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Sell Your Restaurant Stocks NOW!!!

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April 16, 2008 – Comments (14) | RELATED TICKERS: BWLD

I actually am probably a little early on this call, so you don’t have to run out and sell your restaurant stocks immediately, but you probably should do so fairly soon.  Restaurant earnings might be pretty decent for the next quarter or two, but this sector is headed for a lot of pain in the relatively near future.  Why you ask?  Because a huge spike in meat prices is coming and consumer spending is going to slow. 

As everyone already knows, the prices of commodities, like corn and soybeans have exploded.  There is always a significant lag between an increase in feed cost and the subsequent increase in meat prices.  At least that is what happened the last time feed prices doubled in the 1970s.  When feed costs increase significantly as a result of a rally in corn and soybean prices, the first reaction of individual livestock feeders is to try to tough it out with the hope their competitors down the road will reduce production first.  It's sort of a game of chicken, so to speak.  When the industry at large fails to reduce production, individual livestock feeders begin to lose massive amounts of money and they are forced to begin to cut production. This "cut back" means the livestock producers will cull their sow (that's a female pig) herd and/or their cow herd.  In the short term, this will put more meat on the market, causing meat prices trade lower.  This is exactly what we have been seeing lately with meat prices.

According to people in the industry who I have spoken with, there is currently a three-week wait to have sows slaughtered because the demand is so high and meat packers only have so much capacity.  The lag period before we see higher pork prices is likely to be around 9 to 12 months.  For beef it is a little longer, probably at least 12 months.  Once the increase in meat prices begins, it will likely last for several years.  This is how it has happened in the past.  Smart meat futures traders have been “Bear Spreading” hog and cattle futures i.e. selling the nearby contracts and buying the deferred contracts for the reasons stated above.

I became intrigued by this whole phenomenon when a former holding of mine, Buffalo Wild Wings (BWLD) reported not that long ago that chicken wing prices were falling.  When I heard that I said to myself, “how can this be…grain prices are through the roof?”  I did some of research on the subject and I now understand the dynamics of the meat industry and why this happened.  I can only hope for shareholders’ sakes that BWLD has recently or is able to sign a long-term contract for wings in the near future, as they have done in the past.  Doing so would be a brilliant move.  BWLD management has proven to be very capable in the past, so perhaps they will.  I love this chain.  The food, the atmosphere, and of course the beer are all great.  I go there whenever I can, but I finally decided to sell my Buffalo Wild Wings shares and those of any other restaurants that I owned.  I just don’t want to fight this powerful trend.  This is a well-run company we’re talking about here, some of the less well run ones in the United States are going to be blindsided by this rise in prices and get absolutely crushed.

As you can see, on one hand it is very likely that U.S. restaurant margins are going to be squeezed by higher input costs.  As if this wasn’t bad enough, I suspect that the massive increases in food and gas prices are going to force consumers to cut back on discretionary spending for fun things, such as going out to eat.  Not to mention the fact that consumer confidence is currently sitting at its lowest level in fifteen years.  Falling revenues caused by a drop in consumer spending combined with rising expenses spell disaster for restaurants. 

Deej

No position in BWLD

14 Comments – Post Your Own

#1) On April 16, 2008 at 2:06 PM, FourthAxis (< 20) wrote:

WMT here we come!

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#2) On April 16, 2008 at 2:15 PM, Gemini846 (45.99) wrote:

BWLD has already signed a contract at those low wing prices that will continue to cover them for the next 3 quarters. After that it's up for grabs. I'll see if I can get some exact dates for you.

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#3) On April 16, 2008 at 2:21 PM, Gemini846 (45.99) wrote:

Ok. I was wrong. That 9 month contract was last may lol, so that ended Q1. Based on recent company comment:

"Our new model assumes current spot wing costs plus normal delivery costs (or ~$1.50-1.60 per pound delivered cost) following the expiration of a below-market contract this month. Management has not renewed the contract, and thus plans to pay spot prices for the time being. We expect wing prices to remain near current levels, but the risks remain to the upside given the continuing efforts of chicken producers to increase processed chicken prices to offset the rising cost of feed corn. We are also assuming that “non-wing” cost of goods will rise 2-3% this year, below expected menu price increases of 3-4%. These assumptions lead to a projected fall of 65 bp in food cost in 1Q08 but a rise of 60-70 bp over the balance of the year."

