Weathering the storm: Commodities get too hot

Weathering the storm: Commodities get too hot

Not long ago, few investors could imagine a time when a restaurant company’s food cost profile—not its indebtedness, lease obligations or franchising frictions—could be a potential deal killer in a merger or acquisition.

Back then, equally few economists or agricultural experts could have predicted that U.S. farm and energy policies promoting biofuels from croplands would backfire and ignite divisive debate over rampant food commodity inflation. Yet that controversy now rages in the halls of academia, the White House, Congress, countless restaurant corporations and the United Nations’ hunger relief agencies.

Similarly, there was a time when not many commodities speculators or futures traders could have foreseen a day when supplies of such staples as rice, wheat and corn would fall to a point that food riots would erupt in formerly stable nations as American retail chains rationed bulk rice purchases to forestall hoarding.

Fiction lovers in pre-9/11 days would have considered far-fetched a political thriller that drew a straight line between shortages of high-priced staples and $4-a-gallon gasoline, a U.S. recession, a historically weak dollar, global warming, food species depletion and growing middle-class affluence in places like China and India.

Yet, as one pundit said, a “silent tsunami” of man-made and natural forces has overtaken the world’s economy, changing everything from harvest seasons and shipping costs to the calculations restaurateurs use in setting menu prices that won’t frighten recession-wary consumers.

Like an old Hollywood epic with a cast of thousands, the foodservice industry in 2008 finds itself cast as something of a bit player swept up in a deeply plotted, awesomely complex nail-biter of a script whose good guys and bad guys are only vaguely delineated and whose last reel might appear headed toward a calamitous ending.

Hudson Riehle, the National Restaurant Association [3]’s senior vice president of research, says the inflationary cycle the foodservice industry finds itself in is probably the worst in 27 years.

“What we are looking at is something that is unprecedented in recent memory,” Riehle says, adding that recent polls of NRA members indicate that “controlling food costs” has become their single-biggest concern, surpassing labor issues. “Just a few years ago, recruiting and retention were the top priorities of our members. This is a dramatically different landscape.”

Wholesale food prices, as tracked by the Bureau of Labor Statistics’ Producer Price Index, were up in March by double-digit, even triple-digit percentages for wheat, flour, cereals, corn, eggs, dairy products, beef and poultry on a 12-month, seasonally unadjusted basis. Flour led the pack, doubling in price from a year earlier. Wholesale corn costs were up 41 percent.

Wheat—largely due to an eight-year drought in Australia that decimated that nation’s export crop, combined with conversions of U.S. wheat fields to corn for ethanol—was up 160 percent.

Rice, battered by severe droughts and harvest shortfalls in major Asian producing nations and the Middle East, was up 32 percent.

While rice experts and purchasing agents for such brands as P.F Chang’s China Bistro or Panda Express point out that the United States is a big rice producer and is spared the weather patterns suppressing other nations’ rice production, shortages are occurring nonetheless. Just recently, Costco and Sam’s Club limited how many 20-pound sacks of rice their customers, including many independent restaurateurs, were allowed to buy.

Though restaurateurs might reconcile some price inflation as necessary to support biofuel policies aimed at reducing the nation’s dependence on foreign oil, the seemingly seismic ripple effect of U.S. ethanol initiatives has drawn growing condemnation. Shippers continue to pass along ever-higher fuel surcharges for deliveries of food, further aggravating the commodity price hikes.

If economics is the study and management of scarce resources, perhaps nowhere do restaurateurs want economists to apply that discipline’s principles with more intensity than in assessing the value of turning corn into ethanol.

Critics point out that as much as a third of the nation’s corn yield has been allocated to the production of ethanol. Whereas 90 percent of the U.S. corn harvest was shipped to manufacturers of livestock and poultry feed or directly to growers as recently as 1998, that volume has plummeted in recent years, with the result being recurrent pass-throughs of cost increases to restaurateurs for meat, eggs and other essentials.

The NRA argues that the problem has become a matter of national food security and is harming the poor here and abroad. It recently joined 18 other influential trade associations and conservation groups, ranging from the American Meat Institute to the World Wildlife Fund, to urge Congress to stop subsidizing food crop-based biofuel incentives.

“These food-to-fuel mandates and subsidies led to over one-quarter of all U.S. corn being converted to ethanol last year,” the alliance said in an open letter to congressional leaders. “By 2015, that corn to ethanol conversion is expected to increase to almost 40 percent [of the corn crop] if current policies remain the same.”

A United Nations committee, the Global Policy Forum, said the conversion of food crops to biofuels may be contributing to world starvation and accelerating climate change.

“In a world where there is hunger and poverty, there is no policy justification for diverting food crops towards biofuels,” the GPF’s executive board wrote in a letter to President Bush. “We should be filling stomachs, not gas tanks.”

Ed Droste, a co-founder of the Hooters [4] chain who operates Provident Advertising & Marketing in Clearwater, Fla., and is a self-taught researcher of the ethanol issue, says the NRA’s alliance with other industry groups to press for policy changes hasn’t come a moment too soon. An Iowa native whose closest friends include corn farmers there, Droste nonetheless insists converting millions of acres of corn to make biofuel is a terribly expensive and inefficient way to advance America’s energy independence and is the leading cause of margin erosion in foodservice.

