Buffalo Wild Wings

Margins under pressure

Escalating commodities costs force operators to weigh price increases

With the summer’s near-record drought putting pressure on commodity food prices, restaurant operators this fall face the decision of staying in the frying pan and watching margins erode or jumping into the fire with price increases.

Both solutions have their downsides, and for now operators appear to be taking a variety of approaches in addressing the menu-price dilemma. While Buffalo Wild Wings and Wendy’s have said they would contemplate selective price hikes to cover rising food costs, others, including Chipotle Mexican Grill, have said they would be judicious in considering any increases.

The domino effect of the drought on ingredient costs and still-fragile consumer confidence makes the perennially sensitive issue of pricing even more tender right now, said Leslie Kerr, principal at Intellaprice, a Boston-based pricing consultancy specializing in restaurants. She noted, however, that she does not see better alternatives.

“I think people will be taking price,” Kerr said. “It’s hard not to when you know that it does help the bottom line more than many [other] measures.” The fact that many operators have held off raising prices until now gives them a little latitude, she added.

“What we saw in our most recent casual-dining [pricing] study was that there had been a measure of conservatism in price increases,” Kerr said.

“Operators had held off,” she continued. “… They had really been conscious about keeping prices affordable, and that bodes well for decisions right now because it doesn’t mean a price increase on top of a price increase. They don’t have to feel they are adding insult to injury if they do take a price increase.”

Inflation rears its head

The drought’s effect on wheat, corn, soybeans, pastureland, beef, poultry and some produce already is putting pressure on the restaurant market basket.

Executives at Austin, Texas-based Chuy’s Holdings Inc., the 37-unit Mexican chain that went public in July, expressed concerns about commodity-price increases in the company’s first earnings call in August, saying they had started to see modest inflation.

“What we’ve seen in the last half of the quarter is inflation starting in chicken and produce,” said Jon W. Howie, Chuy’s chief financial officer. “And we’re seeing that continue into the third quarter.”

Chuy’s has contracted through the end of the year about 15 percent to 17 percent of its commodities, Howie said. He added that he expects inflation in the last half of the year to be in the 4-percent to 5-percent range.

Steve Hislop, president and chief executive of Chuy’s Holdings Inc., emphasized that Chuy’s works to keep value in the menu, with only three of 49 menu items priced at more than $10. Over the past five years Chuy’s has averaged about 1.5-percent price increases annually, Hislop said.

In price increases for the year ahead, Hislop said, “We’re still looking at probably, as of now, about 1.5 percent. We feel that’s sufficient. We’re probably a little early. You’ll probably start hearing all the big jumps and estimates starting in October.”

Pricing quandaries

Every operator faces a different set of pricing hurdles, according to Intellaprice’s Kerr.

“Flexibility is in the eye of the beholder,” she said. “You have a couple of types of operators out there. One type is confident in their brand leadership and their standing in consumers’ minds. They are comfortable in being assertive in terms of price.

“And the other type of operator is a little bit more sensitive to their guests’ price sensitivity,” she continued, noting that consumers are generally more likely to be price sensitive than not.

When making pricing decisions, Kerr added, “Some of the factors to bring into account are: When was the last time there was a price increase? How much was it? How much of the menu did it cover? And where is there room [for increases] now?”

A menu that is not dependent on a single commodity provides more flexibility. For instance, the varied menu at Spaghetti Warehouse likely will keep the 16-unit casual-dining chain from raising prices, said Doug Pak, chief executive of the Irving, Texas-based venture.

“One positive about our company is that we’re an American-Italian restaurant with a very diversified menu,” Pak said. “We use different proteins, pasta and vegetables; we’re not concentrated on one specific commodity like cheese, burger patties or wings.

"So because we’re not reliant on one primary ingredient, that serves us well in controlling our food costs,” he continued. “It’s very manageable. Also, we go through purchasing contracts to lock in the right prices, so we have not seen big fluctuations.”

One company with a more narrowly focused menu is Minneapolis-based Buffalo Wild Wings. Facing an 86-percent increase in the price of chicken wings that had already taken a bite out of unit-level margins in the second quarter, the company decided to raise prices. A new menu rolled out in July had a price increase of 1 percent, with another 1-percent increase possible in September, officials said.

Sally Smith, chief executive of the 837-unit chain, told analysts that in almost all markets prices for the chain’s Wing Tuesdays promotion had been raised from 45 cents per wing to 50 cents.

“We have not seen any resistance to that price increase at all, which gives us some confidence that, should wings remain high, there’s a possibility for Wing Tuesdays [to] take another price increase,” she said.

She noted that the company was starting market research to find the price level at which customers showed resistance.

