales decreasing 2% due to auto segment declines, Garmin can easily fall back on their outdoor segment since revenues increased 11% last quarter. Future applications for Garmin include golf, training sport dogs, swimming, fishing, chart plotters, aviation, and fitness. Fitness is really a segment Garmin can crush smartphones in since I doubt anyone wants to run or work out in something that is approaching the size of a ‘Get Well’ card. In fact, the future is already here with auto sales contributing less than 25% of all sales.

I don’t expect Garmin to really make an impact in the app space since current attempts have generated poor user reviews, and when GPS apps like Waze provide the service completely free, it is hard to show how improving Garmin’s current apps will do anything for the company’s bottom line. In the end companies like Apple are still trying to catch up with companies like Garmin in acquiring the real value in the GPS market – the complete algorithms and coding. Apple made a deal with Garmin’s competitor TomTom awhile ago to provide the foundation for Apple maps under iOS 6. The mishaps of the mapping service eventually caused Apple to fire management and required Tim Cook to publicly apologize.

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GRMN Total Return Price data by YCharts

The Chipotle Story

Last month Gainesville2go, a local delivery service, started a service for various fast food chains that included Chipotle (NYSE: CMG). While this might sound like a convenient add-on to the current option of pre-ordering food at Chipotle, so far the orders are only in the double digits per day, and the lines are often still extraordinarily long for a place that is supposed to be a mix between casual and fast food.

While Chipotle isn’t suffering from the same public outcry for poor customer service like its ex-investor McDonald’s (NYSE: MCD), it is suffering something possibly worse – dropping margins. The fear of its growth prospects has forced the burrito king’s stock to drop over 21% the past year after soaring nearly 200% the past five years and breaking $440/share in 2012. Currently Chipotle has 1,410 restaurants with 1,399 in the US alone as of the end of 2012. Based on last quarter's earnings, average restaurant sales drifted slightly higher to $2.113 million compared to $2.013 million a year ago. The sales increase was driven primarily by increased customer visits and higher menu prices. The company expects 2013 comparable restaurant sales to be flat assuming no further menu hikes.

I believe the flaws in Chipotle lie in its overall business model. Chipotle has 1 very long line that everyone must go through in order to buy anything – unless you pre-ordered. If you just want a quick soda and chips, too bad. On top of that, the menu, while simple, pretty much breaks every rule in how to outline a ‘guided’ menu to customers to attract them to the highest profit making items. The menu doesn’t give info on portion sizes and does not give the customer a clear indication of how much everything will cost if one wishes to get extra meat or some extra rice. You are basically met with a surprise at the register. While this might sound picky, it is a flawed business strategy in my opinion. To add to the higher menu prices, it appears many share my opinion that portion sizes are shrinking.

I’d like to see Chipotle take some of the qualities of a McDonald’s. Instead of having one very long line that everyone must go through, perhaps have 2 separate lines differentiated by burrito or bowl for example. Improve the menu with portion sizes so that people won’t have to ask for more of something and they will know exactly what they are getting. I also often see people ordering the same exact item receiving varying amounts of the same ingredients. It really is an inconsistent process.

It all goes back to margins. If it can be assumed that there will remain just one line, and that each order takes a predetermined minimum amount of time, then one of the best ways to increase margins is to sell more to each person with portion sizes. The servers need to be paid regardless so why not make each sale worth more? Specifically create a pricing system like any other establishment where smaller portioned items generate slightly more profits thereby encouraging people to order more in bulk. The idea is to create a clear distinction in options and maximize returns. Profit margins can’t drop too much further as they are already well behind McDonald’s. The past five years, Chipotle has averaged just 8.87% while McDonald’s has an industry leading 19.94% in profit margins. Even worse is that while McDonald’s margins are steady, Chipotle’s are declining.

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MCD Profit Margin Quarterly data by YCharts

Bigger Is Better

The growing trend in screen sizes of smartphones I believe will only help Garmin in the long run. There will be a breaking point when consumers prefer smaller screens, more portability, and thinner devices for their phone use. This will push back market share towards companies like Garmin. If things do go south in the standalone GPS market for automobiles, Garmin still has a lot of room to grow in other GPS applications – specifically fitness.

Bigger portion sizes and larger menu choices will allow Chipotle to increase their margins in order to benefit the company for years to come. Their 1,400+ restaurants locations are preventing them from maximizing profits under their current business model. While they grow towards a comparable model like that of Subway, which operates a similar one line system under its 37,000+ locations, they will need to modify their menu in some way to address the declining margins that are now on the minds of Chipotle investors.

Michael Carter owns shares of Apple. The Motley Fool recommends Apple, Chipotle Mexican Grill, and McDonald's. The Motley Fool owns shares of Apple, Chipotle Mexican Grill, and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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