Lower commodity costs may help restaurant earnings

Waitress restaurant
Natalie Behring | Bloomberg | Getty Images

Lower food costs to make everything from hamburgers and pizza to popular breakfast items may have helped restaurant operators in the second quarter. But there's less certainty this deflation will dish savings for the remainder of the year as chains face upward wage pressure.

"Prices were some of the lowest levels in four years," said David Maloni, chief commodity strategist at the American Restaurant Association. "Egg prices are declining... cheese and chicken prices are attractive."

In the second quarter, food costs averaged down more than 15 percent on a year-over-year basis, according to the Restaurant Commodity Inflation Index tracked by the ARA. That marked the fourth consecutive quarter of double-digit deflation when compared with the year-ago period.

Egg prices tumbled 64 percent in the second quarter from the prior year, while dairy fell 20 percent and cheese dropped 12 percent, according to researcher Evercore ISI. These commonly used commodities can represent a significant savings for family-restaurant companies such as Denny's or DineEquity, which have a big portion of their business skewed to the breakfast crowd.

"Commodities continue to benefit margins with the breakfast (restaurant) day-part benefiting the most," Evercore analyst Matt McGinley said in a research note published Tuesday.

The Evercore analyst indicated that restaurant industry same-store sales "appear to have slowed" and that consensus earnings estimates for next year maybe a bit too optimistic due to "persistent labor inflation not fully factored into margins. Overall, restaurant margins are expected to decline in second quarter 2016 as weaker comp growth and wage inflation more than offsets commodity deflation."

Nationwide, wage inflation is hitting restaurants as minimum wages at the state and local level go into effect. They include higher wages that went into effect this month in Los Angeles and Chicago.

Beef prices were down 15 percent in the second quarter from a year ago while chicken prices eased 11 percent, according to Evercore. As for commodity price gainers, pork was up an average 3 percent from the year-earlier period. It followed pork prices soaring around 45 percent in the first quarter.

Morgan Stanley analyst John Glass said in a note last week that chicken wing prices are starting to come down and added that chicken generally tends to be "10 to 20 percent" of the cost of goods sold for the fast-food operators and some other chains.

Dairy can represent 30 percent or more of the costs at major pizza chains such as Domino's Pizza, and 11 percent or more for Cheesecake Factory, according to Glass. Major coffee retailers such as Starbucks and Dunkin' Brands have roughly 5 percent or more exposure on the commodity side to dairy. Commodity costs for coffee dropped in the second quarter from a year ago but were up slightly during the month of June and Arabica coffee futures trended higher in early July.

Dairy Cows California
Sam Hodgson | Bloomberg | Getty Images

Meantime, there are some price jumps showing up in the fresh produce space and other key categories such as steak. Morgan Stanley indicated that the average price of a choice strip steak rose more than 10 percent in June from the same period a year earlier.

"Tomatoes and cottage cheese have started to climb," said Douglas Holnagel, a manager at Paty's Restaurant in Toluca Lake, California. Also, several major meat suppliers indicate that ground beef prices are stable but that steak is trending up.

Indeed, there are signs food commodity inflation has picked up. For example, ARA's restaurant commodity index showed food costs averaged up 3.5 percent in the second quarter from the first quarter.

"We're kind of flattish in some cases and a little higher in Q2 versus Q1," Maloni said. "The first quarter was the lowest in our restaurant commodity index we've seen since Q1 of 2012."

To be clear, Maloni pointed out that the ARA index is for the commodity markets so it doesn't fully reflect a common practice of restaurant chains to have fixed-price contracts. Some of these contract prices could be higher or lower than the commodity index averages.

Maloni's outlook for the current third quarter is for "perhaps modest inflation. Maybe we seasonably tweak back a little bit in Q4 and then modest appreciation with seasonality in 2017."

On Tuesday, the U.S. Department of Agriculture forecast higher prices for some food commodities.

In its monthly World Agricultural Supply and Demand Estimates report, the USDA raised its hog price forecast for both the second half of 2016 and 2017, and lowered expected supplies of hogs in 2017. Also, the government forecast higher dairy prices for the remainder of this year and into 2017, and lifted its egg price forecast for the current year as demand has begun to recover.

That said, Tuesday's WASDE report was positive for the major packaged food manufacturers with exposure to grains such as corn and wheat. It forecast plentiful corn supplies and lower average prices for corn; the season-average farm price for wheat also was trimmed.