Starbucks (NASDAQ:SBUX) is the unquestionable leader in the coffee industry. Its high-quality brews and inviting store atmospheres command a premium from its affluent customer base. Competition from McDonald's (NYSE:MCD) and other entrants into the coffee space is putting pressure on Starbucks to justify its premium prices. However, Starbucks' near-perfect adaptation of the McDonald's model will enable it to fend off its rivals for years to come.
Starbucks improved the McDonald's model
McDonald's was a pioneer in the global restaurant chain concept; it took one store model and replicated it around the world. It built its brand by serving the same menu and providing the same quality of service at all of its locations. As a result, a McDonald's customer in New York can expect the same experience that he gets when he visits a McDonald's in London. The consistency and reliability of service has made McDonald's the world's largest -- and most profitable -- burger chain.
Starbucks unwittingly copied the McDonald's model and added a twist. Like local burger chains, local coffee houses are hit-or-miss in terms of quality; a busy professional would not know how quickly his or her beverage would be served or what it would taste like. Starbucks' baristas go through extensive training to ensure the service is uniform across all locations. This is a powerful advantage that draws people to Starbucks.
The twist comes from the product quality. McDonald's is decidedly low-end when the entire spectrum of restaurants is considered. Starbucks, on the other hand, has managed to grow into an international chain while still serving high-quality coffee. This allows it to charge a premium and earn high margins. Although the company does not break out profit margin by product, one coffee executive claims that a $7 ultra-premium Starbucks coffee costs the company only $1.30 to produce.
Premium quality attracts an affluent customer base -- and those who wish to join the affluent. Chinese customers pay even more than Americans for their Starbucks coffee; in China, Starbucks is seen as a status symbol, an indication of success. No matter where in the world you are, McDonald's is not a status symbol. Starbucks gets an edge because it is higher up the affluence chain, which enables it to charge a premium even if McDonald's were to make the same brew.
Of course, McDonald's could never replicate Starbucks' lineup of drinks. McDonald's has 20 different McCafe drinks, seven of which are smoothies or shakes. Starbucks' basic menu has dozens of coffee-based drinks and 87,000 possible combinations.
McDonald's cannot match the quality or variety of Starbucks' offerings any more than Starbucks can serve cheap fast-food at a 30% operating margin. Starbucks bought 545 million pounds of coffee in 2012. It has relationships with farmers all over the world and a global supply chain to deliver the ingredients efficiently. McDonald's has a similar supply chain to serve its 34,000 locations in 118 countries, but it will never command the premium that Starbucks earns on its coffee -- McDonald's is positioned in consumers' minds as a low-end value chain, while Starbucks is glorified as a high-end chain.
Starbucks generated nearly $3 billion in cash from operations during 2013. Because of its scale and premium brand image, Starbucks will undoubtedly generate more than $3 billion in 2023. How many other restaurant chains can have the same conviction?
The quality of Starbucks' coffee is not a competitive advantage; any local chain can serve coffee that is at least as good as Starbucks'. However, no other company can enter the place in consumers' minds reserved for consistently high-quality coffee served faster than a Happy Meal -- it is already occupied by Starbucks.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends McDonald's and Starbucks. The Motley Fool owns shares of McDonald's and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.