As real income levels in the emerging and developing economies begin to show slow sign of growth, income elastic goods, particularly food, are showing rapid signs of inflation. According to the IMF dinner index, the price of major grains, meats and edible oils has been readily increasing following the second half of 2010. Although farmers have been attempting to increase their yields in order to satisfy the extra demand, they have not been entirely successful in their efforts. This demand shock, without the required counter push in supply, has decreased the global-inventories-to-consumption ratio, which, coupled with adverse weather conditions in Australia, Pakistan, China and Argentina, has contributed to the rise in food inflation.

TUTORIAL: All About Inflation

Prices Continue to Rise
According to data compiled by the International Coffee Organization, average coffee prices have increased by 54% since the beginning of 2010. In anticipation of further price hikes, Brazil, the largest international coffee grower, is currently withholding inventories, thus further fueling the supply and demand imbalance. With surging commodity prices, corporations will typically pass on the additional costs to consumers within 18 months. McDonalds (NYSE:MCD), for example, where coffee represents 6% of total sales, recently announced that it may have to either introduce smaller portions or charge higher prices. Tim Hortons (NYSE:THI), Starbucks (NASDAQ:SBUX) and Second Cup, on the other hand, will face tighter margins in an effort to avoid raising their prices.

Tim Hortons
Tim Hortons utilizes forward currency contracts to hedge the foreign exchange risks associated with purchasing coffee from third parties and implements a purchase commitment strategy to fix coffee prices "for a minimum of six to 12 months, depending upon prevailing market conditions." Although commodity prices are partially mitigated, Tim Hortons typically passes on higher input costs to restaurant owners. Depending on the future prices of coffee, a steep realized contango market may eventually force consumers to face the burden of higher costs. Nonetheless, Tim Hortons expects same-store sales to increase by approximately 5% and EPS to reach $2.40 in fiscal 2011.

Despite coffee inflation, Starbucks reported record operating margins of 21.9% and 16.3% in American and International business segments, respectively. These results contributed to a 41% EPS increase, which was also heavily driven by comparable-store sales growth. Management stated that they expect "higher coffee costs to have a continued impact" on the business and provided guidance that commodity inflation will depress EPS by twenty cents. Nonetheless, the company expects 2011 earnings per share to increase by around 18% to the highest historical level. Starbucks has effectively hedged coffee, dairy and sugar prices to mitigate spot price volatility for the remainder of the year.

The Bottom Line
According to a report put out by the IMF, "over time, supply growth can be expected to respond to higher prices, as it has in previous decades, easing pressures on food markets, but this will take time counted in years rather than months." Although coffee chains and most restaurants are hedged against negative commodity movements in the short term, a continued upward input cost trend will either hurt future corporate margins or consumers' pockets. J.M. Smucker (NYSE:SJM) already announced a 10% price increase on coffee products, while Kraft (NYSE:KFT) raised coffee prices by 12%. As food inflation continues to surface, corporate managers and international policy-makers will be forced to confront the ongoing challenges. (So you've finally decided to start investing. But what should you put in your portfolio? Find out here. See How To Pick A Stock.)

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