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Will Food Costs & Winter Steal the Profits of Eateries?

The restaurant industry has been witnessing signs of improvement. However, inclement weather in the days ahead could be a headwind as witnessed in the first quarter of 2014.

The industry has been facing other challenges too, chief among them being increasing food costs. Also, a soft consumer spending environment and a few political and general issues remain overhangs. These factors should be taken into consideration before investing in this space. Here are some of the factors that may weigh on the performance of restaurateurs both in the short and long term.

Commodity Cost Inflation: Food costs account for about one-third of restaurant sales, thus making the industry excessively vulnerable to food cost inflation. Increase in demand for a commodity is always good news for producers. However, it is only when there is inadequate supply of a particular commodity that prices start to rise.

Products like cheese, beef, bacon, avocado, pork and coffee are some of the key ingredients whose prices have touched record highs in 2014. While a drought in California raised the prices of cheese, beef and avocado, a virus infection in pigs raised bacon costs. The drought in Brazil has resulted in coffee price increases.

Unfortunately, the situation is not expected to improve in the near-term. Wholesale pork, beef and veal prices are expected to jump 4.5% to 5.5% in 2015 per the U.S. Department of Agriculture. Also, the food-at-home inflation index in the U.S. is expected to grow year over year in the range of 2% to 3% in 2015.

Rising costs hurt the margins of a company. Moreover, as companies try to pass on the costs to customers by increasing menu and product prices, it results in a decline in traffic. We would like to remind investors that The Hershey Company (HSY - Analyst Report), Starbucks Corp. (SBUX - Analyst Report), Chipotle Mexican Grill, Inc. (CMG - Analyst Report) and Buffalo Wild Wings Inc. (BWLD - Analyst Report) have already announced price increases for their products in response to rising input costs of key ingredients.

In addition to commodity costs, pre-opening and re-imaging expenses incurred to boost sales also dampen margins.

Bleak Economy/Political and Macro Issues: The restaurant industry has been experiencing low consumption over the last few quarters. The industry is facing difficulties like heightened competition in the U.S. and decelerating growth in Asia. Though the debt-laden Eurozone emerged out of recession in mid-2013, challenges still remain. The restaurants have little pricing power in the region due to a slowdown in consumer discretionary spending, which has constricted the European informal-eating-out (IEO) industry. Among the emerging nations, China and Brazil have their own share of problems. Japan also continues to be a dampener as it is still recovering from the 2012 earthquake.

Despite moderate economic improvement in the U.S., consumers are increasing their spending only modestly as an increase in jobs has yet to translate into significantly higher wages. High interest rates, higher health care costs and still-tightened credit availability continue to hurt consumer discretionary spending in the U.S. As a result, Americans are unwilling to dine out to some extent, which is pulling down sales.
 

Other Challenges: Restaurants with international presence are vulnerable to political and other issues in the regions in which they operate. The temporary closing of McDonald's Corp. (MCD - Analyst Report) restaurants amid allegations of violation of sanitary rules in Russia is a case in point. This was likely the result of the ongoing tension between Russia and the West on the Ukraine issue.

Also, issues like food safety have hurt the comps of a couple of restaurants. In July 2014, McDonald’s and Yum! Brands, Inc. (YUM - Analyst Report) faced serious allegations over food safety in China. The charge was related to their supplier Shanghai Husi Food Co Ltd, a unit of U.S.-based OSI Group LLC, which sold expired meat to the two quick-food chains. Another restaurant chain Papa John's International Inc. (PZZA - Snapshot Report) which received meat from this supplier suffered as well.

Also, there has been considerable debate in the recent past over the wages of restaurant workers. Workers at fast food joints claim that their employer’s profits have not trickled down to their pay, thereby forcing them to go on strikes demanding a wage hike. These movements significantly hurt the reputation of the companies. For the U.S. restaurant sector, which is already battling increased commodity prices, an increase in wages will further stifle margins.

Affordable Care Act to Hurt Margins: Since the sector plays a key role in the nation's employment picture, the Affordable Care Act by President Obama, commonly known as Obamacare, is expected to have an adverse impact on the operators, once fully implemented. The law entails companies to provide coverage for workers or face government penalties, though it is not applicable for employees who log less than 40 hours per week on an average. To avoid these austerities, most companies are trying out different labor models like involving more part-timers and cutting work hours, which would hurt margins at the restaurant chains.

Once the act is fully implemented, companies with 50 or more workers will be required to offer a generous health insurance package or pay an annual penalty of $2,000 for each full-time worker. Some companies are already limiting their hiring, which will eventually increase the unemployment rate. There are also several other factors which would adversely impact the restaurant industry.

To Sum Up

Who can forget the cold wave that dampened the results of many companies in the first quarter of 2014? A few analysts are concerned that winters could once again dent results in the first quarter of 2015. It remains to be seen whether hostile weather conditions impact the business of restaurant chains this time again and how they combat rising food costs and other challenges.