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McDonald's Takes On A Weakened Starbucks - WSJ.com http://online.wsj.com/article_print/SB119967000012871311.html

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January 7, 2008

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McDonald's Takes On A Weakened Starbucks - WSJ.com http://online.wsj.com/article_print/SB119967000012871311.html

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INDEPENDENT STREET1

Wendy Bounds on why McDonald's move might be good for small, independent coffee shops2

McDonald's Takes On A Weakened Starbucks Food Giant to Install Specialty Coffee Bars, Sees $1 Billion Business By JANET ADAMY January 7, 2008; Page A1

OLATHE, Kan. -- This fall, a McDonald's here added a position to its crew: barista.

McDonald's is setting out to poach Starbucks customers with the biggest addition to its menu in 30 years. Starting this year, the company's nearly 14,000 U.S. locations will install coffee bars with "baristas" serving cappuccinos, lattes, mochas and the Frappe, similar to Starbucks' ice-blended Frappuccino.

Internal documents from 2007 say the program, which also will add smoothies and bottled beverages, will add $1 billion to McDonald's annual sales of $21.6 billion.

The confrontation between Starbucks Corp. and McDonald's Corp. once seemed improbable. Hailing from very different corners of the restaurant world, the two chains have gradually encroached on each other's turf. McDonald's upgraded its drip coffee and its interiors, while Starbucks added drive-through windows and hot breakfast sandwiches.

The growing overlap between the chains shows how convenience has become the dominant force shaping the food-service industry. Consumers who are unwilling to cross the street to get coffee or make a left turn to grab lunch have pushed all food purveyors to adapt the strategies of fast-food chains.

It also shows how the chains' efforts to adapt to a changing market have had drastically different results on their bottom lines. McDonald's is entering the sixth year of a successful turnaround, while Starbucks has begun struggling after years of strong earnings and stock growth.

Still, the new coffee program is a risky bet for McDonald's. It could slow down operations and alienate customers who come to McDonald's for cheap, simple fare rather than theatrics. Franchisees say that many of their customers don't know what a latte is.

The program attempts to replicate the Starbucks experience in many ways -- starting with borrowing the barista moniker. Espresso machines will be displayed at the front counters, a big shift for a company that has always hidden its food assembly from customers. McDonald's says

it wants customers to see the coffee beans being ground and baristas topping the mochas and Frappes with whipped cream.

"You create a little bit more of a theater there," says John Betts, McDonald's vice president of national beverage strategy.

Ads for the espresso drinks running in the Kansas City area, where the concept is already being tested, say you don't get a "condescending look" for mispronouncing the size of the drink at McDonald's -- a jab at the "grande" and "venti" sizes at Starbucks. (At McDonald's, you just ask for small, medium or large.)

Starbucks Chairman Howard Schultz popularized lattes and cappuccinos in the U.S. after borrowing the idea from espresso bars he visited in Italy. When he began expanding Starbucks beyond Seattle in the late 1980s, he said he wanted the cafes to serve as a "third place" where people gather between home and work and feel some of the romance of the European cafe.

But the coffee chain has evolved into more of a filling station. It is now battling fast-food outlets for some of the same customers and meal dollars. Today, about 80% of the orders purchased at U.S. Starbucks are consumed outside the store. The average income and education levels of Starbucks customers have gone down, the company has said. As part of a big push into food, Starbucks sells lunch at more than two-thirds of its company-owned locations in the U.S.

Starbucks's rapid store and menu expansion have slowed traffic at older locations and gummed up operations behind its counters. After years of downplaying threats from rivals, Starbucks executives now say they're preparing for competitive encroachment.

"We understand all too well that we have built a very attractive business for others to look at and try and take away," Mr. Schultz told investors on a conference call this November. "We are up for the defense and we are going to get on the offense." Starbucks declined to make executives available for this story or specifically address competition from McDonald's.

McDonald's Takes On A Weakened Starbucks - WSJ.com http://online.wsj.com/article_print/SB119967000012871311.html

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The espresso machine at the counter in Olathe, Kan.

McDonald's executives say they aren't launching espresso drinks to go after Starbucks, but instead to cater to consumers' growing interest in specialty drinks. And although McDonald's is encroaching on the business that Starbucks invented, analysts say McDonald's may pose more of a threat to Dunkin' Donuts, which has a more similar customer base. Analysts also point out that McDonald's overall beverage expansion, which includes bottled drinks, is as much aimed at taking business from convenience stores and vending machines as it is from specialty cafes.

Starbucks increased its sales even in parts of the country where Dunkin' Donuts has a strong presence. Some analysts say Dunkin' and other fast-food competitors actually have helped Starbucks by expanding the total market for upscale coffee drinks.

