"I am quite confident that business students in the future will be reading case studies on the battle between Starbucks (NASDAQ: SBUX) and McDonald's (NYSE: MCD)," says value investor Charles Mizrahi.
In his Hidden Values Alert, the advisor explains, "This is a classic case of a castle with a wide moat coming under attack because the attacker believes it has caught the duke napping." Here, Mizrahi shares a fascinating over the "Coffee War."
"As background, in 1982, Starbucks had five retail stores and was selling coffee to restaurants in Seattle, Washington. It was during that year that Howard Schultz signed on to manage retail sales and marketing. After traveling to Italy, he convinced the owners of Starbucks to open a coffee bar.
"It was a huge success. One year after going public in 1992, Starbucks had 275 locations. Today, Starbucks is the leading retailer and roaster of coffee in the world. There are nearly 7,000 Starbucks stores in the U.S. and almost 1,800 in international markets.
"Schultz's genius is that he took a commodity (a cup of coffee), made it a brand, and was able to charge three times its market price. His vision was to make Starbucks serve as the 'third place' people gather, between home and work.
"As the company's expansion swept the U.S., Starbucks also began adding drive-through window service and selling breakfast sandwiches. By doing this, Starbucks encroached on McDonald's territory, and it was only a matter of time before 'war' would be declared.
"Before attacking Starbucks head-on, McDonald's scoped out the marketplace, saw what needed to be done, and then began executing. In 2003, McDonald's initiated a turnaround strategy, remodeling its stores, moving toward oversized chairs and softer lighting and colors, and even installed wireless Internet.
"In 2005, McDonald's began taste testing its coffee and in February 2007, Consumer Reports magazine rated McDonald's drip coffee as better testing than Starbucks'. In a page out of Starbucks' playbook, McDonald's moved its espresso coffee machines to the front counter.
"The company now plans to roll out coffee bars with similar-tasting beverages, served by baristas, at lower prices, to its 14,000 U.S. stores in 2008.
"Starbucks' moat had done a very good job of keeping competitors from attacking the castle. But over the past few years, Starbucks has slipped up just enough to allow McDonald's to feel confident that it could take on this coffee giant.
"Starbucks is not taking the McDonald's threat lightly. Chairman Schultz became more active, took the title of CEO, and already has made some changes. He wants to bring back the 'romance' and 'theater' that Starbucks once provided.
"In addition, Starbucks plans to reduce the number of promotions and items it offers and to focus on consistency of operations among all store employees. In other words, Starbucks is going back to basics and trying to turn specialty coffee from the commodity item it had become to the branded item it once was.
"Meanwhile, it is too early for McDonald's to call its attack a victory. In fact, it may appear that this attack has awoken the slumbering giant. McDonald's will need to get over several formidable hurdles before it becomes a more real threat.
"Because McDonald's is a franchise system, it is optional for franchise owners to create coffee bars in their stores; most haven't made the investment. Inconsistency is one area in which Starbucks has more control, since its stores are company-owned.
"McDonald's is going to find it hard to change the public's perception of it from a kid-friendly fast-food restaurant to a third home for people between home and work. How successful will the company be in cross-selling a $3 latte to a customer that just a $1 meal?
"Our conclusion is that while watching the coffee war take place, you should keep in mind that the value of a company is not all in the numbers.
"Every day in every industry, companies must be able to continue widening their moats and defending themselves or else their intrinsic value will eventually erode. Weaknesses are exploited, strategies are drawn up, and war is fought for territory-which, in business, is market share.
"At the early stages of this conflict, I would wager that Starbucks has the advantage. Many great companies with strong brands-such as Coca-Cola, American Express, and even McDonald's have regrouped, got back to basics, and gone on to increase value for their shareholders.
"Over the past year, Starbucks' stock price has fallen nearly 50%. Mr. Market has priced in the worst-case scenario for Starbucks and is discounting its market dominance, competitive advantages, and strong brand. A stock price of $19 or less should provide investors with an adequate margin of safety.
"This is based on the assumption that Starbucks can grow earnings by 16% per year over the next five years (a drop of 36% from their past five-year average EPS of 25%) and trade at a P/E of 18. I have found the most profitable investments to be in buying a company with a wounded brand at a discount to its underlying value."
Each day, Steven Halpern's TheStockAdvisors.com offers the latest market commentary and favorite investment ideas from the nation's leading financial newsletter advisors.