Other operators are shrugging off the idea of price hikes. Jack Hartung, chief financial officer of Chipotle Mexican Grill Inc., said in July that the fast-casual brand’s second-quarter sales slowdown reinforced the company’s “conviction that we are not in a hurry to raise prices.”

No immunity

Jeff Powell, president and chief executive of the 15-unit Razzoo’s Cajun Café, said he expects his Addison, Texas-based chain “will be negatively impacted by the drought and other pressures on grain supply.”

He added: “Corn, particularly, is a baseline driver of economics in the supply chain. A shortage of corn caused by drought or other dilution of supply by other uses [such as ethanol production] obviously negatively impacts the dynamic. Corn is a necessary feed and source of oil, and when in shortage the impact on beef, pork and poultry prices is immediate.”

John T. Barone, a Nation’s Restaurant News contributor and president and commodities analyst for Market Vision Inc., agrees. He wrote in mid-August that the “‘sneaky’ price increase will come from the big bump in corn and soymeal prices. That’s because they are the primary feed inputs for poultry, dairy cows, pork — and this year, cattle, because grazing pastures have also been toasted by the drought.”

He added that beef prices would see a boomerang effect.

“Cattle ranchers are liquidating, selling off inventory and breeding stock at an accelerated pace,” he said. “This is currently having the effect of inflating available beef supplies and, as a result, beef prices have been moving lower over the past month. But come spring of 2013 when seasonal beef demand kicks in, there will be hell to pay. The [Department of Agriculture] says beef prices will be 4 to 5 percent higher next year.”

Produce prices also are seeing pressures, said Powell of Razzoo’s.

“Drought and other negative environmental conditions compromise the vegetable supply chain,” he explained. “Supply brokers scramble to find global sources of basic staples in both hemispheres. A reliable supply of jalapeños from Mexico may dissipate, while a more reliable supply may emerge in Chile. … Our produce costs are volatile.”

Powell said Razzoo’s is expecting basic food costs to increase by 5 percent to 8 percent over the next year.

“Solid operators will react to these challenges and will meet what will be a substantial and increasing customer need,” he said. “Others will be driven from the market.”

He said the Cajun-inspired casual-dining chain anticipates a minor price increase of 1 percent to 2.5 percent over the next 18 months. However, Powell said, a “fatal response” for operators would be to compromise quality for a lower cost or to cut portions in the hope that consumers wouldn’t notice.

Even companies dependent on a narrower slice of commodities are concerned. Douglas Muir, Krispy Kreme Doughnuts’ chief financial officer, said in a second-quarter earnings conference call Aug. 22 that “commodity markets have been volatile lately, and the effects of the drought have been significant on many products. We currently are purchasing flour and shortening for the first and second quarters of next year.”

He added that Krispy Kreme expects costs to rise modestly.

“I should emphasize, though, that next year is a long way off, and much can change in volatile times,” Muir said. “Except for sugar, we have not purchased a significant portion of next year’s need, and we are therefore looking to lock in attractive pricing for next year whenever we can.”

James Morgan, Krispy Kreme’s chairman, president and chief executive, added that the company wanted to make certain that if it did take price, it was also increasing value to the consumer.

“I think the two are compatible,” he said.

Stephen Hare, chief financial officer of Dublin, Ohio-based Wendy’s, said in a conference call with analysts Aug. 9 that higher beef costs will be the largest driver of commodity spending for the 6,500-unit quick-service chain. Hare also said the company would make cuts and “implement selective price increases.”

Wendy’s executives said they did see some relief on beef costs for the balance of the year. The price of ground beef is dropping with more cattle being sent to slaughter because of the drought in the Midwest and lowered demand because of the “pink slime” controversy earlier this year. But beef prices are expected to rise next year because of herd liquidation, which could have a long-term impact.

Casual-dining chain Red Robin Gourmet Burgers of Greenwood Village, Colo., said the commodities outlook was forcing the chain to look at “modest price increases.”

Many chains have beef contracts locked in until 2013, but price-increase exposure after that is likely.

Arne Haak, chief financial officer of Ruth’s Hospitality Group Inc., said in July that the Heathrow, Fla.-based Ruth’s Chris Steak House chain of upscale restaurants was looking at menu engineering possibilities and “pricing opportunities.”

Fast-food chains are also facing pressures. Popeyes Louisiana Kitchen recently said commodity prices were up 1.5 percent for the second quarter, and company executives expect a 3-percent increase in food costs for the remainder of the year, owing mostly to the drought and high prices for corn, which is the main feed source for chicken.

Powell of Razzoo’s noted, however, that the commodity challenges are “nothing new.”

“I see this as a healthy and heightened challenge to buy and execute better,” he said, adding that it leads operators to “eliminate waste while maintaining value on the plate, while also improving the overall service experience of the guest.”

Contact Ron Ruggless at [email protected] [2].
Follow him on Twitter: @RonRuggless [3].