10 Possible Starbucks Responses to McDonald's Coffee Threat

SBUX vs. MCD 1-yr chart - Seeking Alpha

By Bill Conerly

Syndicated from Seeking Alpha blog

January 09, 2008

I've used Starbucks' (SBUX) business strategy as a way to discuss the Trial and Error Economy. I'm not, by any means, the world's greatest expert on the company, but it provides a great vehicle for teaching about corporate strategy. Now, according to the Wall Street Journal, McDonald's (MCD) will sell premium coffee drinks made by baristas at most of their 14,000 stores.

How should Starbucks react to the McDonald's threat? Here are some ways:

1. Do nothing. Best implemented with one's nose high in the air, saying that Starbucks customers would never buy coffee at McDonald's. Would work very well for three to six months. Ignores the reality that Starbucks' recent growth has come not from Volvo-driving college grads, but from lower-income, less educated people than they originally served. These are people comfortable at McDonald's.

2. Cut prices. This is the time-honored method of competition. As an economist, I love price cutting. As a business consultant, I almost always advise clients to avoid a price war. In the case of Starbucks, I'd ask the company, "Who do you think has the lower cost structure?" Not only should we look at labor costs, but consider this: at 9:00 am, McDonald's has lots of excess capacity. Serving an additional customer is very cheap. At the same time, Starbucks' chairs are full and there's a line at the order counter. Serving additional customers means real estate expansion and hiring more staff.

3. Differentiate the product. In the classic form, the existing customer begins to differentiate, highlighting their product superiority. Of course, Starbucks is already selling a product that it has successfully differentiated. The practical way to do that now, in the face of McDonald's, is a "nobody makes a latte like Starbucks" campaign (using a catchier slogan than I just suggested, but pushing that theme.)

4. Move upmarket. In conjunction with more product differentiation, maybe Starbucks should raise its prices, ceding the price sensitive customers to Mickey D, but pulling more profit from the loyal customers.

5. Lock up the resources needed to make the product. Starbucks is not going to corner the market on coffee, but in many cities they have cornered the market on corners. That is, they have leased the top spots for urban coffee locations. McDonald's, though, is known for great real estate (not great buildings, but great locations). They are not optimized for the morning crowd, though. Starbucks, for example, favors locations that are on the right hand side of the street for inbound morning commuters. In rush-hour traffic, customers don't like to make left hand turns. I'll bet that McDonald's has ignored this. However, using existing resources instead of building new locations is a huge cost saver. Bottom line: I don't think Starbucks can lock up a critical resource.6. Build customer loyalty. Airlines, beginning with Western Airlines but quickly followed by American, built frequent flier programs. Now a traveler has a big incentive to travel on one airline as much as possible. But the potential rewards from buying all my coffee at one chain rather than another? OK, Starbucks has their prepaid card which is really convenient; I use mine a lot. They could add a rewards element to it; like prepay $20 and get $21 worth of sales. But if I wanted coffee and I saw a McDonald's, with no Starbucks in sight, I would not keep driving just because I had some incentive card.

7. Go head to head. Imagine Starbucks looking for a location across the street or next door to every McDonald's. Some of them might not be profitable locations, but it's a way to try to get McDonald's to drop the idea of specialty coffee. Drive them out of that line of business. I'm guessing that Starbucks already has plenty of locations near the competition, but it would certainly be expensive to target all, or most, of the McDonald's locations.

8. Merge. One of them acquires the other. They announce the Wall Street great synergies and economies of scale. It would be really hard to make this work, but it's tried fairly often in other industries. Investment advice: sell short the merged entity.

9. Cut costs to maintain profits while sales are falling. This is a pretty stupid plan, but common. In Starbucks' case, either the quality of the coffee would fall, or the best employees would leave. The company would end up a shell of its former self.

10. Ask for government regulation. Probably won't happen here, but it's a standard response by plenty of corporations facing competition. They might propose licensing baristas for the protection of customers, enforcement of antitrust laws against the competitor, product safety rules that would be hard for McD's to comply with (no meat preparation in the same location that coffee is prepared, to protect against mad cow).

There's the list of choices. How should Starbucks choose? I recommend that they narrow the list to those that could be tried in a single market, rather than company-wide. That would be 1 through 7 (maybe number 9, but that has really big potential impacts on company-wide reputation). Then Starbucks should let its manager of each metropolitan area do what they want to do. Monitor sales data carefully. Watch McDonald's, perhaps by hiring observers to count cars in the parking lots and going through the drive throughs. Evaluate which response works best. And of course, let metro area managers try other strategies I haven't thought of.

By trial and error, Starbucks should be able to identify the most successful response to the McDonald's threat. The same process can be used in most cases of competition.