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Why falling agriculture prices help costs but won’t drive sales

The importance of food, beverage, and paper expense

Food, beverage, and paper costs make up a large portion of companies’ expenses—ranging from 28% to 34%, depending on business models. When these prices increase, they tend to have a direct negative impact on companies’ costs and profitability margins. On the other hand, falling expenses often help companies’ profitability.

UBS Bloomberg CMCI Agriculture USD Price Index 2013-09-05Enlarge Graph

Agriculture commodity price background

Agriculture and forestry commodities have been rising since 2009 along with a rebound in the global economy. Corn, a commodity that has vast use (ranging from animal feed to baby diapers, crayons, plastic, ethanol, and carpet production), rose from just ~$3.5 a bushel to ~$7.5 a bushel in 2011. China, the second largest GDP in the world but with per-capita GDP of just $5,500 a year, was increasing maize (corn) imports and other agriculture products as its economy grew from 2009′s stimulus.

Poor weather and reinvestment in commodities like sugar, which contributed to limited output, also pushed prices higher. Speculation joined the rally too, driving wheat, corn, soybean, cotton, fruit, and vegetable prices higher in 2010 and 2011, creating such high inflation that several countries had to increase interest rates to cool the economy down. In 2012, global corn inventory hit a record low as a percent of estimated usage, due to a severe drought in the United States. Only recently have prices fallen, as the United States is expected to produce a record corn output due to favorable weather, plantation, and fertilizer use.

Food, Beverage and Paper Expense 2013-09-05Enlarge Graph

Commodity price affects food retailers

As food retailers purchase agriculture products to serve customers, their food, beverage, and paper expense category tends to move along with overall commodity prices. As the above chart shows, companies’ food, beverage, and paper expenses as a share of sales have moved closely with agriculture prices over the past five years. A percent of sales reflects the portion of sales that these expenses make up and adjusts for the sales size. Otherwise, rising food expense could be driven by higher sales volume.

Favorable impact on costs, but beware

The recent fall in world agriculture products will likely lead to lower expense as a percent of sales this year and perhaps next year as well, which will support earnings for companies like Panera Bread Inc. (PNRA), McDonald’s (MCD), Wendy’s (WEN), Darden Restaurants Inc. (DRI), and Chipotle Mexican Grill (CMG). But investors should be careful not to rely on just one indicator to make investment decisions. Sometimes higher commodity prices are favorable for food retailers as well as the iShares Dow Jones Consumer Services ETF (IYC).

This is because companies’ earnings can increase even when the cost of food and beverage rises and profit margins fall. Since food and beverage make up ~30% of sales, if food retailers have to purchase food at 10% higher prices, as long as these companies increase food price by more than 3.0%, their earnings can grow despite falling margins.

Some argue that higher food costs could push customers to eat more at home. If wallets are tight, that will likely be the case. But if the economy is improving, people are earning more and employment is rising, so consumers may consider eating out more. This is because restaurant menu prices increase less than supermarket prices as a percent and possibly in absolute dollar terms. If the cost of making food at home increases from $5.00 to $7.50, and prices at restaurants increase from $10.00 to $11.00, then there’s less harm (psychologically) to eating out more. On the flip side, if there isn’t much inflationary pressure, there may be less incentive for people to eat out, which limits growth prospects. So it’s important for investors to look at other indicators on our developing website.