Dont’ Forget Starbucks in the Breakfast War

Lately, the focus has been on Taco Bell's new breakfast menu and what it means for rival McDonald's (NYSE: MCD  ) . While Taco Bell, a division of Yum! Brands (NYSE: YUM  ) , is mounting an aggressive challenge, particularly with its waffle taco,  the company McDonald's needs to worry about most is Starbucks (NASDAQ: SBUX  ) .

A high-end McDonald's
While most people think of coffee when they hear Starbucks, the Seattle-based company has been quietly building its sandwich and pastry menu. McDonald's may have the Egg McMuffin and Taco Bell the waffle taco, but Starbucks offers eight premiere breakfast sandwiches.

On the breakfast menu at Starbucks, you'll find sandwiches with slow-roasted ham and Swiss cheese, vegetables and Fontiago cheese, eggs and cheddar, sausage and cheddar, bacon and Gouda, and ham and cheddar; for less than 300 calories, you can get a turkey bacon sandwich and a spinach and feta cheese wrap.

It's this menu variation that strikes at the heart of McDonald's executives. For as hard as McDonald's has tried to offer premier sandwiches, the company just cannot shake its dollar-menu image. McDonald's is known for its value, whereas Starbucks is known for quality...but at a higher price point. The good news for Starbucks and its shareholders is that customers are willing to pay.

Bringing back the lemon cake
One area where Starbucks slipped was in going too high-end with its purchase of bakery La Boulange.  Starbucks replaced many of its pastries with items from the La Boulange menu. Even though the pastries from La Boulange were healthier, the portions were smaller.

It turns out that many customers preferred the previous pastry items, including its famous lemon cake, which the company took off the menu. Starbucks will now resume selling the lemon cake along with banana and pumpkin loaf, which was taken off the menu as well to make room for the La Boulange pastries.

Menu selection is critical
For all three companies, getting the menu selection right is critical. These days, coffee-goers can grab a cup of coffee anywhere. While we all have our favorites, it's the other menu items that have higher margins for the restaurant companies. McDonald's knows this and is offering its first-ever free cup of McCafe coffee during breakfast hours nationwide.

The challenge for Starbucks is that its coffee is pricier than other chains, and better menu items are supposed to come with higher prices. However, Starbucks must offer fancier fare than a McDonald's or Taco Bell without going too far and becoming too costly. That's what appears to have happened when Starbucks added the La Boulange pastries. Now that the company is going back to its old fare, albeit in combination with La Boulange recipes, the company is hoping to get it right and appease its loyal customers.

For Starbucks, the food menu is turning out to be a growth area. Food-related sales accounted for 20% of all sales at the average Starbucks company-owned store last year. This is up from 19% two years ago.

It's still all about the coffee
One edge that Starbucks has is with its coffee. McDonald's has been trying to catch up and be more like Starbucks ever since it launched its McCafe line in 2009. This is one area where both McDonald's and Starbucks have an edge over Taco Bell. Taco Bell serves coffee but does not offer a premium blend.

Starbucks always seems to find the finest coffee blends for customers to stay one step ahead of its competition. Through April 14, Starbucks is selling coffee that is grown on what was once King Kamehameha's royal land in Hawaii. This coffee is meticulously grown and is considered one of the finest coffee blends in the world.

How do shares look?
For investors, McDonald's shares are like the dollar menu -- they offer the best value. Shares trade at only 15 times next year's earnings. McDonald's also offers the highest dividend yield at 3.3%. Next comes Yum! Brands, trading at 18 times next year's earnings. It has a yield of 2%. Starbucks is the most expensive and trades at 23 times next year's earnings with a yield of 1.4%.

Foolish assessment
While Starbucks shares may be pricier than McDonald's and Yum! Brands, I think the specialty coffee company offers great potential for investors. Over the next five years, Goldman Sachs forecasts Starbucks to grow to 30,000 locations, up from 20,000 locations today. Globally, there is strong demand for coffee, and I see Starbucks as the company poised to benefit the most.

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