On the Front Lines of a Burger Skirmish

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As an occasional consumer of fast food, I was interested to read in the latest issue of QSR magazine (a trade publication for the "quick serve restaurant" industry) about a burger battle. McDonald's (NYSE: MCD) value menu has been popular for a while, with offerings including a double cheeseburger for a dollar. However, Wendy's (NYSE: WEN) has matched that recently, debuting a 99-cent double cheeseburger, while Burger King (NYSE: BKC) is testing one. So what's greasing up this battle of the burger?

One impetus is the recessionary environment. Consumers are feeling pinched, so value-oriented offerings in fast-food joints have begun to steal market share from casual-dining establishments such as Darden (NYSE: DRI), Brinker (NYSE: EAT), and Ruby Tuesday (NYSE: RT). The strategy has risks, though: If competing chains keep meeting and then beating each other's prices, their profitability might get squeezed. As QSR noted, the franchisees will suffer most, since the percentage of their take going to their parent company won't change, even though they're steering customers away from higher-margin items. And if the economy continues to slide, consumers may reduce their fast-food spending even more.

We can take lessons about price wars from other industries and other times. Back in 2006, for example, Intel and Advanced Micro Devices engaged in a price war over microprocessor pricing, hurting both companies' bottom lines. Airlines have long been a poorly performing industry, thanks to a host of factors, such as volatile fuel prices, weather interference, the cost of empty seats, and of course, price wars. Large-screen televisions are also the subject of intense price competition, with the likes of Best Buy and Costco using lower prices to compete for price-sensitive buyers.

Situations like these are clearly good news for consumers, at least in the short run. But they should serve as red flags for investors. Price wars can inflict great damage on a company's bottom line. For example, AMD's gross margin slipped from 50.5% in 2006 to 37.6% in 2007. This widened the company's loss to $3.3 billion in 2007, compared to a loss of $166 million the prior year. You can bet that lower prices had something to do with it.

Companies with pricing power should hold considerable appeal. When a company can raise prices while generating increased demand, it usually indicates a leadership position within the industry. But when a price war gets started, near-term profitability will take a hit and, ultimately, only one of the players will come out a winner.

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