“I know there is more money to be made selling your corn harvest to an ethanol producer that to the farmer down the road,” he says. “I can clearly see why a wheat farmer or someone in soybeans would want to convert to corn because of the ethanol profits to be made. I am not begrudging a farmer’s right to make as much as they can.

“But let’s look at it. We’re paying 15 [percent] to 20 percent more for chicken wings at Hooters, our core menu item, and we’re being told it’s because of rising feed costs because of corn being diverted to ethanol. So if that is the case, why do we persist in making ethanol, which, from [what] my research shows, burns one gallon of gasoline to produce 1.23 gallons of ethanol?”

By comparison, Droste points to Brazil’s use of sugarcane crops to make ethanol, reportedly through the consumption of one gallon of gasoline for every eight gallons of biofuel created.

But U.S. Agriculture Secretary Ed Schafer argues that high gas prices in general are a bigger factor in the rising costs of foods like Hooters’ chicken wings. Schafer, commenting recently on the farm bill in Congress that allocates tens of billions of dollars toward subsidies for wealthy farmers, said high fuel costs and import demands from the emerging middle-classes of China, India, Brazil and Russia have far more to do with rising American food commodity costs than do corn yields allocated to ethanol.

Some restaurant operators aren’t convinced either way, arguing that market manipulations by opportunistic investors also must be considered when attempting to explain higher food costs.

“Even with all of these factors in play, [high] prices can also be attributed to commodity traders taking advantage of an opportunity to drive up the price of these items, to cash in on rumors of worldwide shortages,” says Ashley Rathgeber, director of supply development for Pizza Fusion [5], a 20-unit, all-organic chain based in Fort Lauderdale, Fla. “In reality, the market is settling down and the prices will come back to within reason over the next few months as the spring crops come in.

“I’ve spoken directly with flour and cheese manufacturers who say the real problem is rising fuel costs. Shipping commodities around the country is extremely expensive, and that, more so than any actual crop shortage, is creating the premium on these staple foods.”

With the advantage of only procuring organic ingredients, even organic cheese, which are not normally traded on commodity exchanges, Rathgeber says that instead of raising menu prices, his chain invests more in advertising and marketing to drive traffic and preserve margins.

Intent on preserving its image as a leading value brand, Detroit-based Little Caesars [6], the largest carryout-only pizza chain, says its 2,300 U.S. branches are holding the line on menu price increases. But unlike smaller competitors, Little Caesars has the advantage of its own 40-year-old purchasing co-op and distribution center, Blue Line. David Scrivano, the chain’s president, says negotiating savvy and market instincts have helped Little Caesars insulate its operators from the run-up in commodity pricing.

Still, Scrivano says, many franchisees have raised prices by as much as 2 percent, mainly on side items like soft drinks and the chain’s Crazy Sticks appetizer.

Wade Winters, vice president of purchasing for Boston-based Au Bon Pain [7], says the 250-unit bakery-cafe chain’s biggest headache is flour costs, though he intends not to overreact by signing long-range contracts today that could end up being more costly tomorrow.

Using his proprietary food-cost-averaging equation, Winters does a complete analysis of the company’s commodity purchases every quarter before locking in the best prices obtainable just three to four months out.

Winters says the company has been taking a 2-percent menu increase twice yearly to keep pace with rising costs.

“But this is unlike any inflation spiral we’ve seen,” says Ed Frechette, senior vice president of Au Bon Pain. “[There is] no way you can hide menu price increases from consumers when everything across the board is rising. Luckily, our guests know that everything is rising and that their disposable income is being squeezed, and yet, we’ve been rewarded with steady improvements in comp-store sales and transactions. I think it shows that our guests still perceive a good price-value relationship with our food. But the most price-sensitive consumer is not our guest.”

One reason Au Bon Pain can post same-store sales gains, Frechette says, is that it opens branches that can cater to a captive market. Office complexes, college campuses, transportation centers and busy intersections of downtown business districts are the sites of some of Au Bon Pain’s highest-volume units.

For independent operators who fear that high food costs could drive them out of business, one option has been to form or join purchasing co-ops with other operators.

But New York restaurateur Todd Birnbaum, owner of the dual-concept Pinch Pizza and S’Mac operation on Manhattan’s Upper West Side, exploited an unusual variation on that co-op theme to offer pizza and macaroni and cheese specialties to his target audience of young moms with children. He and 10 other independents have tapped into 40-unit Ark Restaurants’ purchasing department, and in return the multistate operator became a minor joint-venture partner in their businesses.

“I really didn’t want to pass these prices on to my guests,” Birnbaum says. “But I really didn’t want to keep taking these hits either. So now I’m with a group that goes to market with the purchasing power of 50 restaurants. That’s a lot of comfort. This recession is forcing us to change our behavior.”

But some chains and companies will have no way to escape from higher food costs, which could matter when they are on the sales block.

Addressing the UCLA Extension California Restaurant Industry Conference in Los Angeles recently, Rod Guinn, vice president of Wells Fargo Foothill Hospitality Restaurant Finance, said he expects mergers and acquisitions bankers to continue offering three to four times cash flow in restaurant company buyouts. But investors in the months ahead will be eyeing more closely the target concept’s vulnerability to margin pressures from food inflation, with that factor having a definite bearing on valuations, he warned.

Weathering the perfect storm economy [8]