On the Relationship Between “Increased” Food Prices & Restaurant Margins

22 Apr

I wrote the following from 10/27/2010-11/12/2010, but never published because I wanted to do some more work.  Alas, my ADD got the best of me, and that never really happened.  After paying $1.10 today to have Swiss cheese added to a buffalo chicken wrap at a diner in NJ, though, I’m again curious about the difference between wholesale and retail food price inflation.  So, without further adieu, here are my thoughts from then, which apparently are more valid today then they were just 6 months ago!

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Over the past few years – depending on the particular restaurant and time – I’ve been charged anywhere from $0.40 to $1.00 for adding cheese, tomatoes, etc to lunch or breakfast sandwiches.  I’m hardly an expert in agricultural commodity markets and only slightly less out of the loop re: the finer points of the restaurant business (but also hardly ignorant of either), so I assumed whatever, not a huge deal, I’m sure my patronage is padding restaurants’ margins, but its ~$0.50 and I’m (often) too lazy to make my own lunch so I’ll keep buying from delis/etc.

Enough about me and my elasticity of demand/food preparation inclination/etc…

One would have to be pretty damn naive to think restaurants (from your local deli to the massive international chains) would let rising input costs erode their margins.  One would have to be similarly – if not more – naive to assume they wouldn’t use the opportunity to actually increase margins, i.e. pass off >100% of increased input cost to end consumers, after-all, this strategy is hardly anything new.  It’s just the obvious move (depending on price elasticity of demand, market position, pricing power, and a number of factors I’ll address eventually).

If I ran a deli or restaurant, I could procure a slice of Land-o-Lakes American Cheese for somewhere in the ballpark of $0.09/0.5oz slice (yes, 9 cents/slice!).  I imagine this number drops precipitously for larger chains to somewhere likely half (or less) that.  I also imagine if I’d spent more than 5 minutes googling cheese price and/or had any supplier relationships I could get it for less, as well.  Using a (possibly poor proxy) index for changes in food prices, let’s say that a slice of cheese costs a deli $0.10 and that since 2005 , prices have increased 50% from $0.067/.5oz slice (~ the increase in the IMF Food & Beverage over that time period).

Using these numbers and assuming adding cheese to a sandwhich is 2 slices, the cost of so doing to a business in 2005 was $0.13 and is currently $0.20, yet anecdotal evidence (working on getting empirical, if anyone has, please share!) customers are charged $0.50, not only absorbing the increased input price, but yielding the restaurant an effective 150% return on the cost of investing in those 2 slices of cheese in 2010.  Since memory doesn’t go back that far, I unfortunately have to ignore how this compares to 2005 (pending finding some additional data).

Of course, a popular restaurant/deli may only serve a few hundred sandwiches “with cheese” in a given day (+/-), so while the return %/gross profit padding is amazing in and of itself, on such a relatively small base and scale, the improvement/contribution to the bottom line may be anywhere from a few dozen basis points to several hundred.   E.g. 100 “with cheese” sandwiches/day, 300 days/year would yield an EBITDA improvement of $9,000 for a small-ish restaurant for whom EBITDA (with passing-along only the  increased food price, sans additional margin) may be anywhere from ~ $50,000 to at most, what, maybe $200,000?  Using these numbers (which may be unrealistic), a single restaurant could increase its pre-tax profits anywhere from 4.5-18%, purely by tacking-on a few dimes profit for adding 2 slices of cheese to some sandwiches!

A few thousand $’s a year may not sound like much in the grand scheme of things – especially for restaurant operators that pay themselves a pretty penny of pre-tax profits and/or have other income streams – but let’s extend this logic out a bit where the base is significantly higher and economies of scale come into the picture.

What if we consider a chain with 10,000 restaurants, with huge purchasing power yielding their cost/slice much lower, combined with increased price-making ability (this may be debatable) due to brand loyalty/etc?  How widespread and to what degree do large restaurants pad margins by passing-along >100% of their increased input costs?  Do they exploit their position, brand loyalty, purchasing power, etc to earn a meaningful % of profits not from running their core operations efficiently and effectively, but rather from “bonus buck” strategies like nickle & diming customers on things like adding cheese to sandwiches?

I don’t yet have the answers to these questions, however given the run-ups and resulting higher valuations of some restaurant stocks, I’m anxious to find them.  Look at some popular restaurant stocks’ performance over the past few years, relative to the Market (using the S&P 500) and the Consumer Discretionary ETF (XLY):

The S&P and Discretionary index have barely moved the past few years compared to the stocks of popular restaurants McDonalds, Panera, Yum! Brands, and Chipotle!  Of course there are several factors at play here such as fast food restaurants finally diversifying and expanding their menu’s away from all fat, all the time to healthier/more popular alternatives, but I’m still curious how much (if any) of the above returns (and the $ driving them) are due to restaurants padding their margins with increased retail prices in excess of any increases in input costs they’ve seen.

Similarly, I wonder if grocery chains are also guilty of this practice as well.  I think this may (or not) into a recent back/forth between financial guru Sarah Palin and several MSM and blog types about real and/or perceived increases in food prices, summarized neatly here on Barry Ritholtz’ blog.

I’m going to do some more reading and run some more numbers to see if we can get a better idea of what is/what is likely to be going on.

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