When McDonald’s hinted last month in a conference call that it planned to raise prices this year to offset commodities inflation, many quick-service competitors likely were relieved to hear the category giant would do something they’ve all wanted to do for years.
“For a long time it’s been a game of chicken; nobody wanted to raise prices,” said Dave Stone, managing partner of the New England Consulting Group. “Now McDonald’s is saying it has to, which we think is the right move.”
Still, taking action is another matter, and many operators are weighing the need to offset rising commodities costs against the need to keep still tight-fisted customers coming in the door. According to Stone, the wrong move is to do nothing, but he suspects some players will choose that game plan as well.
“Some will try to hold the line and not move prices, but it’s a terrible mistake not to respond and take some action to protect margins,” Stone said. “It’s going to be awfully hard not to manage this commodities crisis without recovering something through increased prices.”
Confronting the crisis
The restaurant industry is already dealing with increased costs. Favorable commodities prices — the lone blessing of the recent recession — are quickly disappearing as the U.S. economy slowly emerges from its three-year slump. And according to commodities experts, multiple market factors will continue driving prices for corn, beef, pork, grains and dairy upward well into 2011 and possibly beyond.
“There’s no indication they’ve peaked yet,” said Robert Bresnahan, chief executive of Trilateral Inc., a risk management advisor to foodservice companies. “And we’re not dealing with a simple fundamental supply and demand situation for grain crops. This is more about liquidity in the commodities market, money from investors who are looking for a financial rate of return.”
John Barone, president of Market Vision Inc., a firm that advises restaurant companies on commodities purchases, believes surging international demand for U.S. foodstuffs is the main force behind price hikes.
“Developing countries have rebounded from the recession faster than we have, and their increasing affluence is allowing them to import more protein and dairy,” he said. “That demand is pressuring supplies here and moving prices up.”
According to a report issued by Piper Jaffray & Co. in January, the effect of rising corn prices is pushing nearly all other major grains produced in the United States to near-record highs. A staple in livestock feed and the core ingredient in ethanol, corn costs are expected to soar between 35 percent and 58 percent in 2011, according U.S. Department of Agriculture estimates. More modest projections place its price at a 25-percent premium over last year, which is still well above historical averages.
Either way, higher corn prices equate to higher livestock and dairy prices, as well as cost increases for oils, sweeteners and other corn derivatives used in packaged foods.
Wheat costs also are up sharply. While some analysts point to droughts in Russia and Ukraine and flooding in Australia as triggers for wheat price increases, Bresnahan said producer fears of shortages are unfounded because world wheat stocks are more plentiful this year than two years ago, when wheat prices skyrocketed. Piper Jaffray’s report supports his view, stating that while U.S. wheat prices in 2010 finished 0.1 percent lower year-over-year between 2009 and 2010, prices leapt 54.2 percent in December 2010 over December 2009.
Though Piper Jaffray researchers predicted wheat supplies to tighten some this year, they still expect them to remain above 10-year averages. Meanwhile, the USDA is predicting that 2011 wheat prices will increase between 9 percent and 17 percent, a bump that will inevitably affect other commodities prices, Barone said.
“Everything is interrelated, so it’s tough to point to any specific commodity that hasn’t had an effect on another,” he said. “With the global market so intertwined, what’s happening here is only a part of what’s happening to affect all prices.”
Not to be left out, cheese prices also are flirting with high levels for late winter — bad news for pizza companies that have enjoyed nearly two years of low cheese costs. Prices for block cheddar traded on the Chicago Mercantile Exchange have rocketed 49 cents in 2011 to $1.91 in early February, a time of year when blocks typically hover in the $1.40-range. Prices for Class III milk futures also are way up for April, the spring turning point marked by rising production and plunging prices.
“Prices should be lower now and even begin falling further as we move toward April,” said Bresnahan, who cited strong overseas demand for butter and powdered milk as other price drivers in the segment. “But people are investing in dairy the way they’re investing in everything else: not to buy product, but as an investment.”
Mum on price hikes
While there are plenty of rumors that large quick-service players will boost prices, finding any that will share their strategies is next to impossible. Like McDonald’s, Starbucks was equally vague in an earnings call about “recent price initiatives” taken to offset rising dairy, cocoa and coffee prices.
And in a separate earnings call, Chipotle Mexican Grill’s David West, chief executive of the company’s North American Commercial Group, was no clearer about whether the burrito chain might wrap its prices differently for 2011. He made no bones, however, about his reluctance to talk about prices in general: “We are very limited on what we can say about price. …We just don’t like to comment on it at all,” he told analysts.
