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Restaurants face a grim repast in 2011, as rising inflation begins to squeeze their food costs. This unhappy trend could hit some chains much harder than others -- especially those exposed to the rapidly growing cost of beef.
A rock and a hard place
Nearly every restaurant stock's managers have pegged inflation as a major problem for 2011. On Monday, inflation dominated discussion on McDonald's (NYSE: MCD ) fourth-quarter conference call; management announced that price increases were imminent, as its input costs continue to rise.
Efficient operators such as McDonald's are better able to manage these increasing cost pressures through hedging and economies of scale, but even the Golden Arches is having a difficult time managing the cost of beef. While my Foolish colleague Rick Munarriz suggests staying away from casual-dining restaurant stocks, I'd also like to add upscale steakhouse chains like Morton's (NYSE: MRT ) and Ruth's Chris (Nasdaq: RUTH ) to the mix.
McDonald's Chief Financial Officer Peter Bensen spoke about beef prices on the conference call:
We're about as locked-in today as we were a year ago at this time and have a fair degree of confidence in that 2% to 2.5% increase. Probably the biggest variable in that will be beef. We built a substantial increase in our beef cost into that guidance but that's the one market that looks like it could be the most volatile for us.
Food trucks and coupon websites have given more casual dining chains a run for their money in recent months, but Morton's and Ruth's Chris aren't likely to feel the same pinch, since businesses and expense account dinners aren't likely to forgo these chains' USDA Prime beef at the sight of marginal price increases or a $20-for-$40 deal at the local steakhouse.
However, necessary price increases will likely make that occasional luxury a little less occasional -- and upscale steakhouses and fine dining establishments will have a more difficult time with the rising cost of beef. Unfortunately for them, the quality of their product does not allow for lower-cost substitutes.
A quick lesson in beef
Morton's and Ruth's Chris Steakhouses are known for their USDA-graded Prime beef. Only 1%-3% of the country's beef earns this designation. The Prime seal of approval is granted to beef based on the marbling, or fat content, of the beef; in a typical American refrain, the more marbling, the better. The cows that ultimately become the Prime beef on your fancy china are served a heavy dosing of grain late in their lives to achieve this enhanced marbling.
But inflationary pressure and the rising demand for grain worldwide has increased the cost of raising Prime beef immensely. At casual fine-dining restaurants, you're more likely to find USDA Choice beef, which is a notch below (and much less expensive than) Prime cuts. Casual-dining restaurants can also decide to sell similar but less expensive cuts of Choice beef, unbeknownst to most consumers. This is not a viable option for Morton's or Ruth's Chris. Customers paying a premium to eat at upscale establishments expect their favorite steakhouse cuts to be on the menu, there's no substitute for Prime beef.
Tough decisions ahead
Morton's and Ruth's Chris kept prices steady during the recession, but both began marking up their menus incrementally again last year. Both are mulling over further price increases, since the price of beef is expected to continue to rise significantly throughout the year. However, some analysts believe that any price hikes these chains will be able to implement might not offset their increased input costs.
While we can't be sure that inflationary pressure will persist throughout the year, McDonald's cautionary outlook on the beef market should make investors think twice about investing in companies highly levered to the price of this commodity. Almost every restaurant group is facing significant headwinds in the coming year, but perhaps none greater than upscale steakhouse chains.