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August 19, 2004

Looking Behind CPI
by C. Hudson / R. Bend

On Tuesday, the Bureau of Labor Statistics reported that the Consumer Price Index fell 0.1% in July from the prior month and is 3.0% higher than July 2003. This was not only lower than economists' estimates but a decline from 0.3% and 3.3% registered in June respectively. There have been several articles written discussing how consumers have been feeling the pinch of inflation, yet the official calculation provided by the government shows that consumer inflation is quite benign. Over the past several months there has been considerable debate on whether soaring gas prices have dampened consumer spending. While gas prices have been eating a larger portion of household budgets, it remains a relatively small part of consumer spending. According to the Advanced Retail Sales Report published by the Commerce Department, spending at gasoline stations increased 20% in July on a year-over-year basis and represented 8.1% of all retail spending. This was up from 7.2% of spending last year. According to the CPI data, gasoline prices have increased 26.5% from last July. While this obviously has some effect on personal spending, the much bigger issue revolves around other inflationary forces that are hitting the consumer at the same time. Purchases that are less discretionary are experiencing more price inflation than those of a more discretionary manner. For the CPI calculation that only makes up 3.2% of the weighting. But the important aspect of higher gasoline prices is that it is not a discretionary purchase for most people. It is difficult to change driving patterns and throughout most of the country, public transportation is not seen as a viable alternative. The difference can be seen by looking at inflation for "food at home" versus "food away from home." Grocery prices increased 4.6%, while restaurants showed only a 3.0% increase in prices. Furthermore, within the "food at home" category, prices for meat, poultry, fish, eggs advanced 9.2% with dairy products jumping 14.0%. These prices increases are a stark contrast to the 1.5% increase in nonalcoholic beverages, 0.7% increase in sugar & sweets along with other foods.

Medical care prices increased 4.5%. Recent articles regarding the medical benefits prove as anecdotal evidence that consumers are shouldering a much larger increase in medical costs. Just last week, the Hay Group reported that its most recent survey of over 1,000 US companies found that medical premiums rose an average of 10.5% in 2004 and are expected to rise another 10% next year. A large portion of the costs are being shouldered by employees. To help keep health care premiums lower, employers are switching to higher deductible plans and increasing employee co-pays. Even as prices of doctor's visits and other medical services are rising faster than overall inflation, the true costs borne by consumers is likely escalating even faster.

An alternative hypothesis is that goods that have imported competition have not experienced as much inflation as those items that are only available from domestic sources. While not a perfect explanation, excluding energy prices, most of the items that experienced higher inflation were in categories that do not have much import competition. Of the food items listed above, protein and dairy products do not have a lot of imported competition. Obviously medical services do not either nor does education, which had a 7.2% increase. These compare to vehicles which fell 3.1%, apparel (-0.3%) and furniture (-0.7%). While, I've ignored discussing home prices due to the inadequate method used to calculate the housing component of the CPI, housing prices obviously do not face competition from imports and everyone should know what has happened to the price of housing by now.

There are some other reasons that help explain the differences in inflation. Restaurants for example, typically have long-term contracts with suppliers so their prices will generally lag increases seen in grocery stores.

On Monday, food distribution giant Sysco reported their second quarter earnings. With annual sales approaching $30B and a market capitalization of $20B, Sysco can safely be used as a litmus test for the health of the food distribution industry. The company reported second quarter earnings of $0.43 a share versus First Call consensus of $0.45, sending the stock down 7% for the day.

Two weeks ago, we noted that Performance Food Group, another food distributor, reported food inflation of 6%, lowering their real sales growth to 8% from nominal 14% growth reported in the most recent quarter. We also mentioned that grocery retailer Safeway had seen major increases in the cost of milk, cheese, eggs, and meat. Perhaps somewhat not surprisingly, Sysco management echoed that sentiment in their conference call this past week. Management commented that they saw total inflation in food costs of 8%, led by the usual suspects of meat, dairy, poultry, canned and dry goods. Furthermore, they commented that they expect dairy prices to moderate somewhat while "Meat prices, however, look like they will continue to stay high in the intermediate term future and inflation will also continue to impact other protein categories".

If we were to change gears and put ourselves in the place of one of Sysco's customers, such as a restaurant owner, we would have a different set of inflationary problems to be concerned with. Sysco has said that it is seeing that "Effects of prolonged inflation are beginning to take a toll on restaurant operators and customers' willingness to dine out". In fact, on the conference call Sysco said there are basically five alternatives for restaurants when food inflation of this magnitude is present.

• Buy product at a higher price, and pass price increase along to patrons

• Buy product at a higher price, and do not pass price increase along to patrons, which hurts restaurant gross margins

• Lower the quality standards or portion sizes

• Substitute product (change menu)

• Negotiate with distributor over pricing mark ups

It would appear that as long as food inflation of this magnitude continues, margins at both distributors and restaurants will feel pressure.

Last week, Brinker International, the corporation that manages Chili's, Romano's, Maggiano's, and On the Border restaurants, had some interesting comments regarding the performance of its restaurants. The stock was hit hard for 13% after the conference call when management revised its guidance for fiscal 2005. The company said that future sales would be lower than expected and costs would be higher than expected. The lower sales number could be a result of the consumer being more price conscious as menu prices increase. In the second quarter, Brinker took a 2.1% menu increase at its flagship Chili's restaurants. The company also stated that familiar promotions are no longer creating the traction that they once did. This comment speaks to either company specific problems at Chili's or an overall slowdown in restaurant traffic. Brinker closed 30 underperforming restaurants in the second quarter and also said that they will be aggressively pursuing new (probably less costly) food products.

We have discussed how higher steel prices and other raw materials are starting to cause manufactures to increase prices on their goods. There is also ample evidence that inflation is rearing its ugly head in other areas causing consumers to adjust their budget, even as the CPI has shown that inflation is tame. Lately, retail sales have been much weaker than during the first half of the year. While much of this weakness is caused by tough comparisons, it's likely that consumers' budgets are starting to get pinched.

Chad Hudson & Ryan Bend
Mid-Week Analysis
PrudentBear.com

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