Yum! Brands Inc. CFO Richard Carucci said he believes the parent of Taco Bell, Pizza Hut, KFC, Long John Silver’s and A&W All-American Foods will pay 4 percent more for commodities this year. He added, however, that he’s comfortable long-term contracts will pad Yum’s bottom line some and soften some of the impact. Anticipating this year’s commodities run-up, he said the company increased prices incrementally at some of its brands last year.
“We think that generally the consumer handles that better,” Carucci said in an earnings call. He also stated that the company plans to continue a pricing strategy employed in 2010 of strategic positioning of bargain and premium offerings, such as 99-cent menus and the $5 box options at Taco Bell and KFC.
“We’ll continue to … do things like that as we get into 2011,” he said.
Michael Lawton, chief financial officer for Domino’s Pizza, said on an earnings call that the world’s second-largest pizza chain is comfortably locked in on wheat and chicken prices through at least the third quarter, but he expects cheese prices, which make up about a third of Domino’s food cost, to continue rising.
Lawton added that, as a corporation, Domino’s is somewhat insulated from commodities price fluctuations because its domestic pizzeria system is 90-percent franchised.
“So we are not as highly impacted … as some of our less franchised peers,” he said. “However, commodity prices obviously are an important factor for our corporate stores and for our franchisees’ profits and their overall health.”
Harry Balzer, chief industry analyst at The NPD Group, predicts commodity price increases will appear first on grocers’ shelves, and they will trigger consumer backlash that may benefit restaurants.
“As they see prices rise at the supermarket, they say, ‘That’s nutty! It’s cheaper to eat out,’” Balzer said. “Of course, it’s never cheaper to eat out than it is to eat at home, but it feels like you’re getting less for your dollar at supermarkets because you know instantly when prices go up. Restaurants have more ways to absorb those cost increases in ways consumers don’t always recognize.”
But, he warned, consumers eventually catch on, and sometimes they react by spending less, buying smaller portions or sharing their food with others.
“What we know is the average cost per person for a restaurant meal goes up by 2 percent [annually],” he said. “And I think consumers generally accept a 2-percent increase. But if it goes above that, then they make behavioral changes like going to different restaurants or eating different meals.”
Managing the menu
While price-slashing efforts helped maintain quick-service traffic in tough times, Stone said it also conditioned customers to become too reliant on dollar menus and meal deals. The smart way out of the low-price trap, he added, is not just boosting prices all across the menu board, but taking “the emphasis off dollar menus in constructive ways that attract customers’ attention elsewhere.”
A veteran of the soft drink industry, Stone recalled times when producers pushed 2-liter prices down to a margin-crushing 99 cents and saw bottles fly off the shelves. But when prices moved back up to a more favorable $1.29, customers stopped buying them until they returned the price to 99 cents.
“What broke that pattern was when the industry came up with new portion sizes and different packaging,” Stone said. To customers’ thinking, those were new products, and they gravitated to those novel options, he explained.
“In the same way, this would be an interesting time to start messing with certain products and menu bundles,” Stone said. “Maybe you reduce the size of the burger or fries or the drink in a bundle, and introduce it in the $2- or $3-range.” The result is lower food cost for the operator, lower prices for customers and new opportunities to sell add-ons, he said.
Stone said operators also have cornered themselves by marketing products by weight, such as McDonald’s legendary Quarter Pounder. Since size matters in the eyes and hands of well-conditioned customers, there’s no changing the portion, and that leaves operators with little choice but to raise the price if they are going to profit from that item, he said.
“I’d much rather be selling a Big Mac and not have to say what the weight is in case I want to change something,” he said. When he recently consulted with a Mexican fast-food chain, he said, “We really resisted talking about a 1-pound or a two-hand burrito. Once that’s done, you can’t really get away from it.”
Carlos Nuñez, a director at Simon-Kucher Partners, a marketing advisory firm, agreed that altering flagship products is never a good idea, and upping prices on the value menu is equally risky. Where he sees opportunities for change is somewhere in the middle, possibly on items that could survive subtle, targeted alterations.
“You can especially do this with à la carte items,” said Nuñez. Changing portion sizes and altering ingredients converts to pennies saved, which add up to dollars earned.
“With commodities the way they are, there’s dire need for some pricing moves,” he said. “Things have to change, and this is one way to change them.”
Brian Rassel, a colleague of Stone’s at the New England Consulting Group, pointed to the success airlines have had with “unbundling services” to leverage their climbing cost burdens off their balance sheets and onto customers’ shoulders.
“They were under severe pressure three years ago with fuel prices, but they tried to take on a lot of the pain in the beginning,” said Rassel, a project manager specializing in the firm’s restaurant practice.
Pointing to new charges for extra luggage, snacks, beverages, blankets and pillows, he said, “Airlines retrained their customers by unbundling almost every service related to taking a flight. I think that kind of approach could work in quick service.”