A Dunkin' spokeswoman says the company doesn't comment on competition but says the chain believes it has "democratized" espresso and become a coffee destination.

McDonald's grew from a single San Bernardino, Calif., hamburger outlet that opened in 1948 into the world's largest restaurant chain by offering consistent hamburgers and french fries served quickly and at a low price. Its beverage lineup, anchored by Coca-Cola Co. sodas, was designed to complement its food.

McDonald's executives watching the growth of Starbucks at the beginning of this decade realized that they were missing out on the fastest-growing parts of the beverage business. Data showed that soda sales had flattened while sales of specialty coffee and smoothies were growing at a double-digit rate outside

McDonald's. Customers were buying food at McDonald's, then going to convenience stores to get bottled energy drinks, sports drinks and tea, as well as sodas by Coke competitors.

Early on, Starbucks didn't see the Golden Arches as a competitor "because McDonald's was selling hot, brown liquid masquerading as coffee," says John Moore, who spent almost a decade in Starbucks's marketing department before leaving in 2003.

McDonald's move into upscale coffees dates back to a concept that is unfamiliar to most of its customers: the McCafé. It started in Australia in 1993. McDonald's brought the cafes to the U.S. in 2001 by carving out a corner of the restaurant, decorating it with leather couches and adding a counter that sold cappuccinos and sweets. But the cafes never took off here because they didn't feed into McDonald's drive-through business, where two-thirds of sales take place, says Don Thompson, president of the chain's U.S. business.

In 2003, McDonald's initiated a turnaround strategy called Plan to Win. Among other things, it included a total remodeling at thousands of U.S. locations. Molded plastic booths were replaced with oversized chairs, lighting was softened and muted tones took the place of bright colors. Wireless Internet access was also added.

"We began to realize...we could definitely sell coffee in this environment," Mr. Thompson said. In 2006, McDonald's changed its drip coffee to a stronger blend and began marketing it as a "premium" roast.

In recent years, Starbucks started to see fast-food chains as more of a threat, according to former employees and people close to the company. In parts of the Northeast, store managers told baristas their biggest competition was Dunkin' Donuts, now a unit of Dunkin' Brands Inc., which made a national push into espresso drinks in 2004.

Starbucks increased the pace of its store expansion at the beginning of this decade. Some changes, including drive-through windows and breakfast sandwiches similar to the Egg McMuffin, mirrored techniques used by fast-food chains. This led to tensions among management and employees about whether the chain was eroding the core of the Starbucks experience, according to former employees and people close to the company.

At McDonald's, the success of its upgraded drip coffee emboldened the chain. In 2005, it began testing drinks sold under the McCafé banner at a handful of franchises in Michigan. It sold lattes and cappuccinos from the front counter so it could pass them to the drive-through windows.

McDonald's Takes On A Weakened Starbucks - WSJ.com http://online.wsj.com/article_print/SB119967000012871311.html

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WSJ's Janet Adamy reports that McDonald's will add espresso, lattes and other specialty drinks to its menu in 2008. By launching "McCafe," McDonald's hopes grab some of the upscale coffee market from Starbucks.

McDonald's researchers contacted customers of Starbucks and other coffee purveyors and conducted three-hour interviews where they videotaped the customers talking about their coffee-buying habits. The researchers got in the cars of the customers and drove with them to their favorite coffee place, then took them to McDonald's and had them try the espresso drinks.

"There was a surprise factor," says Patrick Roney, a director of U.S. consumer and business insights at McDonald's. "The people who were on the fence...there was an opportunity to get those."

Restaurants that tested the drinks began passing out complimentary small mochas and lattes. "A lot of our customers don't know what a latte is," says John DeVera, an Overland Park, Kan., franchisee who is testing the drinks.

Management advised restaurant operators to hire baristas who are "very friendly" and show a "willingness to learn about the competitor's product," according to a 2006 internal memo about how to start selling the drinks. "For example, a typical Starbucks customer would ask for a Grande Latte; our Baristas need to know that this is a medium size drink," the memo says.

Unlike at Starbucks, where baristas steam pitchers of milk then combine it with the espresso, McDonald's process is more automated. It uses a single machine to make all the components of each drink. Espresso is brewed using beans with a darker roast that are more finely ground than those for drip coffee, resulting in a concentrated form that's usually mixed with hot milk to make lattes and cappuccinos. McDonald's has three flavors it adds to its espresso drinks, a significantly narrower lineup than Starbucks, which boasts thousands of drink combinations.

