The fast-food industry has a dollar-menu addiction, one that's very bad for margins but almost impossible to give up because of how it juices sales.
So, don't be surprised if Wendy's (WEN +0.58%) change to its value menu leads to a drop-off in revenue in the very near future. Worries about profit margins forced the chain to raise prices. But, as we've seen recently, messing with the dollar menu can be very bad for a fast-food chain's top-line results.
Wendy's said last week it was changing its value-menu offerings because selling stuff for only 99 cents was a money-loser amid rising costs for things like chicken, beef and cheese.
The fast-food chain known for square burgers and Frosty shakes is dumping its 99 cents value menu and launching a campaign called "Right Price Right Size," where items will range from 99 cents all the way up to $1.99.
That's all well and good for margins, but if McDonald's (MCD +0.42%) recent experience is any guide, the price hike will punish sales none too soon.
Recall that back in October, McDonald's, the Dow component and world's biggest fast-food chain, posted its first monthly sales decline in nine years, largely because it futzed around with its own dollar menu.
The company blamed the shocking drop on pushing its so-called "Extra Value Menu" -- that is, trying to sell items priced higher than a dollar. McDonald's immediately reversed course, doubled-down on actual dollar-menu offerings and -- voila -- sales bounced back strongly the very next month.
Unfortunately for all concerned, the big players really have no choice but to have value-menu offerings. True, those foods may have little or no margin attached, but they pull traffic into restaurants, and then customers often buy other, more profitable items along with the 99-cent stuff.
Consumers, meanwhile, are as cost-conscious as they've ever been, meaning that if one chain has a dollar menu, all the others have to follow suit.
Competition among the fast-food companies has probably never been more intense. After all, they have never in their histories faced an economy this weak for this long or unemployment this high for this long. At the same time, the old-line outfits also face an onslaught from higher-quality upstarts like Chipotle Mexican Grill (CMG +1.26%).
That puts Wendy's, in particular, in a very difficult position. It simply has to offer margin-killing value-menu items to keep customers coming in the doors, but at the same time it has almost no margin or profitability to speak off.
After all, Wendy's is coming off of two consecutive quarters of net losses, meaning it has a negative net profit margin. And there's little wonder how that came to pass, given how its profitability teeters on a very thin edge at the operational level. Indeed, the company's operating margin stands at just 6.6%.
McDonald's, by comparison, has an operating margin of 30% and a net profit margin of nearly 20%. Even struggling Burger King (BKW -1.83%) has operating margins in excess of 20% and a net of more than 4%. Yum Brands (YUM -2.75%), which owns Pizza Hut, KFC and Taco Bell, falls in the middle, with operating and net margins of 16% and 12%, respectively.
So, as an unprofitable chain with razor-thin margins, it seems Wendy's had no choice but to raise prices on its value menu. And the market certainly appeared to like the move, sending shares up more than 1% on the news.
But that reaction may be short-sighted and short-lived.
Wendy's revenue was forecast to grow just 3% to 4% in upcoming quarters. The company has almost no room for error in its margins -- but then it doesn't have much breathing space when it comes to top-line results, either.