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

A coffee war has been brewing for some time now between Starbucks (SBUX) and McDonald's (MCD). For years, Starbucks had the gourmet retail coffee market largely to itself. Sure enough, there were other large competitors such as Caribou Coffee (CBOU) and Peet's Coffee & Tea (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

Comments

[casey00001:]

Michael: I think you may have your locations swapped. You said.
"It is a place for high school and university students to study and socialize, " speaking of Starbucks. However any college kid I know isn't going to sink $5.00 from his weekend beer budget into a cup of coffee. McDonalds is way cheaper. McDonalds does have wireless and T-mobile hot spots have moved out of Starbucks and into McDonalds. What does that tell you?
Starbucks internet access is also expensive. The first one of these to realize that giving free internet access will sell a lot more product wins. Panera Bread does it already. Thats the play for Duncan Donuts free internet.

Jun 22 09:25 AM

[pelican:]

Starbucks is a quite popular overseas for high school and college students, such as Japan.

Jun 22 10:51 AM

[John Gordon:]

Author is making his point boosting SBUX, but is stretching a bit, and has left a few impressions garbled:

(1) McDonald's returned to its roots in 2002-2004 period and picked up sales momentum thereafter, but not solely due to its new coffee products worked in the 2007/2008 timeframe.

(2) McDonald's IS NOT a coffee shop. 80% of its sales are in the non-breakfast daypart, and coffee sales are just a small percentage of overall sales base (I'd estimate around 5% or so). SBUX, on the other hand, is considerably more coffee sales centric (70 % plus).

(3) Coffee is and was a profit center. The gross margin on a coffee beverage is perhaps 75% (or more). Coffee is a so called gateway product, which can lead to other meal situations and add on sales.


John A. Gordon
Pacific Management Consulting Group

Jun 22 05:21 PM

[Michael J. ...:]

I never meant to suggest that McDonald's revival was due to coffee sales. I don't think I said that. What I said is that McDonald's whole focus on the coffee market has changed. They weren't directly competing with SBUX is that past, but McDonald's current array of premium drinks is a different story. McDonald's exploiting a market largely developed by SBUX, but to McDonald's credit they came out with excellent products at compelling price points. Nevertheless, it does not have the cachet of SBUX and it is not a "Third Place".

Jun 22 09:44 PM

[Nate29001:]

Misconceptions:

1) SBUX Challenges Mom n Pop independents and pushes them out of business. 57% of coffee shops in the US are independent - That's actually a bigger market share, and it is a number that has grown quite rapidly since big green started their world domination tour of 1992.

2) "McDonald's sells good coffee" - No they don't. McDonald's sells McDonald's coffee dressed up to look like specialty coffee. It's still McDonald's. If one were to serve a Big Mac on fine china with nice flatware and some garnish, one would not have a "good cheese-burger", one would have a gussied up Big Mac. Same goes for coffee.

Jun 23 08:12 AM

[HKI:]

I don't get the point of this article. There are hardly any facts or analysis in here. Most are conjectures on the part of the author. For example, MCD and SBUX have become stronger competitors of each other and the smaller independents have fallen by the wayside. How did you arrive at this conclusion? Did a coffee shop in your town closed down? Or did the share of revenue of SBUX and MCD in a specific market actually went up based on a study?

Another example: "Starbucks was not only eating into their [MCD's] coffee revenue but breakfast sales". Where is the proof for this unsubstantiated statement? Maybe some type of customer profile or survey? Or is this just your conjecture that now that SBUX offers breakfast, MCD must be losing customers?

Jul 09 12:01 AM

[Michael J. ...:]

Katherine Glover has written a related article to this topic entitled: "Is Starbucks Good or Bad for Independent Coffee Shops?" citing my article at: industry.bnet.com/food.../

Nov 05 05:13 PM