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Starbucks vs. McDonald's: The Coffee War Begins to Percolate

February 01, 2008 | About:
Charles Mizrahi

Charles Mizrahi

19 followers

Several years after the Civil War, Union General William Tecumseh Sherman was delivering a speech to a graduating class of cadets. When he finished his speech and was about to leave the podium, he turned toward the cadets and said, “I tell you, war is hell.” In no way can one compare the death and destruction of war with their counterparts in business, yet war and business have much in common. The book Market Warfare, by advertising and marketing gurus Al Ries and Jack Trout, outlines different strategies that companies take to win market share. The authors borrow liberally from On War, a book written by Prussian military strategist Carl von Clausewitz in the 1830s.

Warren Buffett, too, sees that the business world engages in warfare. He has compared the competitive landscape of business with the weapons technology of the Middle Ages, saying, “I don’t want an easy business for competitors. I want a business with a moat around it. I want a very valuable castle in the middle, and then I want a duke who is in charge of that castle to be very honest, hardworking, and able. Then I want a moat around that castle.” [1]

For a business to succeed, it must have both a strategy and an enduring competitive advantage over its competitors. Most businesses fail in their first year, and only a small percentage are still around in five years, because they offer nothing to the marketplace that a competitor does not offer already. If a business does not have a competitive advantage or some type of “moat” around it, there is a very low chance that it will still be around in the years to come.

A Look Back

Do any of these companies–Midvale Steel & Ordnance, International Mercantile Marine, or Cambria Steel–ring a bell? I didn’t think so. Back in 1917, these three companies were considered among the best and strongest companies in the United States (ranked 8, 11, and 22 respectively by asset size). However, by 1923, Midvale Steel & Ordnance and Cambria Steel had been acquired, and International Mercantile Marine was dissolved in 1932. In fact, only 13 of today’s top 100 companies (ranked by asset size) were on the initial list in 1917. [2]

The business environment has not gotten easier since 1917; in fact, it became a heck of a lot harder for a company to stay on top. Looking at the top 100 companies ranked by assets in 1985, a little more than two decades ago, is even more of a revelation, as what were then household names have now been knocked off their perch. Sears Roebuck, the second-ranked company in 1985, is ranked 63rd in 2007; the 28th-ranked Eastman Kodak and 39th-ranked Westinghouse Electric and Manufacturing didn’t even rank in the top 100 in 2007. [3]

A company making the S&P 500 index list in the 1930s had a very good shot at staying on the list. On average, companies that made the index in the 1930s could expect to stay there approximately 65 years. The consulting firm McKinsey & Company estimates that by 2020, the average time a company will spend on the S&P 500 index will be only 10 years, due to attrition and mergers.

Staying power

There are several reasons why it is so hard for a company to stay on top. Many companies disappear simply because they were unable to change with the times, becoming dinosaurs in the face of rapid changes in technology. It appears that companies that constantly innovate and increase their “moats” are the ones to survive.

Recently, a competitor has been trying to breach the moat and attack the castle of a market leader. In the near future, I am quite confident that business students will be reading case studies on the battle between Starbucks and McDonald’s. This is a classic case of a castle with a wide moat coming under attack because the attacker believes it has caught the duke napping. Rather than get ahead of myself, let me give you a little background.

Commodity Becomes a Brand

In 1982, Starbucks had five retail stores and was selling coffee to restaurants in Seattle, Washington. It was during that year that Howard Schultz signed on to manage retail sales and marketing. After traveling to Italy, he convinced the owners of Starbucks to open a coffee bar. It was a huge success. He left Starbucks shortly after to start his own coffee bar and eventually acquired Starbucks’ retail operations for $4 million. One year after going public in 1992, Starbucks had 275 locations.

Today, Starbucks is the leading retailer and roaster of coffee in the world. There are nearly 7,000 Starbucks stores in the U.S. and almost 1,800 in international markets. In several zip codes in New York City, there is a Starbucks every 0.20 miles. Schultz’s genius is that he took a commodity (a cup of coffee), made it a brand, and was able to charge three times its market price. His vision was to make Starbucks serve as the “third place” people gather, between home and work.

The whole Starbucks experience–ordering the coffee, having the baristas prepare it in front of you, and then sitting down in an overstuffed chair to work on your laptop–is a competitive moat that has been difficult for competitors to breach. When comparing coffee retailers, there is Starbucks and there is…everyone else. For the past decade, Starbucks has grown by leaps and bounds. Other coffee retailers have tried to compete, such as Caribou Coffee and Peet’s Coffee & Tea, but they pale in comparison to Starbucks.

