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Restaurant Anthology – Part 1

We have recently commented on four major themes:

1. Recent trends in food and labor costs and their impact on margins
2. Use of promotions to drive traffic at the expense of margins
3. Companies levering up at the wrong time
4. All leading to a less than toxic Q2 earnings season

Although most of these themes do not sound all that encouraging, we have also outlined a couple of companies that are making the right capital allocation decisions and should see an improvement in underlying fundamental trends.

For more details regarding any of the following highlights, please refer to the relevant postings over the past two weeks, which are sorted by date on the portal.
  • Food and Labor Costs

    Food and labor costs as a percent of sales have been moving up consistently for the restaurant companies as a whole in line with rising commodity costs and increasing average hourly earnings. Unfortunately, I do not see these inflationary pressures going away anytime soon. Just yesterday, YUM management stated that it underestimated the full-year impact of rising commodity costs by $45 million (represents a 6% hit to U.S. operating income growth) – posted July 17. Companies will work to offset these inflationary pressures by rising prices, but this, too, has its own set of risks as I have seen too many times concepts ruined by excessive pricing – posted July 16.

    That being said, restaurant-relevant commodity costs (corn, soybeans, wheat, cattle) have moved down rather significantly over the last two weeks. Corn futures closed down sharply, amid widespread commodity declines and pressure from outside markets, including crude oil and soybeans. U.S. wheat futures closed lower on spillover pressure from weakness in other markets and on forecasts for increasing world production. These recent moves down, however, might not be sustainable as a University of Illinois study states farmers are facing significantly higher production costs in 2009 – posted July 18.
  • Traffic versus Margins

    Restaurants are using an increased level of promotion and value messaging to drive traffic in this tough consumer environment so margins will be hit by a larger mix of low profit transactions at the same time input costs are going up.
  • YUM raised its FY08 U.S. same-store sales guidance but took down its operating profit target, which implies the company will see more, less profitable traffic as a result of its Why Pay More initiatives at Taco Bell and its pasta introduction at Pizza Hut – posted July 17.
  • Subway experienced a 14% YOY traffic increase in the February to April time period as a result of its new $5 price point. This low price point will obviously impact Subway’s margins, but more importantly, such a significant increase in traffic in today’s environment will be watched and copied by Subway’s competitors. I think the fast casual chains have the most to lose as consumers can spend $5 on lunch rather than $8-$9 – posted July 12.
  • Starbucks announced that a majority of its U.S. locations will be offering some sort of deal between now and early September. These promotions may help curb the company’s declining traffic trends, but they could also hurt the company’s already depressed U.S. operating margins – posted July 10.