Rising Meat Prices Could Hurt McDonald’s Margins

Beef and pork prices have been on a rise for over 12 months now and are showing no sign of reversal as the demand for meat products continue to increase, especially in the developed nations. Meanwhile, meat consuming companies are struggling to adjust to rising meat prices. McDonald’s Corporation (NYSE: MCD), the leader in fast food industry, is one of the companies hugely affected by the rising meat prices, especially after its disappointing series of quarter results.

The price of Ground Chuck 100% beef rose to $3.85 per pound in May 2014, up 11% year-over-year, whereas pork prices grew 19% over the same period with prices hovering over $6 per pound for sliced bacon. ^[1] According to United States Department of Agriculture (USDA), prices of other quality and type of pork, beef and chicken show a similar trend. ^[2] In comparison to this, overall inflation is reported to be 2% and 1.9% for a wide range of food products.

The dominant factor responsible for this price hike is the drought in the western region of the U.S. over the last three months, further diminishing the already tight supply of cattle in the U.S. According to U.S Drought Monitor, the drought intensified in the months of April and May, spreading to seven western and central states, due to a prolonged weather pattern of warm and dry ridge of high pressure over these regions. ^[3]

Adding to the problem, last month, Centers for Disease Control and Prevention (CDC) reported the outbreak of E.Coli O157:H7, a disease caused by the bacterial germ Escherichia coli. The outbreak, already responsible for significant number of infections and deaths in the U.S., was supposed to bring down prices with a common view that meat suppliers would be reluctant to sell beef to consumers, but consumers have continued to sustain demand, in fact, accelerate it. Consumer confidence and disposable income has improved in the U.S., and they seem willing to pay more for good meat. This imbalance in demand and supply is likely to drive the prices for beef and its products higher.

Another unfortunate development is the outbreak of deadly piglet disease called Porcine Epidemic Diarrhea Virus, or PEDv. The disease has been reported to cause deaths of nearly 8 million pigs or about 10% of the U.S. herd since last spring, thereby driving pork prices to all-time highs of $4.1 per pound. The virus thrives in cold and damp conditions and has slowed due to warmer temperatures in the U.S. after February. A renewed outbreak may lead to losses worth millions of dollars for the U.S pig farmers affecting around 2.5 million pigs over the next 12 months. Consequently, the farmers are forced to use high quality expensive feed. Moreover, according to USDA’s WASDE report for the month of April, pork production for the year 2014 will be down 1.9% from last year, the lowest level since 2011. On the other hand, pork consumption is not affected and demand for hogs remain high. This may lead to significant rise in retail pork prices to as high as $4.6 by the end of this year, according to USDA’s estimates. Rising red meat prices have also sent the demand for chicken, the cheaper meat, to its highest level in three years. ^[4]

Rising meat prices has already played a vital role in dwindling profits in McDonald’s Q1 results. Despite the inflationary pressures, the company did not raise its menu prices in the first quarter, thereby shrinking the margins. However, in the current quarter, the company decided to pass on the rising costs to customers by increasing prices of items whose input cost was over the threshold. This might give a boost to the company’s average sales per customer visit on one hand, but might diminish the customer traffic, leading to slow revenue growth and consequently, tighter margins.

We have a $103 price estimate for McDonald’s, which is about 2% above its market price.

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Dwindling Profits vs Average Spend Per Visit

For the last two years, McDonald’s faced a tough period with lower than expected restaurant sales in most quarters, due to sluggish economic growth, growing competition from other fast food & fast casual brands and operational inefficiencies. This year can prove to be much more of a struggle for the company as it is facing higher commodity and food costs including beef and pork prices, increasing labor cost, protests from its minimum wage employees and tough competition in the breakfast segment. The fast food giant is already been facing a fall in customer count for the last couple of years.

Rising prices of beef and pork, two major raw products for the company’s food items, will put a huge pressure on the input costs. McDonald’s has already raised prices of its top selling items such as Hamburger, Double Cheeseburger, Big Mac and McBacon in the first quarter of 2014. This cost is being passed on to the customers, which has led to an increase in average spend per visit but has also led to a significant decrease in customer traffic, resulting in a slower growth of overall revenues.

Decrease in revenue might translate to lower margins for the whole financial year. However, according to Bureau of Labor Statistics, U.S. consumers paid 2.6% more at eateries (food away from home) in 2013 over the last year, while food prices were 6.2% higher at supermarkets or retail stores. ^[5] Consumers get a wide idea of price inflation for the core items and they are less likely to react against rising menu prices at restaurants. As a result, restaurants can raise prices as long as they do not exceed prices for food-at-home items. In this case, McDonald’s might be able to sustain its margins but not for much long.

As a precautionary measure, McDonald’s joined hands with reputed associations for beef contracts such as Irish Cattle & Sheep Farmers’ Association to book some of its supply for the next year. The food giant is the largest buyer of Irish beef and one of its five burgers served across Europe is made from Irish beef. We can expect the company to take further actions to fight the increasing input costs such as introducing new menu items which excludes the use of beef and pork.

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1. Bureau of Labor Statistics [↩]
2. USDA: Meat price spreads [↩]
3. U.S Drought Monitor [↩]
4. Profit Tastes Like Chicken in Hunt for Cheaper U.S. Meat, bloomberg.com [↩]
5. Eateries to lift prices to catch food-at-home inflation [↩]