As the company’s expansion swept the U.S., Starbucks also began adding drive-through window service and selling breakfast sandwiches. By doing this, Starbucks encroached on another company’s territory, and it was only a matter of time before “war” would be declared.

 

Attack of the Clown

After going through several rough years, McDonald’s Corp. began turning things around. Now in the sixth year of this turnaround, the company is more responsive to its customers and to the marketplace and has become more profitable. Before attacking Starbucks head-on, McDonald’s scoped out the marketplace, saw what needed to be done, and then began executing.

In 2003, McDonald’s initiated a turnaround strategy called “Plan to Win.” The company slowly began remodeling its stores, moving from molded plastic booths and bright colors toward oversized chairs and softer lighting and colors, and even installed wireless Internet. In 2005, McDonald’s began taste testing its coffee and received positive feedback from people who sampled it. One year later, the coffee was changed to a stronger blend and marketed in McDonald’s stores as premium roast. And in February 2007, Consumer Reports magazine rated McDonald’s drip coffee as better testing than Starbucks’.

In a page out of Starbucks’ playbook, McDonald’s moved its espresso coffee machines to the front counter and added more “theater” to the process of ordering coffee. The company plans to roll out coffee bars with similar-tasting beverages, served by baristas, at lower prices, to its 14,000 U.S. stores in 2008.

Starbucks Slips

Starbucks’ moat had done a very good job of keeping competitors from attacking the castle. But over the past few years, Starbucks has slipped up just enough to allow McDonald’s to feel confident that it could take on this coffee giant. Starbucks was able to take a cup of coffee, dress it up with great atmosphere, and charge a much higher price than anyone had previously dared. But when the company installed drive-through windows, which now make up 80 percent of purchases, it lost the atmosphere premium. What was once a simple ordering process now became slower and more complex when breakfast and lunch sandwiches were added. Starbucks’ drive-in windows and breakfast sandwiches started to get that “fast food” feel.

Starbucks is not taking the McDonald’s threat lightly. Chairman Howard Schultz became more active, took the title of CEO, and already has made some changes. He wants to bring back the “romance” and “theater” that Starbucks once provided. In addition, Starbucks plans to reduce the number of promotions and items it offers and to focus on consistency of operations among all store employees. In other words, Starbucks is going back to basics and trying to turn specialty coffee from the commodity item it had become to the branded item it once was.

McDonald’s challenges

It is too early for McDonald’s to call its attack a victory. In fact, it may appear that this attack has awoken the slumbering giant. McDonald’s will need to get over several formidable hurdles before it becomes a more real threat. Because McDonald’s is a franchise system, it is optional for franchise owners to create coffee bars in their stores; most haven’t made the investment. Inconsistency is one area in which Starbucks has more control, since its stores are company-owned.

McDonald’s is going to find it hard to change the public’s perception of it from a kid-friendly fast-food restaurant to a third home for people between home and work. How successful will the company be in cross-selling a customer that just a dollar meal –a $3 latte?

Conclusion

While watching the coffee war take place, you should keep in mind that the value of a company is not all in the numbers. Every day in every industry, companies must be able to continue widening their moats and defending themselves or else their intrinsic value will eventually erode. Weaknesses are exploited, strategies are drawn up, and war is fought for territory–which, in business, is market share.

At the early stages of this conflict, I would wager that Starbucks has the advantage. Many great companies with strong brands–such as Coca-Cola, American Express, and even McDonald’s–have regrouped, got back to basics, and gone on to increase value for their shareholders.

Over the past year, Starbucks’ stock price has fallen nearly 50 percent. Mr. Market has priced in the worst-case scenario for Starbucks and is discounting its market dominance, competitive advantages, and strong brand. A stock price of $19 or less should provide investors with an adequate margin of safety. This is based on the assumption that Starbucks can grow earnings by 16 percent per year over the next five years (a drop of 36 percent from their past five-year average EPS of 25 percent) and trade at a P/E of 18. I have found the most profitable investments to be in buying a company with a wounded brand at a discount to its underlying value.

References:

  1. Buffett Talk to MBA Students at Florida University 1998
  2. The Leuthold Group, “Are Google & Cisco Forever?…No Growth Is Permanent,” September 2007
  3. Ibid.

About the author:

Charles Mizrahi
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 4.2/5 (26 votes)

Comments

kfh227
Kfh227 premium member - 6 years ago
I think Starbucks coffee is garbage.

I've seen a McCafe on the Mass highway already. Talk about location that will help build consumer awareness!

