Commodities moved higher, week-over-week, supported by fundamentals and the decline in the dollar. Even dairy, which moved lower week-over-week, is near peak levels and likely concerning those companies with un-hedged exposure.
Commodity markets are certainly not showing much in the way of price stability recently. While coffee, Wheat, and corn prices gained 9.1%, 6.5%, and 5.5%, respectively, cheese prices fell 2.9%. The dollar declined over the week and commodities duly went higher. The inverse occurred last week, which is not surprising given the -0.88 inverse correlation between the CRB Foodstuffs Index and the USD (one year of data). Cheese prices have come down week-over-week but remain higher than the level reached during the spike in prices in 1Q11. We believe CAKE’s stance on dairy costs has not been cautious enough and the fundamentals and – most importantly – the price supports our view more as time passes.
Coffee is hitting the headlines at the moment as J.M. Smucker is cutting prices by an average of 6% nationwide and other players in the space, including SBUX, are being questioned about a possible reduction in prices after a series of price hikes over the last year.
From a supply perspective, much of the news flow over the past week was bearish for prices given that Brazil’s frost season is coming to an end, India’s Minister for Commerce and Industry stated in parliament that coffee production in that country will increase 6.7% year-over-year in 2012, and longer-term supply dynamics are strong.
From a demand perspective, it seems that demand will continue to grow over the long term. According to a source, cited by Bloomberg, in the Uganda Coffee Development Authority, the increase in demand for coffee will come from Brazil, India, Indonesia, Mexico, and Costa Rica. However, the consensus seems to be that a “coffee surplus” will weigh on prices in the back half of 2011 and into 2012. As recent weeks and months have dictated, however, the dollar will continue to be a key driver of coffee prices.
Below is a selection of comments from management teams pertaining to coffee prices from recent earnings calls and/or media reports.
PEET (8/2/11): “As we indicated, in our first quarter call, we had to buy a small amount of our calendar 2011 coffee beans at significantly higher prices and this coffee will roll into our P&L during the third and fourth quarter.”
“Higher priced coffee resulted in gross margins this quarter being 290 basis points below prior year. In our first quarter conference call, we indicated that in addition to the overall higher price coffee market, we had to buy a small amount of coffee this year at significantly higher prices. And as a result, we expected our coffee cost to be 40% higher in fiscal 2011.”
HEDGEYE: Peet’s is a company with a very competent management team that manages coffee costs extremely well. Its higher-end, loyal customer base makes the price elasticity of demand more inelastic than for other coffee concepts’ products.
SBUX (7/28/11): “As I mentioned earlier, are absolutely a headwind for us in the full business and that's most acutely impactful on margins in CPG as it's a much more coffee intensive cost structure, as you know. I can tell you that the decline as I spoke about it earlier from about 30% operating margin in CPG this year down to the target 25% next year is really all explained by commodities. Absent commodity inflation we'd be at or improving our margin in the coming year.”
“As we had anticipated, in recent weeks, coffee prices have retreated significantly from a high of more than $3 per pound just a couple of months ago to levels now near $2.40 per pound. As prices have been falling we continue locking up our needs for fiscal '12 and now have virtually the full year price protected.”
HEDGEYE: Starbucks is aligning itself with the right partners to gain more control of its coffee costs to provide investors with more certainty going forward and to protect its margins as global coffee demand continues to rise.
GMCR (7/27/2011): “However, what we've said is that should coffee prices or other material costs spike, we will certainly consider price increases as necessary. We certainly hope that we do not have to cover one again next year. But our objective long-term is attempting to maintain our gross margin as we would see input costs come along.”
HEDGEYE: GMCR hedges out 6-9 months in advance. Without a rising dollar and some stronger supply growth to counteract growing global demand, we expect sustained elevated prices.
Jones Coffee Roasters – a local producer that sells to retailers like WFM (8/17/11): “We’re thinking about not doing the last [of three prior planned] increase because the market’s going back down”.
HEDGEYE: Coffee consumers have certainly noticed price increases over the last year, such as SBUX raising prices in its packaged coffee by 17% in May, and there will be pressure on retailers in stores and in the aisle to adjust prices if input costs do continue to come down. Yesterday, SBUX CEO Howard Schultz said that he is looking at ways of lowering prices.
Corn and wheat prices gained 5.5% and 6.5%, respectively, over the last week as the dollar moved higher. From a supply and demand perspective, the vast majority of the data points seem to be supportive of elevated prices. After poor yields during the growing season, the poor prospects for planting now seem to be compounding the problem. In the US, the severe drought in Texas, Oklahoma, and southern Kansas will possibly cut acreage of winter crops set to be planted next month. Specific to wheat, the USDA said today that the output of hard, red-winter wheat, grown primarily in the Great Plains, may drop 22% to 794.4 million bushels from last year due to the persistence of dry weather since late 2010.
Going forward, we will be watching corn yields in August closely as TSN management said on the 8thof this month that “the month of August, as we saw last year, is very important in the crop’s yield”. How the standing crop of corn shakes out will be a significant factor in determining the fundamentals for protein costs into 2012.
