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Will Higher Food Prices Spoil Diners' Appetites?

Dining-out buffs could find themselves chewing on sticker shock as a side dish.

Restaurant traffic has steadily improved for most operators over the past few months, indicative of an improving consumer spending environment, and supporting our mid-single-digit top-line growth forecast for the restaurant industry in 2011. However, we don't believe the magnitude of commodity inflation has been fully recognized by the market, and we would not be surprised to see cautionary revisions to full-year expectations from many restaurant companies during the coming quarters.

A heady mix of supply shocks and growing demand from developing markets has spawned a formidable surge in year-to-date protein, grain, and dairy commodity prices. Given these rising costs, we would not be surprised to see restaurant operators cooking up ways to offset the looming cost headwinds over the coming months. As hedges against input costs expire throughout the year, restaurant operators will undoubtedly be forced to either raise prices on customers, or swallow the cost increases themselves.

Most restaurant operators have already started to raise prices in light of rising commodity costs, and several have locked in a portion of their commodity costs for the year. However, we believe margin pressures are going to become much more pronounced during the coming months.

Based on the rapid increase in the cost of certain inputs, a 2%-to-3% price increase may not be enough to offset cost pressures in 2011. Additionally, planned price increases could stunt restaurant traffic growth that has slowly been recovering over the past few quarters.

How are restaurants preparing for food cost inflation? Which companies are taking steps now to mitigate any damage?

The Trickle Down Effect
A spike in prices across a wide spectrum of food groups (grains, dairy, meat, produce) have restaurants reeling, and taking steps to offset these woes through a range of tactics. In particular, corn, which is largely used as a feed grain for animals, has, as noted by the USDA, skyrocketed in price to an estimated $5.40 per bushel in the 2010-2011 market year, up from $4.20 per bushel during the 2007-2008 market year and $3.55 per bushel in the most recent 2009-2010 market year. A variety of factors are driving up prices of feeds such as corn, soy and other grains, with some claiming heavier use of corn in ethanol production (uses over 30% of corn produced) as a main culprit. Additionally, more animals to feed, poor yields due to bad weather in Eastern Europe, and greater export demand, have led to low domestic supply levels. In fact, the USDA suggests that corn stocks on hand relative to what we use is at its lowest level since the 1995-1996 market year. These key factors, among many others, have resulted in a supply/demand imbalance that continues to drive prices skyward.

As feed costs increase, prices of proteins have subsequently soared. In a February 2011 report, the USDA estimated that the rise in feed costs, coupled with higher domestic demand and increased export demand from emerging middle classes for beef, would result in the price for choice steers jumping anywhere from 7% to 14% in 2011. This represents a dangerous woe, as the trickle down effect from feed to proteins finally ends up on the doorstep of some restaurants in our coverage universe. The reason we focus on proteins is that many of the firms in our restaurant coverage universe have directly addressed the subject of not being locked in for their protein costs. This is a significant concern for both the consumer and the restaurants, as it will ultimately mean more expensive menu prices at a time when discretionary spending is already in a tenuous state of rebound, due to stagnant wage growth, rapidly rising gas prices, and ongoing housing market woes.

Varying Responses to Rising Commodity Costs
So what are restaurants exactly doing to combat an estimated 3% to 4% increase in the Consumer Price Index for food prices? Not surprisingly, the overwhelming majority of restaurants in our coverage universe have alluded to their intentions to pass these costs on to consumers in the form of higher menu prices. Some, like  Sonic  and  Brinker (EAT) will issue annual run-of-the-mill increases in line with historic figures, and a name like  Red Robin (RRGB) announced its first price increase in over three years, as it combats a slow rebound in traffic, and trading down. Others, like  Chipotle (CMG) and  Darden (DRI), are holding off any price increases for now, on as they analyze the effects of the cost pressures on both themselves and consumers. Most firms have stated their intentions to combat food cost inflation, but what may be the effects on traffic? And who is most likely to pass on these costs effectively while also expanding their business?

Although we expect restaurant patrons to tolerate some price increases during 2011, we've also sensed overconfidence in the ability to pass on rising input costs during our recent conversations with management teams, especially with heightened sensitivity to prices among today's consumers. As such, we believe price increases could be a bitter pill for consumers to swallow, making 2011 margin improvement goals for many restaurant operators more difficult.

We also expect restaurant operators to tweak menu items, and publicize limited time offerings that shift consumers away from higher-cost proteins like beef and pork selections to cheaper alternatives such as poultry. In our view, companies with a wider menu selection such as  McDonald's (MCD),  Yum Brands (YUM),  Cheesecake Factory (CAKE), Chili's, and Olive Garden, will have an easier time convincing consumers to make the switch, relative to steakhouse concepts such as  Texas Roadhouse (TXRH) and Famous Dave's (DAVE). Furthermore, we believe companies such as Chipotle Mexican Grill, which source their products from small- to mid-size suppliers instead of large food processing conglomerates, will have greater flexibility in negotiating favorable prices.

Grocery Stores Are Not Immune
Rising commodity costs will also raise prices at grocery stores, possibly eating away even more at consumers' dining out budgets. With food prices surging, it only makes sense for restaurants to raise their prices. However, with discretionary spending on shaky ground, could this lead to some form of a double dip in customer traffic? In our opinion, we do not think it is out of the question. Consumers are going to start feeling a tighter pinch, particularly in the aisles of the grocery store. Packaged food and beverage firms will also need to raise prices to offset their own rising costs, but purchases of consumer staples like breads and juices are deemed more necessary than dining out. For instance,  General Mills (GIS) announced mid-single digit price increases on half of its portfolio.  ConAgra (CAG) also announced price increases on half of its portfolio, while  PepsiCo (PEP) recently declared increases for its Tropicana line of nearly 8%. Even more shocking is the 22% increase  Kraft (KFT) announced for its Maxwell House ground coffee. If trends like this continue across the food manufacturing industry, coupled with the impact of rapidly rising prices at the gas pump, there will be little left for already squeezed consumers to spend at restaurants. Ultimately, we think consumers would more likely opt to pay up for groceries rather than dining out, and this could yet again foster a promotional environment in the restaurant space.

Where Can Restaurant Investors Turn for Protection from Rising Input Costs?
Are there any safe havens among restaurant operators where investors can turn to avoid commodity cost inflation? While we anticipate that restaurant-level margins will be pressured for just about all companies in 2011, we do think some firms are better positioned to handle food cost inflation than others. First, those companies with a higher percentage of franchise-owned units such as  Tim Horton's  (99% franchise-owned), McDonald's (81%), and Yum Brands (78%) should be better positioned to handle inflationary pressures due to long-term rent and royalty agreements, which require payments from franchisees regardless of an inflationary cost environment. We also think fast-casual operators such as  Panera  and Chipotle, which should continue to post industry-leading comparable-restaurant sales growth (we anticipate mid-single-digit same-store sales growth for both Chipotle and Panera this year, compared to low-to-mid single-digit growth across our broader restaurant coverage universe) are well-positioned to stave off the risks stemming from commodity costs inflation. Despite our optimism about these firms' ability to offset rising commodity costs over the next several quarters, overall, we have concerns that commodity costs could put downward pressure on all restaurant stocks as the year progresses.

R. J. Hottovy also contributed to this report.

Jeremy Cohen does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.