As for starbucks, I once went to a Panera bread company and next door, out the window from where we were eating was a Starbucks. I kinda laughed and explained barrier to entry to my wife. She totalyl got it, eve though I think she just smiled and nodded for hte most part. I wouldn't invest in Starbuks for one reason. What does it take for a competitor to enter the market place? It takes one person that is a coffee expert that can get a loan to start a business. And he could open up shop right next door. That is all it takes.

With McDonalds, it is a very similar problem. But more like Cokes problem. Anyone can easily make a can of soda. What is tough is building a brand. And that is McDonalds crowning achievement.
wmichel
Wmichel - 6 years ago
These 2 companies serve 2 different crowds: One is a fast food company with a family orientation (Mikky) and the other one is for students, professionals, aspiring professionals eager to meet and network. Some of these poeple need their coffee on the go too. I'd say , in exchange for people using their real estate for meeting, Starbucks charges a higher price. Depending on location, McCafe will definitely take customers away from Starbucks. Then again it's 2 different types of crowds. There's enough room for 2 players.
buffetteer17
Buffetteer17 premium member - 6 years ago
A lot of discussion and there is one little thing that has not been mentioned at all. The quality of the coffee.

Maybe that is not such a little thing. It is a big thing to a dedicated coffee addict like me. Starbucks buys high quality green beans, roasts them, and brews the coffee. The green beans are stable and can be stored for many months. After roasting the quality deteriorates rapidly; after about two weeks, most of the subtle flavors and odors have dissipated. Grinding the roasted beans exposes more surface area and the degrading process goes much faster. Starbucks with their fast turnover of beans, pretty much stays within the two week window between roasting and serving, and of course they don't grind the coffee until just before it is served. Lately I've noticed from the taste that sometimes the roasted beans have been stored too long.

Unfortunately for Starbucks there is no real moat for coffee quality. There is no secret. The high quality green beans are available in bulk for around $3-4/lb. Coffee roasting ovens and grinders are pretty much commodities. On the other hand, doing things right does cost money and because everything involved is commoditized, the only way to make a cheaper cup of coffee is to sacrifice quality. That is exactly what MacDonalds and other low-priced venues have done, and it shows in the taste. I haven't tried a MacDonalds coffee bar yet. If they are doing what it takes to keep up the quality, they will have to charge a pretty high price to make a profit. I'll happily pay if the quality is there.

Mostly I do it myself. I buy the green beans and roast them myself about once a week. For most people this is too much trouble.
madbulk
Madbulk - 6 years ago
This is a blip on the screen for both companies. And I'm hoping for a lower greedier entry point on sbux. Sbux is selling COOL, much in the way Apple is. That's the moat. I wouldn't be seen walking down the street with a McD coffee cup. I wear my Sbux cup like it's a nice wristwatch. Pervades the whole experience. That's how we got here. And McD isn't affecting that in the least.

wwsmead
Wwsmead - 6 years ago
Did you all buy Wrigley in 1911 when it was a 20-year old public compamy and people thought it had saturated the market?
DaveinHackensack
DaveinHackensack - 6 years ago
A little over a year ago I went to Buenos Aires on vacation and stopped in a McDonald's downtown that had a coffee bar in it. This was a large McDonald's, with the fast food counter about 100 feet in from the street entrance, and the coffee bar area was closer to the street entrance. That area was very un-McDonald's-looking: it had wood floors, earth-tones, classy-looking tables and chairs, and a fancy glass pastry case featuring desserts like tiramisu, that were served on real plates. The only McDonald's-like aspect of the experience was that when I ordered an espresso, the cookie served with it gratis was popped out of an individual plastic wrapper by the barista.

I don't know how common those sorts of coffee bars are in international McDonald's restaurants, but McDonald's has done a great job of expanding into emerging markets like China and Russia. Conceivably, those sorts of coffee bars could compete with Starbucks overseas, particularly where both Starbucks and McDonald's represent an 'exotic' American experience. I don't know.

I do know that I am bullish about Howard Schulz. I don't own stock in either company though.
madbulk
Madbulk - 6 years ago
I just learned of a McCafe in my area. Gonna check it out for y'all today. Maybe.
kfh227
Kfh227 premium member - 6 years ago
madbulk Wrote:

-------------------------------------------------------

> I just learned of a McCafe in my area. Gonna check

> it out for y'all today. Maybe.

