Soaring beef prices are changing the way we eat. In order to deal with the costs they can't pass on to consumers, restaurants are serving smaller burgers, lower quality steaks, and pushing chicken. They are faced with the tough choices on how to deal with the situation while still attempting to remain just as profitable.
On that note, you would think the company made famous decades ago for its "Where's the beef?" commercials would be the first one worried about high beef prices. But in reality the impact on Wendy's (NASDAQ:WEN) is minimal. There are several reasons why the effect may be less than you think.
Where's the cheap beef?
Terrible weather such as droughts has caused feed prices for cattle to spike. The domino effect has led to cattle farmers cutting back and cattle numbers residing at their lowest levels since 1952. The result is beef prices have nearly doubled over the last decade.
In the last 12 months alone, the shortage coupled with increasing consumer demand for beef has caused an 11% spike in beef prices over the last 12 months. The U.S. Department of Agriculture expects further price increases ahead dwindling the hopes that the recent spike will ease off any time soon.
Location, location, location
Of the 6,557 Wendy's locations in operation at year-end 2013, 76% were owned by franchisees. Higher costs are normally not good for anybody, but Wendy's gets a 4% monthly royalty fee off gross sales from "substantially all" of its franchisees, according to the annual report. These fees represented roughly two-thirds of Wendy's gross profit in the first quarter.
This means whether the franchisees make money, lose money, make a little, or make a lot, Wendy's gets its cut straight off the top. In fact, any franchisees that are able to pass on some of the costs to consumers in the form of higher prices on the menu will also be paying out higher royalties to the parent company, which is all profit for Wendy's.
More sizzle than steak
Next you have the other 24% of company-owned spots, which is still a decent chunk even though it's obviously a far cry from 100%. According to CEO Emil Brolick in an interview with CNBC, beef prices are at record levels, but that doesn't bother him. He reminds everybody that beef costs are only between 19% and 20% of Wendy's overall commodity costs.
Chicken, for example, is also around the same amount. Then you have the buns, the veggies, and all sorts of other ingredients with varying inflation and even deflation in costs. None of those are directly affected by beef prices.
Wendy's did lower its guidance for company-owned restaurants' gross profit margin. Originally Wendy's had guided for gross profit margins of between 16.8% and 17%, and now it's a range of between 16.3% and 16.8% for across-the-board, overall commodity inflation.
Those numbers should be taken in context. First, it's only at most a 0.5% difference. Second, it still exceeds 2013's profit margin level of 15.4% any way you slice it, and it's even much higher compared to 2012's 14% profit margin.
Then there are of course price increases. Wendy's CEO Emil Brolick hinted in the interview that the company has already implemented some price increases and may do so further in the future.
Foolish final thoughts
To sum up, just 24% of Wendy's restaurants are company-owned. Only 20% of commodity costs that are even beef. Factor in the 11% beef inflation over the last year, and we're only talking an effect of an 11% cost increase on 20% of the commodity costs affecting only 24% of its restaurants. It affects Wendy's overall by a rather tiny amount even before any price hikes on the menu. . In other words, for Wendy's investors, fear not. Word of beef prices going higher is just noise.
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Nickey Friedman has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.