RealMoney Silver - McDonald's vs. Starbucks: Not Much of a Coffee Fight

McDonald's vs. Starbucks: Not Much of a Coffee Fight
By Bill Trent
RealMoney.com Contributor
10/2/2007 4:32 PM EDT

The coffee business can be a tough one, and there are no shortage of companies that would like to take a slice of Starbucks' (SBUX) sizable business.

Some investors believe that McDonald's (MCD) may be the company to carve off a significant chunk, but I have my doubts about its ability to do so and the attempt's effect on Starbucks' shares.

After 50 years of selling hot mud, McDonald's continues to awaken to the notion that its customers might enjoy coffee that tastes good. According to Crain's Chicago Business, "McDonald's Corp. plans to sell lattes, cappuccinos and other specialty drinks in all of its 14,000 U.S. restaurants next year. McDonald's predicts the new drinks will add more than $1 billion a year to sales."

Not surprisingly, the anti-Starbucks crowd has latched on to this announcement as proof that Starbucks is doomed. 24/7 Wall St. even called it a "coup de grace," which is defined as a "death blow intended to end the suffering of a wounded creature."

Although Starbucks' stock is certainly suffering, down about a third from the high reached earlier this year, it is difficult to make the argument that the company is wounded, or in need of a merciful end to its suffering.

Reality Check

It's time for the doubters to face some facts. First, McDonald's is not planning to match Starbucks "product for product." Last month, Bloomberg reported that McDonald's President Ralph Alvarez said the company has no plans to offer the breadth of Starbucks' beverages. Instead, they intend to compete for the plain-Jane cappuccino, offering it at about a 25% discount to the equivalent Starbucks model.

Secondly, Starbucks doesn't need to concede future market growth to others. McDonald's is already selling cappuccinos in two thirds of its stores, according to the Bloomberg article. That potential market-share loss has already been baked in, and it doesn't seem to be hurting Starbucks too badly.

Starbucks' same-store sales growth is running at 4%, below its historical norm but above that of most retailers. If anything, the fact that most of McDonald's rollout will be complete next year could ease the pressure on comp. sales.

If further convincing is necessary, just look at the expected sales numbers. McDonald's wants specialty drinks in 14,000 stores to add $1 billion to sales. In 2006, Starbucks had an average store count of approximately 6,500 and produced $6.5 billion in sales from them. In other words, they are still selling 14 times as much coffee per store as McDonald's.

The further incursion from the remaining one-third of McDonald's expansion, even under the generous assumption that 100% of those sales would have otherwise gone to Starbucks, amounts to about 4% of Starbucks' trailing 12-month company-owned retail sales -- about one year's worth of same-store sales growth at worst.

The Starbucks Way

Meanwhile, over the last 12 months, Starbucks has generated $1.2 billion in cash flow from operating activities and used just $1 billion to expand those operations by 15%. Assuming that two-thirds of the capital expenditures went to open new stores and the rest was routine maintenance, the free cash flow from its existing store base is approximately $700 million per year, for a 3.5% free-cash-flow yield on the $20 billion enterprise value.

It isn't what I would call cheap, but it is much less like a wounded animal than a healthy tiger pouring its energy into a continued pounce by opening still more stores. At its current expansion rate, in two years, the free-cash-flow yield would exceed that offered by Treasuries, and Starbucks would still be only halfway through its expansion plans.

The Bottom Line

I would consider the stock cheap if it went down another 15% to $22.50, or if it just stayed at about the current price for another year. Since neither of those outcomes is certain, Starbucks fans will have to pick their own entry point.

In the meantime, my favored strategy of writing put options may be worth considering. The April 2008 27.50 puts are selling for about $2.30 right now. By writing those options, you could earn an 8.5% six-month return if the stock goes up, or buy the stock for an effective price of about $24.25 (which by April would probably meet my "cheap" criteria) if it goes down.

I think it is great that McDonald's is offering its customers good coffee, and I think the two companies can coexist, much in the same way that McDonald's has coexisted with, for example, hamburgers sold at ballparks. The two companies have very different customers and serve different purposes for them throughout the day. As for a "coup de grace," I don't expect either company will need one any time soon.