Wheat has increased less on a year-over-year basis than corn as we lap weather events and the impact of Russia lifting its grain export ban, enacted in the wake of drought and fire depleting crops in the country in 2010.
Below is a selection of comments from management teams pertaining to grain prices from recent earnings calls.
AFCE (5/26/11): “On a full year basis, we now expect the Popeye’s system will experience an increase of 4% to 5% in food costs. This is up from our previous guidance of a 2% to 3% increase, primarily due to higher commodity costs in corn and soy, which impacts our bone-in chicken, as well as increases in the cost of flour and cooking oil.”
HEDGEYE: Corn costs going higher are going to squeeze margins for food processors and, in turn, their clients. The food processor space as been depressed for some time, on a relative price performance basis, and any improvement in their margin outlook could bring strong stock performance in that space. For now, though, the input cost outlook is not positive.
PNRA (7/27/11): “Just to note on the cost of wheat, in 2011 overall, the per-bushel cost will be about the same as 2010 due to our laddering purchasing strategy.”
“We are going to take price in the fourth quarter. This price will offset dollar for dollar the per-bushel inflation of wheat of approximately $3 a quarter that we're going to see in the fourth quarter of this year and then across next year”
“We do continue to expect significant inflationary pressures in 2012, 4% to 5% food inflation, $10 million of unfavorability on wheat costs, which means that we don't expect operating margin much better than flat to full-year 2011 in 2012.”
HEDGEYE: It seems probable that wheat costs are going to remain elevated and PNRA’s earnings will not be helped by any decline in wheat prices.
DPZ (7/26/11): “We're fairly locked in on our chicken, locked in on our wheat into – partway into next year.”
PZZA (8/4/11): “We're actually covered through Q1 from a contract standpoint. So from a supply chain disruption or even significant price impact we don't anticipate anything between now and the end of the year.”
Cheese prices are extremely elevated at the moment. This caused DPZ to raise guidance for its full year 2011 food basket inflation to 4.5%-6% from 3%-5%. CAKE has not followed suit, despite that target previously being predicated on softening dairy costs – which the company does not have hedged – in the fourth quarter. Looking at the chart below, the company’s stance on inflation is becoming more and more tenuous.
Increasing demand from emerging markets (like China’s growing penchant for pizza, apparently) and shrinking herd sizes are providing tailwinds for dairy prices.
Below is a selection of comments from management teams pertaining to cheese prices from recent earnings calls.
CAKE: (7/20/11): “We continue to believe that food costs will moderate on a comparative basis in the fourth quarter, and expect total cost of sales to be 35 basis points to 55 basis points lower in the fourth quarter of 2011 versus the prior-year period.”
HEDGEYE: We think that management is being aggressive in assuming inflation this benign given the trajectory of dairy prices. The company is taking price this summer and also planning on increasing efficiencies through $3-5 million in planned cost savings to offset the inflation it is seeing but we still believe that the food cost forecast assumption is aggressive.
JACK (8/11/11): “Cheese accounts for about 6% of our spend and we continue to expect a 13% increase for the year. We have 100% coverage on cheese through the remainder of the fiscal year. Additionally, we have more than 50% of our spend for cheese covered for fiscal year 2012.”
DPZ (7.26.11): “Given higher than originally anticipated cheese prices, we currently expect our overall market basket for 2011 will increase by 4.5% to 6% over 2010 levels. This was up from our previously communicated range of 3% to 5%.”
HEDGEYE: Last week we highlighted the fact that DPZ’s last earnings call took place during a trough in cheese prices and we expected a change in tone from the commentary in early May. CAKE is likely, in our view, to make the same transition in tone at some point this year.
Sentiment has been worse on this name than any other large cap retailer. That will now change. Still one of our top long TAIL ideas.
Solid quarter, great quality beat, and quite possibly the best looking SIGMA out of any of the retailers who have reported thus far this quarter. Sales +4.6% on 3% inventory growth – though it might not seem like much, it is meaningful for TGT, and represents the most favorable sales/inventory swing the company has seen in over 2-years.
We haven’t been too concerned about this one from a TRADE perspective (30 days or less) and we’ve been confident in the name on the TAIL (3 years or less), but our lingering concern has been on the TREND duration (3 months or more). This quarter came a step closer to eradicating our (and the Street’s) issues surrounding items like P-Fresh and the Redcard 5% rewards program. Simply put, we saw good comp numbers without an outsized hit to gross margin (which was down only 35bps at retail).
We’ve been quite amazed in our discussions with investors as to how many people have been flat-out afraid of owning Target due to near-term concerns – despite what they admit is a very cheap valuation. On one recent trip to Boston, Casey and I were placing bets by the end of a 10 meeting day as to how long it would take a PM/Analyst to say “Yeah, I hear you on TGT, but I just can’t go there.” This quarter should go a long way in turning around the negative sentiment.
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Coffee prices are down almost 20% from the early May peak. Despite a recent bounce in prices, the overall decline has investors wondering if coffee retailers might cut prices. Only yesterday it emerged that J.M. Smucker will be cutting prices for majority of coffee products sold in U.S. by average of 6%, citing declines in green coffee futures market.
