Get High on Caffeine this Fall

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At least 40% of the US population between 18-24 years of age, and 54% of those between 25-39 years of age, are addicted to its use every day. Come or go a recession, 37% of its total users see no change in their buying pattern. For them, it has become a necessity and their day simply won’t begin without having it.

You got it! Coffee!

US consumers spends over $18B each year on specialty coffee (latte, cappuccino, mocha) and over $4B on imports of coffee. Sales of coffee hold 83% of the hot beverages market in the US, and 64% of the total population today prefers drinking it over tea, water and soft drinks.

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Stats indicate that the coffee industry is likely to become an even bigger and a more lucrative market in the coming years. Noteworthy industry players including Starbucks (NASDAQ: SBUX) and Dunkin’ Donuts (NASDAQ: DNKN) have performed well in the recent years. As of this year, Starbucks, a premium seller of coffee, generates 75% of its store sales from hot and cold beverages. Of the total, 4% of sales come from whole-bean and soluble coffee. Dunkin’ Donuts, however, holds the no. 1 position as a premium coffee brand at retail stores. Its bagged coffee has been a hit. Additionally, Dunkin’ Donuts’ K-Cups, introduced by Keurig (held by Green Mountain Coffee Roasters (NASDAQ: GMCR)), account for 40% of its total US sales.

Specialty coffee retailer Green Mountain saw tumultuous times in the recent quarters, but its stock was one of the few that survived the post-2008 Great Recession and came out victorious, even while competitors tumbled.  

And now we’re hearing of McDonald’s (NYSE: MCD) filing trademarks for ground and whole-bean coffee under its name. This either means that McDonald’s is looking for deeper penetration into the coffee retail industry, or it means nothing. It may have filed the trademark because it doesn’t want it being used by a competitor. But in case the former speculation turns out to be true, this could prove a breakthrough for McDonald’s in the coffee industry.

The coffee industry has branched out to different players, some of whom directly compete with each other and others who don’t. There are some who sell the instant drink at their restaurants, like Dunkin’ Donuts, Starbucks and McDonald’s. There are others who sell their branded K-Cups, whole beans and ground coffee at retail stores, like Green Mountain Coffee Roasters and Mondelez (NASDAQ: MDLZ) (spun-off from Kraft Foods). And finally, there are the brewing machine sellers, like Wal-Mart, Bunn, and now Starbucks (which recently launched its brewer, Verismo).

So, if McDonald’s does decide to enter the launch its own brand of coffee in the grocery sector, it will not only be strengthening its foothold against rivals like Starbucks and Dunkin’ Donuts, but also entering into direct competition with Green Mountain and Mondelez (and others). Can the fast-food chain dare to make this move?

Yes, it's tried, tested & profitable.

Coffee is not a new product line for McDonald’s. The chain already owns an existing line of coffee and related products focused on the McCafe concept, which has been a huge success internationally. Coffee, which contributed only 2% to its sales back in 2004, moved up to contribute 6% of the fast-foods joint’s total US sales last year. This may look like a small percentage but taken in absolute terms, this 6% makes over $2 billion in sales for the international chain.

So for McDonald’s this is a tried and tested recipe, unlikely to go wrong. The idea is to add a sub-product line of bagged coffee that will be sold at retail stores under the iconic brand symbol of the Golden Arches. A daring move; but will it be welcomed?

Yes, thanks to strong international branding.

McDonald’s has something that none of its competitors in this particular industry have: insanely strong international brand appeal! McDonald’s takes the 7th position in the best international brands, and the next closest coffee competitor on the list is Starbucks at 88th position. Move out of the US and McCafe holds an even larger share of total sales than the 6% it holds in the US—mainly in Australia, the UK, and emerging markets such as China and India, where competitors like Starbucks either haven’t reached or aren’t as famous as the Golden Arches. So shopping at a grocery store, foreign buyers are likely to pick a McDonald’s branded coffee bag over Kraft or Dunkin’ Donuts. However, will customers stay with McDonald's in the long run or make a switch to one of its peers?

Yes, loyalty will make them stay.

According to a study reported by Wall Street last year, 53% of the people who went to Dunkin’ Donuts or Starbucks to grab a coffee said they would occasionally go to other coffee providers as well. By contrast, only 29% of McDonald’s coffee customers said they cheated on McDonald’s to go to its rivals. One reason for this could be McDonald’s cheaper prices compared to what Starbucks or Dunkin’ Donuts charge for their premium coffee. Whatever the reason, McDonald’s President Don Thomson, sees “Coffee as a point of leverage and growth for us as we move forward.”

So, if every factor is in favor, should McDonald's consider charging into other branches within the coffee industry, such as the Green-Mountain-style brewing business?

No, remain focused on what you're good at.

With brewers like Green Mountain suffering under intense competition and Starbucks’ brewer launch not receiving the kind of enthusiasm that was expected, McDonald’s should choose to go down the same road that Dunkin’ Donuts went--that is, avoid the machine business and focus on coffee only.

Coffee sellers presently have higher revenue growth rates than McDonald's. If McDonald's chooses not to undertake this venture any time soon, can we still expect improvements in revenues?

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SBUX Revenue Growth data by YCharts

Yes, the macro-environment may help

It is expected that interest rates will be cut to curtail economic slowdown. This will depreciate the dollar against foreign currencies. McDonald’s generates more than 3/5 of its revenues in foreign currencies. Strengthening foreign currencies will help McDonald’s report stronger earnings in the next quarters, assuming that revenues remain the same as the last quarter.

Bottom line

If McDonald's does formally announce a bagged coffee venture in line with the recent trademark filing, consider buying the stock for long term rewards.

Know What You Own

With Green Mountain as cheap as it's ever been, many investors are wondering whether this is the end of the former market darling, or the perfect entry point for an enormous rebound. You can find a recommendation for how to approach investing in the company in The Motley Fool’s new premium research report. In it you'll find everything you need to know about Green Mountain, including whether it's a buy at today's prices. Click here for instant access.

PalwashaS has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's and Starbucks and has the following options: long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters, short DEC 2012 $21.00 calls on Green Mountain Coffee Roasters, and short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Green Mountain Coffee Roasters, 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.If you have questions about this post or the Fool’s blog network, click here for information.

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