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A coffee war has been brewing for some time now between Starbucks (NASDAQ:SBUX) and McDonald's (NYSE:MCD). For years, Starbucks had the gourmet retail coffee market largely to itself. Sure enough, there were other large competitors such as Caribou Coffee (NASDAQ:CBOU) and Peet's Coffee & Tea (NASDAQ:PEET), but they didn't and don't possess the scale and cachet to eat into Starbucks' market share to any great degree. While McDonald's and other fast food establishments had always served coffee, it was merely a necessary menu item and certainly not a profit center.

Dunkin' Donuts is the obvious exception to this generality (along with 7-Eleven to a much lesser degree as it is a more direct competitor of Dunkin's transient and sporadic coffee customer), but it has always attracted a different demographic than Starbucks. Why do I make that statement? Because Dunkin' Donuts has been around since the 1950s and preceded Starbucks' existence by decades. Clearly, the two competitors played in different areas. And so it went for most of the 90s and the first few years of this decade. (The same analysis can also be applied to 7-Eleven.)

In the past few years, Starbucks finally awoke the sleeping giant. McDonald's, with at least 13,800 outlets in the U.S. and over 30,000 in the world,and continuing explosive growth in China and other areas of the globe, realized that Starbucks was not only eating into their coffee revenue but breakfast sales as Starbucks began selling more food items throughout the day, with an especially big push into the breakfast market.

After some fits and starts, McDonald's came out with a brand of speciality coffee drinks both hot and cold. And they tasted good and were cheaper than Starbucks' fare. McDonald's began to reverse the trend of market share declines and instead began to capture previous Starbucks loyalists. Starbucks' stock started a downward spiral exacerbated since 2007 coinciding with the overall economy. No longer was it affordable for many to spend $4 or more a day on their favorite Starbucks concoction.

Howard Schultz, Chairman of Starbucks and the mastermind of its phenomenal growth, took back the CEO reins in early 2008. He adopted a plan to ward off McDonald's and the economic malaise. While his leadership has reinvigorated Starbucks, his results to date have been mixed though he has seemed to stop the hemorraging to at least a slow bleed.

But in the midst of the McDonald's challenge and the economic crisis, a funny thing has come to pass. McDonald's and Starbucks have become stronger competitors of each other and many of the independent coffee shops and small chains have gone or are going by the wayside. For while Starbucks always threatened the independents' survival due to its size, scope and customer loyalty, the additional assault by McDonald's has proven too much. As a result, the fierce competition between Starbucks and McDonald's will actually benefit both of them in the future at the expense of many former coffee retail rivals.

Based on the above, I believe that the coffee market will be left with three behemoths, Starbucks, McDonald's and Dunkin' Donuts, all of which compete for a limited common target market, yet each of which appeals and will continue to appeal to its diehard demographic due to the difference in qualitative experience.

For example, according to Howard Schultz, Starbucks is what he refers to as the "Third Place". That place away from home and the office where people can relax and hang out, surf the internet and conduct business with laptop computer in tow. It is a place for high school and university students to study and socialize, for yuppies to mingle with each other and their young kids. This is a predominantly Starbucks demographic.

McDonald's sells good coffee but is not a particularly desirable or "cool" place to hang out or go "wireless" via computer or other gadgetry. It primarily appeals to people in a hurry who are looking for value. They are not lingerers. It is not a "so-called" Third Place like Starbucks.

And then there's Dunkin' Donuts which has rejuvenated its coffee product line but still appeals primarily to the more middle-class demographic that it has always had before and after the emergence of Starbucks and the coffee ascension of McDonald's. Its growth story largely remains intact and it serves many rural markets that are not economically feasible for Starbucks. For this reason, I believe that McDonald's is actually a greater threat to Dunkin' Donuts than Starbucks because they do compete for the rural demographic. Having said that, Dunkin' Donuts owns the late-night crowd. It is typically open 24 hours a day in most locations not just for drive-thru but for in-store service.

While Starbucks has some stores that fit within that category, they are few and far between and, at least to this point, only seem economically sensible in large urban markets with a large clientele nearby a particular location that garners traffic in the wee hours. Similarly, McDonald's serves most late-night customers via drive-thru as it also only has a relatively small number of in-store service late night outlets, especially in comparison to the percentage of its outstanding restaurants vís-a-vís Dunkin'.

In conclusion, the brutal competition particularly between Starbucks and McDonald's has made each one stronger in relation to the overall retail coffee market. The competitive landscape has reduced the number of smaller competitors which benefits both of them. And while they have some overlapping clientele, they each present a different qualitative experience with a strong and loyal following and that is unlikely to significantly change in the foreseeable future.

Positions: Long, SBUX; No Position: MCD, CBOU, PEET

Source: Starbucks vs. McDonald's: Filtering Through the Coffee Wars