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How pricey shrimp is hitting Red Lobster profit

Thursday, 19 Dec 2013 | 1:25 PM ET

Decreasing sales and fewer visitors aren't the only problems Red Lobster is facing: Expensive shrimp are hitting the company's bottom line.

After disease hit Asian shrimp supplies, prices have soared. Even though Darden Restaurants' Red Lobster, like most other restaurants, locked in a large portion of its seafood supply through contracts, it hasn't been immune to the price jump. Amid this increase, Darden has seen its food and beverage costs rise 6 percent, outpacing the increase in sales.

Shrimp and lobster meal at Red Lobster.
Source: Red Lobster
Shrimp and lobster meal at Red Lobster.

The price increase comes at a bad time for Red Lobster, whose parent company announced it was exploring options for a spin-off or sale of the chain Thursday.

(Read more: Darden to spin off or sell Red Lobster restaurants)

"Food inflation in the second quarter was approximately 2.4 percent, with shrimp inflation in the high teens and land-based protein inflation in the mid-single digit range," said Bradford Richmond, Darden's chief financial officer, principal accounting officer and senior vice president.

Through the rest of the fiscal year, Red Lobster expects shrimp prices to keep increasing, Richmond said on Darden's conference call Thursday. Through fourth quarter 2014, the company estimates it has about 75 percent of its seafood usage covered.

"We don't anticipate relief on shrimp until early in fiscal 2015," he added. Earlier this year, the company pegged seafood costs at 25 percent of Darden's total costs. Within this, shrimp is its highest volume protein.

Earlier this year, researchers identified the bacteria strain that caused the disease that's decimated shrimp farms in Asia, saying it affected supply by causing extremely high levels of mortality in shrimp. While some strains of the bacteria cause disease in humans, the strain of the virus responsible for the shrimp deaths is not among them.

During the quarter, Darden said Thursday, net income fall to $19.8 million, or 15 cents per share, from $33.6 million, or 26 cents per share, a year earlier.

This crustacean headache is not the first for Red Lobster. In late 2003, its president left following an unlimited crab special that proved to be too popular and hit profit.

Despite these long-term contracts, restaurants aren't able to lock in prices forever and are therefore not immune to pricing increases, said R.J. Hottovy, an analyst at Morningstar.

"For the current fiscal year, our expectation is our commodity basket will see net inflation in the range of 2.5 to 3 percent, which is about 50 basis points higher, primarily driven by shrimp, than we expected in June but is consistent with the expectation we talked about in September," Richmond added.

Bigger exposure to shrimp

"Red Lobster has a higher exposure to shrimp than other casual dining places. I think it's certainly had an effect of profitability for the past several quarters," Hottovy said.

In light of this jump, why doesn't Red Lobster just boost prices?

"The higher the cost of the input commodity—they can only charge so much for it given the sensitively of the cost," said Peter Saleh, a senior research analyst at Telsey Advisory Group. "This is not a high-end restaurant."

Saleh added that restaurants typically try not to outpace increases in grocery stores. This metric has risen marginally as measured by prices of food at home, up merely 0.8 percent in October, compared to the year before, according to Consumer Price Index data.

(Read more: Chipotle plans expansion into pizza)

"I think a 1.5-percent increase in menu prices is about as much as these restaurants can take. … Only certain brands have the ability to take more than that," he said. A increase of this magnitude is a far cry from the rise in shrimp.

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Possible scenarios

"If shrimp prices continue to climb, they're going to have to figure out how to offset it with other costs cuts, or shift the menu away from shrimp, which would be tough to do given you're a seafood place," Saleh said.

"If the sales were fine, I don't think we'd be worried as much about shrimp price volatility because it's a near-term problem," he said. "But the sales are down and the shrimp prices are up, and that creates a terrible environment."

If the company continues to see a shortage, it could prompt Red Lobster to boost prices or enact restrictions on promotions like the popular Endless Shrimp, Hottovy said.

"If we continue to see a shortage, it could lead to higher costs and a longer lasting impact on profitability," he added.

—By CNBC's Katie Little. Follow her on Twitter @KatieLittle

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