Wednesday, October 3, 2007

Starbucks Greatest Threat

It really doesn't matter what management says at this point as their track record in the issue is spotty at best. It isn't rising coffee, dairy prices or the likely event that 1 billion Chinese tea drinkers will not instantly convert to coffee. It is a red headed guy in a funny suit.

McDonald's(MCD), after test marketing cappuccinos and iced coffee in various markets, is ready to begin rolling out a makeover of all its U.S. restaurants by 2009 to feature specialty beverages such as coffee drinks, smoothies, energy drinks, and other bottled beverages. It is estimated the move will result in an additional $1 billion in sales for the company.

Selling specialty drinks is the final piece of a vast beverage plan that has taken direct aim at Starbucks (SBUX). In the last few years, the two companies have tried to cut into each other's core businesses, with Starbucks thus far unsuccessfully adding breakfast sandwiches and McDonald's selling premium coffee. The strategy has worked for McDonald's, whose coffee sales have risen 15% since the upgrade last year and has spent the past year testing iced coffee, mochas and cappuccinos in various parts of the country.

In test markets including California, Georgia, Michigan and Texas, specialty coffee has increased customer traffic by 44% a week. Most importantly, the initial tests show the new plan doesn't require more employees or slow down service. This is again contrary to Starbucks sandwich results in which the additional was fraught with production problems and customer complaints of even further deterioration of service times.

McDonald's plans to equip 1,500 restaurants to sell the new drinks by the end of 2007, with the rest completed by late 2008. Specialty beverages such as lattes have much higher profit margins than sandwiches. Sales in this new beverage category could rise by 90% in the next five years.

The billion dollars a year in sales are not going to be created out of thin air. They are going to be at the expense of Starbucks and other coffee chains. Obviously it will not be a dollar for dollar offset, but for a company planning to grow 18% a year to have a 13,000 store behemoth selling your products for far more affordable prices, one has to wonder where that growth is going to come from?

One thing is for sure, don't look to management for a straight answer.

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