There is one in Montreal that is awesome. The one on the highway I saw didn't look impressive at all but it did catch my attention.
John Krantz
John Krantz - 6 years ago
Starbucks is a company that should be on everybodies radar, imo. If they continue to struggle a little during the upcoming recession this is a great brand that could sink to absurdly low levels. Their problems of store cannabilization and brand dilution are recognized and completely fixable in my opinion. There is a lot of room for a lot of growth too. I think this stock could get a lot lower this year but its definately on my radar.
dude
Dude - 6 years ago
Starbucks will eat McDonalds alive in the pure coffee space but McDonalds is clearly after a less sophisticated market here. Starbucks concentrates on a focussed brand and experience that represents a massive "moat" (to use the oft used word) that allows it to charge a premium, avoid discounting and promotions and yet still increase store numbers and sales. As to whether its product is better than others, trust the numbers rather than your own tastes. The 20 million people it serves per week can't be wrong. Overseas it is opening new stores and increasing sales, which can only mean that humans generally (not just Americans) enjoy the product. After all, apparently Pepsi beats Coke in taste tests.
expectingrain
Expectingrain - 6 years ago
The whole Starbucks vs. McDonalds thing seems like a stretch to me. I go to Starbucks every Saturday morning to read my Barron's, not for the coffee (I order Tazo Tea) but to get out of my house for a little while. I really can't see going to McDs for the same experience. McDs is more convenience/necessity while Starbucks is more experience related.
valuemodel
Valuemodel - 6 years ago
Mr. Mizrahi, that was a beautifully written piece, and I think you are very right about the numbers not telling the whole story. I will not let my personal biases interfere (Starbucks is not as good as the Indonesian or South American coffee I grind at home every day), because on occasion, I am that person with a computer in an overstuffed chair at Starbucks, and it is equally or more about atmosphere (and hopefully, jazz playing in the background.)

Before I commit to SBUX, I'd like to find out the ROC trends, have an accurate idea of future capex (my impression is that market is VERY saturated: I can choose from two Starbucks within a mile of my home, not including the Starbucks in the Safeway, also within a mile.) If ROC is going to continue to decline, then I have to be careful about what I pay for SBUX.

The simplistic view, which I think a lot of people have, is to buy and trade SBUX for a 10-15% move. Longer-term, the fundamentals and corporate strategy, will matter. I am not so sure that SBUX can indeed grow at 16% over the next few years, because among other things, they are floating the idea of retaliating to MacDonald's by introducing a $1.00 cup of coffee. That doesn't seem to me to be the wisest response, or even indicative of a solid understanding of where their own strengths lie.

Dave in H., I've been to a MacDonald's in Rome (the kids got their say of where to eat one day), and it was also molto elegante. Maybe they should go more upscale here?
sonymordechai
Sonymordechai premium member - 6 years ago
I dont like coffee, but I love Starbucks overall! The enviroment is very friendly and the quality of food healthy / good enough... with the exception of Romania all other places I have visited, Starbucks is consistenly good enough. Especially in London, they are great.
kfh227
Kfh227 premium member - 6 years ago
Seems like there are alot of coffeee fans here. Well, remember one thing. Most people could care less for taste and if they can get coffee for half price or better by going to McDonalds, they will.

I drink "burnt" coffee on occasion and I do not care. The 25 cetns I pay to the coffee mess for each cup at work is well worth it when i get 12 ounces of caffinated delight.
jsterling
Jsterling - 6 years ago
After dinner last night my date suggested we go for coffee at Starbucks. I wonder what she would have thought if I had suggested McDonalds instead.

onewisp
Onewisp - 6 years ago
I think McD has the advantage here. McD has great locations in almost every cities in US and outside US. SBUX has some too but compare to McD's stores, it's still small.

Right now it's McD attacking SBUX's moat. McD can open up smaller sexier stores that only serve coffees and some burgers. I doubt SBUX can do the same to attack McD's moat.

In the future, probably McD is going to start offering wireless connection and market it to different market segment. At that time, SBUX probably has no advantage at all.
pigsgetrich
Pigsgetrich - 6 years ago
The problem with McDonald's as compared to Starbucks is like Jsterling implies - the ambiance around the business is much more conducive for social interaction. This is exactly what makes the Starbucks brand so good.

However, anyone that can take away from that business (piece by piece) will severely hinder SBUX bottom line.

Plus, with the current valuation, is it worth the price you have to pay? Will their earnings continue to increase for the next decade as they did in the last decade? Is the stock at the bottom or is it a falling knife?!

fk
Fk - 6 years ago
I've noticed starbucks has a presence at our local Safeway supermarket. They have a little section with couch, comfy chairs and coffee table, and free wireless internet. But being in a safeway, with food shopping traffic nonstop just destroys any ambiance they had, and in my mind it devalues their image.

Starbucks and bookstores works well, wells fargo and safeway works well, but starbucks and safeway, I don't think so.

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