Tuesday, 19 February 2008

The Bull Market That's Killing Domino's Pizza in the US

"We have no choice but to raise prices substantially," said Dick Bond last week...

Dick Bond is CEO of Tyson Foods. Tyson is the world's largest processor of chicken, beef, and pork. Corn is Tyson's largest expense. That's because chicken, beef, and pork are ultimately just different forms of processed corn with higher profit margins.

Right now, corn prices are at 12-year highs because of the U.S. government's drive to produce ethanol. And higher corn prices have led to higher wheat and soybean prices. Wheat is at an all-time high. Soybeans are at an all-time high. The most recent quarterly earnings at Tyson Foods declined 40% because of these high grain prices.

According to Bond, government mandates for corn-based ethanol drove up grain prices, which have cascaded through other agricultural markets. "Cooking oil, flour, and other feed ingredients are all on the rise," said Bond. "For the foreseeable future, consumers will pay more and more for food, especially protein."

Domino's Pizza is another company feeling cost pressure. Cheese makes up 50% of the cost of a pizza. Cheese prices jumped 15% in 2007. Flour prices are also rising strongly. Bread prices rose 7.5% last year. And according to Goldman Sachs, wheat stocks in the United States are the lowest they've been since 1948.

So far, Domino's has resisted raising the price of its pizza in the United States – it will raise prices in the United Kingdom – and is paying for it. In its most recent profit report, Domino's reported a 55% decline in earnings. By the end of 2007, Domino's share price had fallen 70% from its 52-week high.

Kraft owns brands like DiGiorno Pizza, Maxwell House, Oreo, Oscar Mayer, and Philadelphia Cream Cheese. Kellogg is America's largest cereal maker. Both companies reported fourth-quarter results two weeks ago. Kraft's earnings fell 6.3% compared to the same period last year. Kellogg's earnings declined 3% over the same period.

"The fourth quarter was one of the worst ever for food companies in terms of commodity costs," said Reuters, commenting on the announcements by Kellogg and Kraft.

I wrote to my farmland contact – a hog farmer in Sioux County, Iowa – to find out how higher prices had affected life in the Midwest.

"I don't think locals are manic about Ag yet," says Roger, "though land prices have tripled in the past five years."

Roger says many of the grain elevators near him are close to insolvency. Grain elevators buy grain from farmers and then hold it in storage until the customers show up.

To protect themselves from falling prices – while the grain is held in storage – they take short positions in the futures markets. Roger says these short positions can generate huge margin calls when crop prices rise... and destroy the profits at grain elevators. The average grain elevator in Iowa, he says, pays an extra $2 million per day when prices move up just half the daily limit allowed on the exchange.

I think this boom still has decades to run, even though the easy money is probably gone. The easiest way to play it is through the PowerShares DB Agriculture Fund. The symbol is DBA. This fund moves in line with corn, wheat, soybean, and sugar futures.

You should also expect higher bills at the checkout counter and in restaurants for many years to come...

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