Why the Fast Food Industry Needs to Avoid Another Price War

By Motley Fool Staff Markets Fool.com

The past year was tough for fast food companies, and 2017 does not look like it is going to be any easier.

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In this episode of Industry Focus: Consumer Goods,Vincent Shen is joined by Fool.com contributor Daniel Kline to talk about the state of competition in the quick service restaurant industry, as the leading franchises increasingly turn to discounting to win over customers.

But at what cost?

A full transcript follows the video.

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This video was recorded on Jan. 26, 2017.

Vincent Shen: In light of our main topic today, which is major trends that we're watching in the fast food industry, can you tell me, Dan, what was the last major fast food chain you dined with?

Dan Kline: Chipotle. I wanted to try the chorizo. I've heard complaints: People say it's dry. I think it's really good. It's tasty, it's different, it's a nice change of pace. I think the market -- and we'll talk about this a little with trends later on -- is poised to hate anything Chipotle does. If they came out and said, "It's four tacos for $5 and we give you a $10 bill when you finish," people would be like, "Ugh, it's costing me!" It just wouldn't work. So, I think they're making the right moves, and I have been a customer steadily, but they're in a lose-lose situation now.

Shen: Sure. And every time I go, maybe a couple times a month -- and I usually go for dinner, because there's one really close to my place, and I'm always watching the lines. Pre-food safety scandal, the line was always out the door around 7:00 p.m. or 7:30 p.m. Now, it's gradually building back up. It's a little promising, at least.

Kline: I think it's one of the problems they have. We're also going to talk about this later on the show. If you go to Chipotle, and there's three people in line in front of you, it could take 25 minutes. I think that has hurt them as much as the E. coli scandal. That, and every time they make an announcement, "Chipotle is going to do something new," I expect them to say, "We're going to melt the cheese," because it's more fun to bring Chipotle home and throw it in the microwave for eight seconds, and then it's not cold. Their entire model is built around giving you a cold taco, and you want a hot taco.

Shen: OK. First topic we'll touch on, for the fast food industry, discounting and some of the price wars. I know you've written about this. You think about the more traditional chains like McDonald'sand Burger King, and how people still approach that kind of restaurant with value in mind, and how the different companies are trying to capture that. What is the story here, and looking at the bigger picture, looking out at least a few years, how do you think this will change? Do you think it's only going to get worse, and margins are going to get tightened?

Kline: It's going to get worse. It's a tightrope. The number we talked about this morning is, McDonald's, since 2012 when it dropped the Dollar Menu, has lost 10% of its U.S. traffic. It has made up for that in charging more. The problem is, if your traffic keeps falling, you either have to keep raising prices or getting people to spend more, or, eventually, you're going to lose business. The tightrope that everybody is walking is, how do we have attractive values that bring in customers that are shopping value, or bring in someone who's pretty sure that's what they're going to get, and they add a shake and who knows what else to their meal?

And the way it's been working at every place except McDonald's, Wendy's and Burger King. They're doing those four or five items for $4 or $5 packages, where you get the burger, the fries, the chicken nuggets and the drink, for $4. The problem is, you're starting to see margin go down on those, because to be fresh, now Wendy's offers a double cheeseburger in theirs, and somebody else offers bacon on their cheeseburger. Every item you add, every little bit of beef or whatever it is you add in cost, you go from four chicken nuggets to five, takes an already losing proposition and makes it even worse. And it goes back to, these were originally limited versions of value. You couldn't buy one item and just spend $3 by picking and choosing, you had to buy the package. But it's a very tight line, where you and I want to go to lunch: I want to be cheap, you're willing to get the extra stuff, and we pick Burger King because I can spend $4 and you end up buying three Whoppers or whatever it is you get at Burger King.

Shen: Sure. It seems, as well, between these companies, there's always this issue of one-upsmanship with these packages. Somebody started with a four for $4, then it was a five for $4. Before you know it, I think, longer term, the way that I view it is, these fast food restaurants generally occupy the lower rungs of the price ladder. That's why people tend to like them -- the value there. These value-based offers like the McPick 2 or the four for $4, they can sometimes bring in new traffic. But if you really think about it, they ultimately reinforce the expectation that these companies and their menus will be very cheap.

Kline: The bigger success in the fast-food space has really been innovation. If you're Burger King and you can do a tie in, and have the Kit Kat Burger where the buns are both Kit Kats, or whatever ridiculous trend you come up with -- people will pay for that. So, as you go forward with this, the correct play is to do value sometimes. You want to during slow times to incentivize people, maybe times that they're out anyway, so say, "Yeah, we have 10 nuggets at Burger King for $1.49." When that becomes a permanent menu fixture, then people go and look, "Where can I get the cheapest cheeseburger?" And that's a very slippery slope that can end very badly, as it did for McDonald's for a lot of years.

Daniel Kline has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. The Motley Fool has a disclosure policy.