Inside the Coffee Wars: McDonald's New Strategy to Take On Starbucks

McDonald's (NYSE: MCD  ) is hoping to poach coffee-drinking customers from Starbucks (NASDAQ: SBUX  ) , as the fast-food chain attempts to refresh slowing sales in the United States, McDonald's largest market. Increased competition and poor execution has burned McDonald's lately. The company reported fiscal fourth-quarter results last week that failed to impress, as same-store sales fell 1.4% in the U.S.

These challenges have also hurt McDonald's stock performance in the past year. Shares of the Golden Arches edged up just 10% in 2013, compared to a 25% gain in the broader market. Starbucks, on the other hand, has been firing on all cylinders. The java giant last week celebrated a record first quarter that included a 12% spike in quarterly sales for revenue of $4.5 billion. Unlike McDonald's, Starbucks said U.S. same-store sales grew 5% in the quarter, helped by increased foot traffic.

Given these results, it's not surprising that McDonald's wants to be more like Starbucks. That's why the world's largest restaurant chain is making a big bet on coffee beverages in the year ahead, with a new plan to boost market share in the $65 billion informal eating-out coffee category.

Ahead of the glass
There's a clear opportunity for McDonald's in the specialty beverage segment. In fact, the burger chain could see as much as $3 billion in incremental sales from this category, according to research from Morningstar. Not to mention, premium coffee drinks such as McDonald's McCafe Frappes pack higher profit margin than do burgers and fries. The company's McCafe concept has caught on in markets such as Australia and Europe, but continues to struggle in the U.S., where McDonald's franchisees have been reluctant to invest in pricey espresso machines and restaurant renovations.

Nevertheless, McDonald's is also following in Starbucks footsteps through a partnership with Kraft (NASDAQ: KRFT  ) to sell packaged McCafe coffee in U.S. grocery stores this year. If you remember, Starbucks had a similar agreement with Kraft that ended on a bitter note in 2010, after the coffee chain prematurely terminated a deal for distribution of Starbucks-branded products in grocery stores. As a result, Starbucks was recently charged with a $2.76 billion fine for its breakup with the pre-split Kraft Foods.

In an interview with Bloomberg last year, McDonald's CEO Don Thompson said, "By selling coffee in grocery stores and in other outlets, we're marketing the brand so a person is reminded to come into a McDonald's restaurant."

Brownie points
Yet as McDonald's tries to sell more customers on its McCafe offerings, Starbucks is offering more food options in a push to grab customers at other parts of the day, outside of breakfast.

The world's biggest coffee chain is putting its $100 million acquisition of bakery chain La Boulange to work at thousands of U.S. Starbucks locations. More than 3,000 Starbucks cafes now serve fresh La Boulange pastries, and the company plans to add sandwiches, salads, and soups to its nationwide rollout this year.

For Starbucks, adding more food items is a smart plan that should boost profitability at stores as they attract new customers from various dayparts. Meanwhile, the McDonald's strategy to go after Starbucks' customers may prove more challenging. Sure, a latte from McDonald's may save you $0.76 compared to the same latte from Starbucks. However, McDonald's average customer base isn't as accustomed to paying premium prices on beverages, while Starbucks drinkers hardly bat an eye when paying nearly $4 for a latte.

As a result, the burger-and-fries chain might have a harder time getting its customers to buy premium brews and McCafe smoothies. Nevertheless, selling its packaged coffee in grocery stores should help it build brand awareness around its McCafe products. But for now, Starbucks doesn't need to worry about McDonald's stealing its customers, as this isn't something that's going to happen overnight.

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