During testing, plain shots of espresso were taken off the menu and more whipped cream was added to some drinks. The company also moved the espresso machines to the front counter from the back after realizing the drinks undersold when employees made them with their backs to the customer.

Drinks are priced from $1.99 to $3.29 and come in vanilla, caramel and mocha flavors. In advertisements in test markets, McDonald's tells customers those are 60 cents to 80 cents less than competitors' prices.

Heather Pelis, a 19-year-old babysitter from Rayville, Mo., says she didn't like the McDonald's vanilla latte when she tried it. "It was a little syrupy tasting," Ms. Pelis said recently while drinking a drip coffee at a McDonald's in Liberty, Mo. But she says she'd be willing to try another espresso drink because they are cheaper than the caramel macchiatos she buys at Starbucks, and because McDonald's is more conveniently located. The nearest Starbucks is a 30-minute drive from her, she says.

McDonald's franchisees say they think the new coffee drinks will be particularly helpful in drawing young consumers who prefer them to drip coffee. Gary Granader, a Detroit-area McDonald's franchisee, has started seeing groups of teenagers at some of his restaurants after school since he added espresso drinks a year ago. Mr. Thompson says McDonald's also is considering adding some type of music-downloading service at its locations.

McDonald's beverage expansion will add a new line of bottled drinks by Coke competitors. The drinks being considered include PepsiCo Inc.'s Mountain Dew, Lipton green tea and Red Bull GmbH's namesake caffeine drink. Restaurants also are getting a soda fountain with flavor shots that allow customers to create their own drinks like cherry Sprite and vanilla Diet Coke. Mr. Thompson said that Coke remains the "big brand" at McDonald's, and a Coke spokesman said the company is not concerned about the competing beverages being sold at McDonald's.

Only about 800 of McDonald's U.S. restaurants have the specialty coffee drinks now, and some may not get the full beverage program until 2009. Executives and franchisees will not give specifics on how well the espresso drinks have sold in tests.

McDonald's has already made some headway in gaining coffee credibility. In February, the magazine Consumer Reports rated the chain's drip coffee as better-tasting than Starbucks. Starbucks responded that taste is subjective and its millions of customer visits per week demonstrated the popularity of its coffee.

The rating nevertheless angered some top officials at Starbucks, according to a person familiar with the situation. Around the same time, Mr. Schultz sent a memo to Starbucks executives warning that the chain may be commoditizing its brand and making itself more vulnerable to competition from fast-food chains and other coffee shops. He lamented the loss of the "romance and theatre" that occurred when the company switched to automated espresso machines several years ago.

To improve store traffic and same-store sales growth, Starbucks has said it is trying to make its operations more consistent. It is reducing the number of items and promotions it offers and is focusing on what executives call the "vital few" areas that improve results, like selling more beverages and attracting more customers.

McDonald's Takes On A Weakened Starbucks - WSJ.com http://online.wsj.com/article_print/SB119967000012871311.html

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Starbucks executives have attributed the slowdown in sales growth and store traffic in the U.S. to the weak economy.

Mr. Schultz has said that new competition actually helps Starbucks by expanding the specialty-coffee category. "Those consumers over time are going to trade up," he told investors in November. "They're going to trade up because they are not going to be satisfied with the commoditized experience or the flavor." He has emphasized that Starbucks's baristas, who are instructed to memorize customers' drink orders and make genuine conversation with patrons, will continue to set the chain apart.

But some Starbucks baristas say that the chain's push into food and drive-through service has made that a lot more difficult. Some workers say their managers instruct them to ask customers whether they want a breakfast sandwich with their coffee -- a selling technique that feels unnatural when they know the customer doesn't want one.

"The more and more business they get in the store, the more it seems like another fast-food job," says Joe Tessone, a Chicago barista who has worked at Starbucks for three years.

The overlap between McDonald's and Starbucks has put Jack Rodgers in an unusual position. In 1958, McDonald's pioneer Ray Kroc granted Mr. Rodgers one of the chain's first franchises for a restaurant in St. Charles, Ill. Mr. Rodgers eventually traded that location and today owns part of three McDonald's around Newport Beach, Calif.

Mr. Rodgers later moved to Seattle where in 1985 he wound up investing in the predecessor chain of the modern-day Starbucks cafe. He later became a Starbucks board member and executive. He left the company in 1996 but remains a shareholder and a friend of Mr. Schultz.

Now Mr. Rodgers is looking at adding the lattes and cappuccinos to his McDonald's restaurants. He didn't envision the chains would compete so closely when he first invested in Starbucks. "Not in my wildest dreams did I see this coming," he says.

Write to Janet Adamy at [email protected]

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