McDonald's, Peers Facing Major Headwinds From Farming Crisis
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Food gets a lot of attention in the media. The diets, the calories, the happy meals, but right now an entirely different type of epidemic is affecting the food industry – drought. Low rains caused a small corn yield. This, in turn, pushes the cost of meat up as the animals are fed a diet that consists largely of corn. In this way, drought conditions can cause the price of groceries to go up, but it also raises the cost for restaurants.
Larger restaurants may not feel the burn as readily as smaller ones – when you charge $50 or even $20 for a steak it is easier to absorb some cost – but when margins are thin, such as with fast food restaurants, there is little room to maneuver. “When you're McDonald's, a lot of your products are priced to be 'value' offerings, so there's not a lot of room to absorb cost increases," said Executive Vice President of restaurant consulting firm Technomic Inc., Darren Tristano. "Restaurant operators are in a position where they don't have much of a choice but to raise prices because they operate on such thin margins." Further complicating matters for restaurants and other food-related retailers, is the fact that consumer confidence is at its lowest level since November 2011 and fast food restaurant traffic is expected to be flat for the next two years, so making the difference up on quantity is somewhat unlikely.
This leaves companies like McDonald's (NYSE: MCD), Buffalo Wild Wings (NASDAQ: BWLD) and Chipotle Mexican Grill (NYSE: CMG) with just three options. They either have to pass the rising food costs on to consumers, emphasize low-cost menu items to keep customers coming through the door, or take the hit. “RBC Capital Markets analyst Larry Miller said his research has shown that diners are ordering more ‘value’ items and fewer premium-priced entrees and appetizers, indicating they are trying to manage the size of their restaurant bills more ‘than we've seen in a while,” reports the Wall Street Journal. “The potential for weak or flat sales growth combined with rising costs is ‘downright scary to us,’ he added.”
But, really, there is only so much a company can do. According to Buffalo Wild Wings, “the price per pound of chicken wings in the second quarter was up 86% from a year earlier.” At that type of difference, of course the company is going to have to raise its prices. McDonald’s is taking a two pronged approach – raising the price of some items like its burgers while lowering the cost of, say, chicken nuggets. In contrast, Chipotle is sticking with its current pricing as long as possible. CFO of Chipotle Mexican Grill, Jack Hartung, said recently that the current slowdown in its business "just reinforces our conviction that we are not in a hurry to raise prices."
And, of course, there is always the innovators. Starbucks (NASDAQ: SBUX), for instance, is pursuing a slightly different strategy. Many locations have added “treat receipts,” offering customers a discount if they return in the same day.
But, not every fast food restaurant is effectively managing the situation. Burger King Worldwide (BKW) and The Wendy's Company (WEN) are both in the process of revamping menus and refurbishing their locations to breathe new life into the companies, but this comes at a cost. Margins are already tight so competing in price right now is going to be more difficult unless they absorb some of the costs.
What investors need to realize is that the food situation is not changing for a while. Bad weather in general have affected food yields across the US and Europe. “Corn and soybean production in the U.S. has been cut by up to 13 percent this summer because of drought and prices for those commodities have jumped by as much as 40 percent since June,” writes the Globe and Mail. “Poor weather in Ukraine, Russia and other parts of Eastern Europe has hurt wheat crops and sent wheat prices up 36 percent this year.”
Food prices are still well below the historic peak of 238 points hit in February 2011, according to the World Food Programme, “the global food price index produced by the UN Food and Agriculture Organization (FAO) climbed by 6 percent to 213 points in July after three months of decline.” It is too early to say whether levels will soar past that February level, “but, in general, there are many signs that high food prices and volatility will continue in coming years, making farmers, consumers and countries more vulnerable to poverty and food insecurity.”
For investors, I recommend playing the food crisis to advantage by not investing in restaurants or food suppliers but instead looking to the equipment manufacturers. As the drought continues, farmers are able to charge a premium for their produce. “U.S. farmers are heading for their most profitable year on record despite the worst drought in half a century as high grain prices and payouts from a federal crop insurance program compensate for a smaller harvest,” according to the Financial Times. “Net farm income will reach $122.2 billion in 2012, the highest-ever nominal profit and the second highest in inflation-adjusted terms after 1973, the US Department of Agriculture said in its first forecast since drought spread across the corn belt.”
These rising incomes are going to increase sales at companies like Deere & Company (DE) and Caterpillar (CAT) as farmers look for ways to effectively spend the surplus from the increased profits in preparation for improved conditions down the road.
StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Buffalo Wild Wings, Chipotle Mexican Grill, McDonald's, and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Buffalo Wild Wings, Chipotle Mexican Grill, McDonald's, and Starbucks. 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.