Published on September 13, 2021 by Samuel Sunny
Restaurant stocks underperformed all major US indices in 2020 due to the pandemic’s significant impact on the sector. Publicly traded restaurant stocks had a median price increase of just over 4% in 2020, compared to a 16% increase in the S&P 500 Index. We believe restaurant stocks will continue to underperform the major US indices in 2021 as well, due to an expected margin compression because of labour shortages and high raw material costs. However, we expect bigger names with pricing power (e.g., McDonalds, Yum! Brands and Starbucks) to fare well.
Labour issues are a headwind and will likely remain so in the near term due to tight labour markets. We expect high raw material costs to be compounded by labour shortages as suppliers start to pass on increased costs of doing business to consumers. Restaurant managers expect margins to remain under pressure in the near team, as they have not been able to pass on the full increase in costs through higher menu prices. However, bigger names with pricing power, better sourcing techniques and greater negotiating power (e.g., McDonalds, Yum! Brands, and Starbucks) should be well placed to maintain margins.
Restaurant wage inflation to be in the high single digits, driven by labour shortages
Most US restaurant brands are being impacted by labour shortages in the domestic market. Wage inflation is estimated in the high single digits this year as companies increase wages to attract and retain staff amid the labour shortages. However, a few restaurant brands (e.g., Bloomin’ Brands and The Cheesecake Factory) are seeing relatively muted wage inflation, due to higher retention rates and lower turnover, attributed to avoiding layoffs during the early days of the pandemic.
In a bid to reduce dependence on staff, there is an increasing focus on technology investment both at restaurants and back offices in an effort to find operating efficiencies to ease the pressure on margins. For example, Papa John’s in-house GPS system helps drivers learn their routes faster than they normally would. This change has enabled the company to reduce delivery time and deliver more. Restaurant brands are also launching “delivery only” menu items, which is adding to their top lines with better margins.
Food costs to see high-single-digit inflation in 2021, accelerating in 2H 2021
Restaurants’ food cost inflation is likely to be in the high single digits in 2021, driven mainly by strong demand (both national and international), higher feed costs (due to shortages caused by drought) and supplier constraints. The impact of labour shortages is beginning to show up on the food-cost line as labour-constrained suppliers pass on their increased costs of doing business.
A key category driving food cost inflation is meat, including beef, veal, pork and poultry. The US Department of Agriculture expects full-year inflation of 3-4% for beef and veal, 4-5% for pork and 2.5-3.5% for poultry. Food-away-from-home prices have risen 2.8% so far this year, and they are expected to increase 3.5% for the full year, implying an accelerated rate of 4.2% in 2H. In 2022, food-away-from-home price inflation is again expected at 3.5%.
Too early to conclude whether inflation is transitory
While the mainstream narrative remains that inflation is transitory, the educated guess in some pockets of the economy is that inflation is here to stay for a while. The CEO of CattleFax (a research house in the US covering beef and broader proteins) expects beef prices to remain elevated through 2024, mainly due to supply-demand dynamics, with a shrinking cattle inventory owing to severe drought in some parts of the US making it unable to meet record domestic and global demand. CattleFax also expects corn and soybean prices to remain elevated for the next couple of years, fuelled by China rebuilding its pork industry after culling large portions of its herds in 2018-19 due to the African swine flu; there has been a fresh outbreak in 2021.
Recent comments by restaurant managers indicate early signs of easing labour constraints, with job applications slowly increasing. States that have come off stimulus are said to be seeing slightly better job application rates than states that have not. It is, however, still too early to say if removing stimulus would rectify the issue, as the labour environment remains tough, indicating there may not be a quick fix to the issue.
Restaurants are passing costs to customers through higher menu prices
Seeking to protect margins, restaurants have responded by increasing menu prices. Quick-service-restaurant menu prices are up 6.6% so far this year, while their full-service counterparts have raised menu prices by 4.3%. Quick-service restaurants (e.g., McDonalds, Yum! Brands and Starbucks) offer minimal table service, while full-service restaurants (e.g., Chili's, Applebee’s and The Cheesecake Factory) offer full table service. Another strategy restaurants employ to protect margins is increasing average ticket size through customisation or premiumisation of orders (e.g., attaching a beverage to an order).
Some of the larger brands are better placed to weather the tough operating environment through better sourcing and greater negotiating power. For example, Yum! Brands, the parent company of the KFC, Pizza Hut and Taco Bell brands, has a coordinated sourcing effort for all its brands, giving it greater negotiating power and access to better prices. Starbucks sources green coffee 12-18 months in advance and currently has coffee prices locked in for the next 14 months. McDonalds has most of its commodity book hedged and, consequently, expects food inflation to be in the low single digits for 2021.
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Restaurant management commentary
US Department of Agriculture, Food Price Outlook 2021: https://www.ers.usda.gov/data-products/food-price-outlook/summary-findings/
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About the Author
Samuel Sunny has over five years of experience in Equity research. Samuel currently supports a sell-side equity research team covering the US restaurant sector. Samuel holds a Bachelor's in Commerce from Madurai Kamraj University and a Master's in Business Administration from Ramagiri Centre for Business Studies.
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