Are Drought Effects Overhyped?
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The recent hot weather in the United States and elsewhere has devastated crop yields and left many farmers scrambling. The prospect of rising is food costs are understandably negative for fast food chains. Inputs like corn, bread, and meat are an important part of operating costs. Looking at the historical data it appears that the risk that year's poor harvest may be overrated. Partial hedging programs and income from franchise fees mean that these corporations are able to deflect the costs of rising inputs. Rising food costs are not a positive development but its negative effects can be over hyped. In the modern era food costs constitute a much smaller percentage of income than in centuries past. Also, fast food companies benefit from being some of the cheapest options on the block. As consumers are faced with higher food costs they are more likely to downgrade from full sit down restaurants to fast food joints. The chart below shows the operating margin for the trailing twelve months plotted against the spot price received for US corn. History shows that increases in food prices do not automatically mean a decrease in operating margins.
It is interesting to note that even though the last major spike in corn prices occurred during the 2008 recession and yet had little effect on operating margins. Higher food prices are commonly pushed off into the poorer regions of the world. Nations like Egypt had massive food riots in 2008 as the sudden increase in primary food inputs like bread had a great impact on the average consumer.
In order to maintain margins restaurants could have increased prices. A serious drop in income could have resulted. Below net income and income from continued operations show that for the majority of the companies this did not occur. Wendy's (NASDAQ: WEN) is the one company which showed a major reaction in their operating margin to the increase in corn prices. Income from continued operations was also affected. In order to make the scale easier to read Wendy's is removed from the below charts but it should be noted their bottom line had a major hit during as food prices spiked and the U.S. went into recession.
McDonald's (NYSE: MCD) has a great overseas presence. As stated in the most recent 10-Q around 22% of their revenue is derived from Asia/Pacific, Middle East and Africa. The average Chinese urban consumer still spends a relatively high amount of income on food as stated here. Recent U.S. data shows that the average U.S. consumer spends around 13% of their income on food which is significantly less than the average Chinese consumer. The company is relatively more exposed to low income consumer in developing nations than other like Tim Hortons (NYSE: THI) and Jack in the Box (NASDAQ: JACK) which are focused on the North American market. Sustained increases in food prices will impact these emerging market consumers but the domestic U.S. and European operations will help to even out total earnings.
Tim Hortons is a smaller chain based out of Canada. Their coffee is famous in Canada and their hot soups and sandwiches make it more of a fast food restaurant than a coffee house. They do have a hedging program and the charts show that the changes in food prices have not had a major impact on operating or net income. The Canadian economy has fared slightly better than the U.S. which gives them added underlying strength. The lower unemployment rate helps to boost their customer base but the stronger U.S. dollar is a negative force on their coffee costs.
Jack in the Box has the majority of their stores in California and Texas. Continued high unemployment in California has impacted their income and operating margin after the 2008 recession. Increases in food costs do not seem to be the major concern with this company but instead their ability to fend off competition.
Yum! Brands (NYSE: YUM) is an international player like McDonald's with over 14,000 outside the U.S. and more than 4700 restaurants in China. Although they weathered the food spike in 2008 fairly well a strong increase in commodity prices will impact in their developing markets. Their international exposure does provide diversification but sustained high food prices will have a noticeable impact in their consumers in the developing world.
(Note: Wendy's is removed from two charts above because their strong fluctuations make the data almost unintelligible.)
It easy to look at the sudden increase in food prices and state that everything is going to hell in a hand basket. The probability of revolutions and riots in lower income food importing nations like Egypt will increase with the price of bread. The future prospects of major fast food chains are a different story. Even during the 2008 recession and spike in food prices, the majority of fast food restaurants were able to maintain their margins and net income. Wendy's did not fare very well but the biggest players like McDonalds and Yum were fine. Firms focused on the U.S. market do have an advantage as food expenditure as a percentage of income is less than in developing nations.
MrCanadian1 has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's. Motley Fool newsletter services recommend Jack in the Box, McDonald's, Tim Hortons, and Yum! Brands. 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.If you have questions about this post or the Fool’s blog network, click here for information.