In other words.. what Deej said ;)

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#4) On April 16, 2008 at 2:23 PM, madcowmonkey (< 20) wrote:

Meat is a hot topic lately. I did this way too early, but it only hurt the accuracy not my pockets. I liked your DCR rec and now this.  I do disagree with the blindsided. Most restaurants have been on the down, because of gas prices. The big problem is they now have gas, consumers, food, inflation, and who knows what else weighing them down. I have stated this on DAVE a while ago, do people think these problems for restaurants are going away? They have to pass it on to the customer to stay in the black, well sorry I will cook my own ribs in a crock pot and just buy your bbg sauces if you are lucky. Now I just need a couple of wet naps to clean up with. Also, some of the Fools are getting caught up on the fact that they like a restaurants food, that isn't enough for me to be bullish on a company that doesn't supply something I can't get my hands on. I am a horrible writer and apologize if the last sentence doesn't make sense, but I don't think being bullish on the restaurants makes much cents either. Good posts Deej.

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#5) On April 16, 2008 at 2:25 PM, mandrake66 (41.84) wrote:

Deej, the Ahead of the Tape article in the WSJ today said much the same thing. See my latest blog entry for the link. Basically it was just a write-up on the fact that owners of livestock are culling down their herds because maintaining them with feed is so expensive right now, leading to temporary meat surpluses. This is unlikely to last very long.

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#6) On April 16, 2008 at 2:39 PM, abitare (47.45) wrote:

YUM, EAT, MCD, etc....

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#7) On April 16, 2008 at 3:16 PM, xthecritic (51.22) wrote:

old story - already priced in

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#8) On April 16, 2008 at 3:37 PM, TMFDeej (99.23) wrote:

Thanks for the comments everyone.  I HIGHLY doubt that significantly higher meat prices are priced into the stock prices of restaurants yet.  If you think so, xthecritic, you should be gobbling up their shares.  According to what I've seen people have only been pricing a minor economic slowdown into restaurant stocks and many of these stocks have bounced back some, trying to look past this.  Not only do I believe that the consumer slowdown will be much worse than what the prices of restaurant stocks are currently reflecting, but I don't belive that restaurant stocks in general are adequately pricing in the significantly higher input costs that they will have in the near future.

Thanks for the link, mandrake66.  I plan on hopping on over to check out the WSJ article right now.

Does anyone know if there is a restaurant ETF that I can short in CAPS?  I don't know of any.  I'm already short XLY (just in CAPS, not in real life).

Deej

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#9) On April 16, 2008 at 3:48 PM, xthecritic (51.22) wrote:

I didn't say I thought there was upside to the stocks, I don't - but just saying the entire casual dining sector took a very hard dive throughout Q4 07 and beginning of Q1 08.  This coincided with the first leg up of the ags/commodities.

I don't disagree with your hypothesis just the timing of it.  Admittedly, I may be biased because i shorted the sector during the time period mentioned above and exited.

In fact, I believe the near term recessionary influence on commodities and dollar bottoming will actually alleviate upward cost pressures (near term = next 12 months).  But the long term trends will be inflationary for commodities.  Market timing is everything during this volatile/uncertain market.

Of course, government intervention, energy policy, the farm bill/ag subsidies in the US and Europe are all wild cards.  I anticipate/hope ag subsidies will be thrown out with the bath water now that farms are swimming in cash.

Of course, opportunities will remain - on the short side IHP is very richly valued.  But many of the others are/have been stuck in trading ranges.  EAT is a great one to play on the trading range short at $19.50 for 10% moves down and go long if it gets below $17.00.

Good Luck.

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#10) On April 16, 2008 at 3:52 PM, TMFDeej (99.23) wrote:

Here is the article that mandrake mentioned:

Respite in Meat Inflation Could Prove Short-Lived

The part about meat is buried in the second half.  Thanks again for the link, mandrake.  Its premise is similar to what I wrote a little while ago. 