Full service restaurants underperformed its peer subsectors in the food, beverage, and restaurant categories.
- SBUX CEO says that the company is looking at ways to lower coffee prices as J.M. Smucker cuts prices.
- MCD has named Doug Goare as President of the Europe Unit. Steve Easterbrook resigns effective September 30 to join Gondola Group, becoming CEO of PizzaExpress.
- BOBE reported earnings for the first quarter of FY12 last night, EPS came in at $0.59 versus $0.51. Comparable sales were disappointing; Bob Evans restaurants’ comparable sales declined -1.8% versus consensus +1.2%. The company increased its dividend to 25c from 20c.
- TXRH will have accelerating revenue growth in 2012, according to Morgan Stanley.
“The American Republic will endure until the day the Congress discovers it can bribe the public with the public’s money.”
-Alexis de Tocqueville
I have my doubts that Texas Governor Rick Perry has ever read Alexis de Tocqueville. This is not to say that he is not an intelligent and well-read person, but he just doesn’t strike me as a person who really cares what a Frenchman wrote about America over 150 years ago. Regardless, de Tocqueville and Perry certainly share common ground on their suspicion of government.
In his kick off speech this past weekend, Perry went directly to the heart of his view on government:
“That’s why we reject this President’s unbridled fixation on taking more money out of the wallets and pocketbooks of American families and employers and giving it to the central government. ‘Spreading the wealth’ punishes success while setting America on a course to greater dependence on government.”
As the early and vitriolic attacks from the left have shown, The Cavalier Cowboy has them right rattled only a few days into his campaign. Meanwhile over on the political right, if his political competitors haven’t shown they are rattled publicly, they will soon. A recent Rasmussen poll shows Perry with 29% support for the Republican nomination, Romney at 18%, and Bachman running a distant third at 13%. As they say in Texas: Yeee-haw!
Clearly, Perry is experiencing a post-announcement bump in popularity and his poll numbers are likely to come down over the coming days. On the other hand, if the first few days are any indication of the campaign Perry will run, his rhetoric is more than likely set to accelerate.
Perry has proven himself to very quotable early into his entrance into the campaign. His most notable quote was a not-so-guised criticism of the Federal Reserve and Chairman Ben Bernanke. Actually, forget guised critique, the cowboy from Paint Creek, Texas took a double barreled shotgun to the Fed with the following statement at a campaign event in Iowa:
“If this guy prints more money between now and the election, I dunno what y’all would do to him in Iowa but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in history is almost treasonous in my opinion.”
Perry could have chosen his words more carefully, but the interesting takeaway is that he is currently the front runner in the Republican field, could realistically become President, and has in one of his earliest campaign appearances taken a direct shot at the Federal Reserve. Historically, a critique of the Federal Reserve has been left to the devices of more fringe candidates (enter Ron Paul), as the Fed has become an accepted institution in America. Not so anymore.
Whether the nature and organization of the Federal Reserve truly becomes a central campaign issue over the next 18+ months is yet to be seen, but if it does Americans should welcome it. With the proliferation of Keynesian economists in America over the last eighty years, the majority of Americans have largely accepted the role of the Federal Reserve in their economy despite the contra voices of economists such as Milton Friedman.
In Friedman’s classic, “Money Mischief: Episodes in Monetary History”, he wrote about the Fed:
“I have observed that non-economists find it almost impossible to believe that twelve people out of nineteen – none of whom have been elected by the public – sitting around a table in a magnificent Greek temple on Constitution Avenue in Washington have the awesome legal power to double or halve the total quantity of money in the system in the country.”
After both an extended and continued period of the lowest interest rates in U.S. history and two rounds of quantitative easing, monetary stimulus over the past two years have been largely ineffectual in promoting the Fed’s dual mandate of lowering unemployment and creating price stability. In fact, the only real growth we’ve seen is in the size of the Fed’s balance sheet. Time will tell whether The Cavalier Cowboy will have the staying power to win the Presidency, but in mainstreaming questions about the Fed, even if poorly worded, he is already doing a service to the country.
The other role that Perry will likely play is as a headwind to incremental monetary easing. Our view currently is that the Fed will not implement another round of quantitative easing until we see at least three months of negative employment data, which places the potential timing for incremental easing into late 2011, at best. Perry’s heightened rhetoric will only increase both scrutiny of the Fed and questions by certain Fed Governors of the real benefit of incremental easing, which could serve to lengthen the time frame on implementation of additional easing.
As the Fed continues to play the wait and see game related to lagging economic indicators, back in the market economy data continues to deteriorate. Specifically, the high yield market has had it worst month in over twenty years. High yield yields have backed up by more than 9% over the last thirty days and were up more than 14% at their peak.
In the Chart of the Day, we emphasize this point by showing an index of credit default swaps on high yield bonds over the last year. Credit default swaps on high yield bonds are now at yearly highs and are up more than 30% in the last thirty days. Given that the Fed has explicitly stated that interest rates will not increase well into 2013, it is not interest rate risk the high yield market is signaling . . .
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
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