American Coffee Shops Are Far Out in the Far East

Have you ever traveled on a city bus in South Korea? If the answer happens to be yes, then you might have enjoyed the strong scent of Dunkin' Donuts while en route to your destination.

No, Dunkin' Donuts hasn't opened tiny stores on city buses in South Korea. However, it does use machines to spray its coffee scent on city buses, and many of those buses happen to stop near Dunkin' Donuts restaurants.

This is only one of many ways in which Dunkin' Brands (NASDAQ: DNKN  ) is establishing its presence in a country where coffee is now so popular -- having surpassed the popularity of tea -- that the government has considered limiting the amount of coffee shops allowed to be in operation. But it gets even more interesting.

Source: dunkindonuts.co.kr

Caffeine crush
South Korean consumers have a crush on caffeine right now. Since most Koreans live with their families, regardless of their age, visiting a coffee shop like Dunkin' Donuts provides more than one benefit. The most obvious benefit is caffeine consumption, which leads to increased alertness and more energy. Caffeine is also mildly addictive, which likely plays a significant role in the demand for coffee in any country. The second benefit is that meeting friends at the coffee shop is a way out of the house for a few hours.

Yes, "a few hours." Dunkin' Donuts in South Korea is nothing like Dunkin' Donuts in the United States. In South Korea, customers visit primarily in the late afternoon and at night, and they stay for a few hours. Going to get coffee is a social event that people enjoy after work, whereas in the United States, most people visit Dunkin' Donuts for a few minutes to retrieve their morning coffee.

Due to this difference in consumer habits, Dunkin' Donuts restaurants in South Korea don't have drive-thrus. Another difference is that South Korean consumers are allowed to remove the doughnuts from the shelves themselves, which Dunkin' Donuts says increases the likelihood of customers taking more than one. 

"This message will self-destruct..."
No, this doesn't pertain to the article you're reading. It pertains to a digital coupon Dunkin' Donuts is sending to Korean consumers via its new app, which states that the coupon must be cashed in within three hours or it will digitally "explode" and be worthless. Now that's what you call creative marketing.

If you're wondering about the role of Starbucks (NASDAQ: SBUX  ) in South Korea, you might be surprised.

Source: istarbucks.co.kr

A different atmosphere
Starbucks is an amazing company that continues to find ways to innovate and locate its stores strategically in order to drive growth, but in South Korea, the party is at Dunkin' Donuts.

If you walk into a Dunkin' Donuts restaurant in Seoul in the late afternoon or evening, you'll likely find scores of young people socializing, providing the restaurant with an enjoyable buzz. If you walk into a Starbucks restaurant in Seoul, you'll likely find an older, wealthier, and quieter crowd enjoying the soothing music in the background.

Dunkin' Donuts might be the hip American coffee shop in South Korea, and this is currently the company's largest international market, but the real future growth potential for Dunkin' Donuts and Starbucks is found in China.

A race to the Chinese consumer
Prior to looking at future potential for Dunkin' Donuts and Starbucks in China, let's first take a look at the performance of an established American brand in China that serves coffee: McDonald's (NYSE: MCD  ) .

McDonald's has just shy of 2,000 locations in China. For fiscal-year 2013, comps slid 3.6% in China. However, this was primarily due to customer fear surrounding the avian flu, not customer dissatisfaction. 

McDonald's plans on innovating to help drive growth in its entire APMEA segment, with increased menu variety, convenience, and affordability. But considering China doubled its imports of coffee since 2010, and since barista academies are beginning to open up there, McDonald's might want to focus on coffee. South Korea's population is just 50 million, whereas China has a population of 1.4 billion. If a caffeine crush took place in China, it would lead to substantial opportunity.

Dunkin' Donuts only has 50 locations in China right now, with plans to open 100 more during the next five years. While Dunkin' Brands is an exceptional growth story thanks to westward domestic expansion, it doesn't have a large enough Chinese presence to make a real impact. It's going to be well behind Starbucks, which plans on having 1,000 locations in China by the end of the year. So far, it's going very well for Starbucks in China; the company has delivered an 8% year-over-year comps growth in the China/Asia-Pacific segment in the first quarter of fiscal year 2014.

So... what should we make of all this?

The Foolish bottom line
Thanks to its superstar presence in South Korea, Dunkin' Donuts has proven that it's capable of catering to local demands via menu offerings and store innovations. On the other hand, Starbucks has established a larger presence where the real growth potential exists, which is in China. Furthermore, Starbucks might have an advantage over McDonald's because McDonald's is already perceived as a dining establishment in China, as opposed to a coffee shop. Thanks to enormous cash flow and marketing power, McDonald's has the potential to turn this around, but if you're looking for the most growth potential in coffee in the Chinese market during the next few years, then it's likely to be Starbucks.

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