Don't Underestimate Your Competition

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When a small company hears about a bigger competitor trying to take some of their business, they have to put on a brave face and pretend it doesn't bother them. This is what it seems like happened when the news hit that McDonald's (NYSE: MCD) was running a test market for their “Mighty Wings” at restaurants in the Chicago area.

Apparently McDonald's realized that chicken wings are extremely popular and wants to expand their menu once again. The response by smaller competitor Buffalo Wild Wings (NASDAQ: BWLD) was predictable -- they aren't worried. When you aren't worried about one of the largest restaurant companies in the world, you may have already lost the game.

In the article on MSN Money, the author said, “if Buffalo Wild Wings is worried about the decision of McDonald's to test market chicken wings, it sure isn't showing it.” The response from Kathy Benning of Buffalo Wild Wings sounded pleasant, as though the company welcomes the competition. She said, “it's no surprise that others want to tap into something we've known for years: people love wings.”

To say that people love wings is an understatement, because according to the same article, an “estimated 25 billion wing portions were sold last year.” Even at $0.50 per portion (a relatively cheap price), this represents over $12 billion in sales. For McDonald's, with over $27 billion in sales, this could be a significant market opportunity.

There are several reasons that Buffalo Wild Wings management should be shaking in their boots. First, McDonald's has morphed into a restaurant that sells everything from frappes to burgers to oatmeal. If the company sees chicken wings as a way to diversify their menu further, the company will roll this concept out to all of its restaurants. What Buffalo Wild Wings might not want to admit is, McDonald's can be both more efficient, and sell their wings more cheaply than Buffalo Wild Wings could. In addition, McDonald's might not be the only competitor to step on Buffalo Wild Wings' toes if this test is successful.

I could also see both YUM Brands (NYSE: YUM) through their KFC Chain, and maybe even Panera Bread (NASDAQ: PNRA) stepping into this arena. KFC naturally already sells chicken and wings, but the company could do more to diversify what they sell. While this might seem an unusual suggestion for a company like Panera Bread, the company has been willing to expand and diversify its menu before. A broader menu could draw in new business, and Panera operates close to many Buffalo Wild Wings locations already. The big reason that Buffalo Wild Wings should worry about these competitors is they each carry much higher gross margins, which would make a price competition a challenge for the smaller company.

Due in part to the fact that Buffalo Wild Wings has such a high connection to chicken costs, their gross margin recently was 23.78%. By comparison, YUM Brands sports a gross margin of 28.75%, McDonald's shows a margin of nearly 40%, and Panera Bread carries a gross margin north of 70%. One of the differences between these companies is, the larger three competitors all tend to franchise their restaurants and Buffalo Wild Wings tends to own more of its stores directly. Their competition also has a more diversified menu, which cuts down on their reliance on one input cost. This higher gross margin from their competition also leads to better free cash flow as well.

Buffalo Wild Wings is still rapidly expanding and naturally this leads to a lower level of free cash flow in the meantime. While their expansion is a good thing for investors, lower free cash flow means they would be hard pressed to match more established competitors if they engaged in a price war. Buffalo Wild Wings generates about $0.02 of free cash flow per dollar of sales, and even Panera Bread does slightly better at $0.03 of free cash flow using this same measure. By comparison, McDonald's and YUM Brands generate $0.17 of free cash flow per dollar of sales. Since both companies are constantly looking for new ways to grow, the addition of a big push around flavoured wings could represent a big opportunity. If you are an investor, you need to be keenly aware of this new threat and take it seriously.

New menu items usually generate positive results. McDonald's in particular seems poised to steal at least some of Buffalo Wild Wings customers. Since the “Golden Arches” already pays an over 3.3% yield and is expected to grow EPS by about 9%, any additional growth from new menu items is a positive. YUM Brands is positioned well with its KFC brand to expand their wing options, and if McDonald's successfully steps into this arena, YUM Brands will likely follow. Where Panera is concerned, the company is expected to grow EPS by over 13% in the next few years. For the stock to keep its momentum, the menu will certainly have to expand. When it comes to Buffalo Wild Wings, the company's growth story looks good, but less certain than before this news.

Buffalo Wild Wings' stock sells for about 21 times forward estimates, and analysts expect 20% EPS growth in the next few years. The stock appears fairly valued at the current time, and investors need to watch same-store sales carefully. If McDonald's or other entrants are beginning to erode Buffalo Wild Wings' base of customers, it would show up in same-store sales first. Since the company is so reliant on chicken wings, any diversification of their own menu would be a positive. I'm not suggesting that Buffalo Wild Wings is immediately in trouble, but a new entrant like McDonald's changes the competitive landscape. The company might not appear worried, but investors shouldn't make the same mistake.


MHenage owns shares of McDonald's. The Motley Fool recommends Buffalo Wild Wings, McDonald's, and Panera Bread. The Motley Fool owns shares of Buffalo Wild Wings, McDonald's, and Panera Bread. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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