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Wheat Costs Chains Some Serious Bread

Tight supply has driven up wheat prices, giving a likely hit to restaurant chains.

It could be time to take some bread off the restaurant table.

Soaring prices for wheat and other commodities that go into making bread, tortillas and baked goods will likely start hurting profits at casual dining eateries. And that comes on top of elevated prices for other commodities.

"If you are any one of the major restaurant chains, your costs of buns, bread and other breakfast items is going to rise," says Georges Yared, chief investment strategist at Minneapolis-based Yared Investment Research. "

Papa John's

(PZZA) - Get Report

,

Starbucks

(SBUX) - Get Report

and

McDonald's

(MCD) - Get Report

, are the obvious ones."

Yared also adds to the group

Chipotle Mexican Grill

(CMG) - Get Report

, which he believes could provide a good shorting opportunity.

"If the commodity pricing environment remains high and stays high, I think you are taking the potential froth from any of these stocks," he says.

Other companies are already feeling the pinch.

Sara Lee

(SLE)

last week announced that it would be raising the suggested retail prices of baked goods by 5% because of the elevated costs of wheat.

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The news comes hot on the heels of another 5% price hike in April. Mark Goldman, a spokesman for Sara Lee in suburban Chicago, says the firm says it has tried to be conservative with past and current price increases.

And there is plenty of good reason to believe the price strength in wheat won't be disappearing anytime soon, because the supply/demand balance is keeping the market particularly tight.

"We are at a 30-year low on wheat inventories," explains Mike Woolverton, a grains economist at Kansas State University in Manhattan, Kan. "Demand for wheat has been increasing around the world as countries develop."

At the same time, the major producing areas in the world have had poorer than usual harvests, he adds.

As a result, futures prices for the grain have skyrocketed to record levels of over $9 a bushel earlier in the month. Recently they have pulled back to around $8.69, but that's still more than double the long-term average, which Woolverton estimates at around $3.50 a bushel.

And it doesn't look like it's a temporary spike. Although the higher prices generally lead to increased production, the Northern Hemisphere won't be able to add to the supply until the new harvest starts next May.

"Pretty much the wheat on hand is what is going to sustain us until then," explains Woolverton. And that will mean prices well above normal.

It may be welcome news on the farm, but it's not going to be much fun for restaurant chains, especially those which target the budget-conscious. While the impact on the price of bread alone might not have been too much to swallow, it comes at a time when other restaurant costs -- including other food items and energy -- are rising also. And on top of that, consumers are feeling a dent in the pocketbook from higher gasoline prices.

"The real question is, how much pricing power are the restaurants going to have?" says Alan Gayle, senior investment strategist at Trusco Capital Management in Richmond, Va.

Likely, not much.

Pricing power refers to the ability of a company to raise the amount it charges consumers without seeing a reduction in its volume of business.

Firms facing increases in costs face the choice of raising prices charged to consumers or watching their profit margins get squeezed, with the likely outcome being a combination of the two. Either way, with a softer economy, the profits are likely going to come under pressure.

The employees could also feel the pain, as some diners will undoubtedly choose to leave lower tips to partially offset the rising tab.

For those reasons, YIR's Yared says the sustained high costs of commodities will, at a bare minimum, take the sizzle out of any chance at upside surprises.

As an example, he points to analysts' 53-cents-a-share consensus earnings estimate for Chipotle in the current quarter.

"If Chipotle was going to hit 54 cents or 55 cents, does that extra penny or two become unavailable because of higher costs?" he posits.

Chipotle spokesman Chris Arnold doesn't see a problem. "This year has certainly been a difficult year compared with last year, but we've done a really good job at managing those higher costs with higher revenue," he retorts.

But a good job may still fall short of expectations, says Yared, because the bigger problem with Chipotle is that it's priced to perfection. Investors also seem to have become accustomed to the chain's stellar performance.

For that reason, he believes Chipotle -- unlike other stocks he mentioned -- is a shorting opportunity. Whereas it may suffice to simply lighten holdings in other restaurant stocks, Yared has a downside stock price target for Chipotle over the next couple of months in the low to mid-$80s, vs. the current $109.

A spokesperson for Starbucks declined to make any projections about future price increases, although the company did already put through an increase in beverage prices at the end of July.

McDonald's also indicated that it wouldn't comment on commodity price moves. Papa John's could not be reached for comment.