Over the past number of quarters, top line numbers have taken precedence over food cost trends in determining investor sentiment. With food costs continuing to increase, when are investors going to shift their focus?
Looking at the restaurant space, it is difficult to know which factors are driving the space. The health of the consumer, commodity costs, and government policy are all important and interconnected. As I outlined on 9/20 in a post titled, “NO MORE ROOM AT THE TROUGH”, regulatory action has been a cause of food inflation and remains a potential cause today. With the topline results of many restaurants remaining robust, it seems that any investor concerns on inflation are assuaged by same-store sales growth. It is only when the tide goes out that the rocks beneath the water line can be seen.
The narratives that we can spin around current stock moves are legion. Perhaps consumers are defaulting on their debt and splurging on discretionary items. Perhaps the prospect of more quantitative easing, and lower mortgage rates to refinance to, are boosting spending. Or perhaps we are burning brightly just before we plunge into a dark depression. Rather than bother with these anecdotal hypotheses, we prefer to look at some data. The chart below shows clearly that some restaurant and agriculture stocks have been performing strongly of late, with several exceptions (particularly the agriculture stocks).
Many of these price moves are confirmed by top line trends. CMG and MCD have been outperformers from a sales perspective, while EAT and WEN have been softer on that same metric. Looking at the possibility that commodity costs have played any role in these recent price moves, it is instructive to observe the agriculture stocks’ price action. I will allow readers to decide for themselves, but one thing that stands out to me is that Monsanto (MON) is a beneficiary of higher corn prices but has been underperforming. Given a number of factors alluded to in the aforementioned note from 9/20 (Dollar down=corn up, ethanol blend in gasoline, strong demand), we believe that corn prices are set to move higher with the inverse relationship with the US Dollar being our main focus. While TSN, CAG, and SAFM have been going down, as one would expect, MON would be expected to perform strongly with high corn prices. See the table below for some correlation data (stock to corn).
Due to contracts or other hedging mechanisms, the impact of higher commodity costs may be somewhat staggered versus price performance in the restaurant space but it seems that CMG, BWLD, YUM, CBRL, and CAKE stand out as being impervious to commodity cost increases. We know that BWLD has outlined lower year-over-year chicken wing prices as being earnings accretive over the next few quarters but other largely uncontracted (CMG) stocks are also unimpeded, thus far, by the threat of rising costs.
At Hedgeye we are currently short the US dollar and have a very bearish view for the intermediate term. As the table above suggests, this stance implies a bullish view on corn prices. When planning for the next fiscal year, many companies begin to lock in their commodity needs late in Q3 and early Q4. I was surprised earlier this week to learn that DRI management have left themselves exposed to certain commodities given the recent spike in commodities. Management believes that current levels of some commodities the company uses are unsustainable. I am not sure I would be so confident. The table above outlines the correlation between the USD and certain commodities.
Howard Penney
Managing Director