I came up with the idea for this blog post while thinking about BWLD over the past couple of weeks and listening to Rick Santelli mention meat prices on the simulcast of CNBC in my car on the way to work this morning.  The information in my post came from speaking to commodities traders that I know.  The WSJ article contains a lot of great statistics that I did not have when I wrote this, but it just reinforces what I said.  Here are two great quotes:

"The weekly slaughter rate of hogs was up 7% in March from a year earlier, according to the Agriculture Department's March Hogs and Pigs inventory report. Beef production has also risen, according to the department's latest World Agriculture Supply and Demand Estimates."

and

"While other food prices are soaring, extra supply is holding down meat prices for now. A pound of USDA choice steak cost an average of $4.12 in February, down from $4.16 a year earlier, according to the Labor Department. Ham shanks are two cents cheaper."

Deej

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#11) On April 16, 2008 at 4:05 PM, TMFDeej (99.23) wrote:

Thanks again for the comments, xthecritic.  I love a great, informed discussion.  I see that you are the score leader for EAT, so you were definitely early to this trend.  Nice call. 

I'm just afraid because I see lots of people around Motley Fool talking about picking up shares of restaurants that have fallen, like BWLD, but I think that the stock of many U.S. restaurant chains has a lot further to fall.  I'm not shorting these companies in real life (I rarely short anything for real...CAPS is a different story though ;) ), but rather I'm trying to open the eyes of some of the people who are trying to pick a bottom in restaurants that we may have much further to fall.

IHP is a great one.  At first glance it looks way overvalued.  I just shorted it in CAPS.  I never understood how IHOP bought Applebee's anyhow.  I guess that my perspective is skewed by the fact that I don't have many IHOPS in my area and the ones that we do have are really rundown, but there is a ton of Applebee's.

Deej

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#12) On April 16, 2008 at 6:59 PM, a1japb (< 20) wrote:

Buy futures, in Cattle, soya,grains,chicken and Hogs if you have the stomach for it.

Now i'm hungry.... gotta go eat.

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#13) On April 16, 2008 at 8:19 PM, dwot (44.78) wrote:

When I looked at it I was just looking at pork, which is record low prices right now.  It is about boom and busts.  A few years back there wasn't much pork out there so farmers got an exceptional price.  Lots got the same idea to increase their pork supply and more pork for sale, lower price.  Right now farmers have so many pigs, and it costs money to feed them, yet they can't get that back, so they slaughter and sell for what they can get. 

Pork prices will definitely be going up as the excess supply is killed off and fewer are breed.

I was thinking pork would be up by the end of summer. 

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#14) On April 16, 2008 at 10:04 PM, cluelessmorgan (73.40) wrote:

I did notice on YUM that analysts have sales growth moving from 5.1% - March '08 down to 1.2% by Dec '09.  Perhaps what you are saying is why.  The however is, when the costs are passed on down to the customer.  And there goes another area of inflation. 

But then there are also suprises.  Also, fact: a good portion of YUM's profit is driven by its Asian divisions.  First China pulled it in, and now India is driving sales growth as well.  Actually, domestic sales growth is not very high at all.  YUM would not be very profitable were it not for overseas.

 Another case for YUM to continue growth.  They are already making moves to increase profitablility.  I don't know about the other regions but the Central Region is in the middle of a lot of upheaval in middle management and anyone making a ot of money who has been around for awhile seems to be getting canned.  I don't think its an accident by any means.

Then you have the delivery charge going to $2 while the delivery drivers get a measly .05 cent increase every three months.  Currently .95 cents goes to the delivery drivers out of the $2 a customer is charged.  So there's some scimping for profits. 

How do I know all this?  Well, until recently, I worked for them.  Now I've moved to a Fortune 10 Company. So I have a pretty good inside feel for what YUM is all about.  I really don't think they will take much of a hit because of rising meat costs.  They are pretty forward looking.  I'd sell shares within  6 mos just to realize some profits, but not all of them.  Just my advice for what it's worth.

I don't know details of how tight other companies are, but I imagine the ones that are run well will compensate and remain profitable, it's either that or go out of business.  Its do or die out there in this environment.

 

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