January 23, 2007
McDonald’s Tests Coke Competitors
By Duane D. Stanford
COLLEGE STATION, Texas -- The dinner rush is on, and counter clerks at a McDonald's near Texas A&M University fill paper bags with cheeseburgers and hot french fries for slap-happy students in the throes of exams.
A quiet little test project in College Station and metro Kansas City is threatening Coca-Cola's more than 50-year-old monogamous relationship with McDonald's. For nine months, the fast-food giant has experimented with bottled drinks as it tries to win back revenue from burger-buying customers who get their bottle of pop from a convenience store next door. It also wants to keep customers who prefer energy and sports drinks to carbonated soft drinks.
The test includes popular drinks made by Coke and its archrival, PepsiCo, an unsettling reality for executives 800 miles away at Coke headquarters in Atlanta. Coke has had exclusive pouring rights at McDonald's since the chain's founding in 1955.
The test project represents a crack in the wall Coke has built around the burger company.
It's unlikely Pepsi could steal the lucrative McDonald's account from Coke anytime soon. But if the bottled drink test is expanded nationwide, especially with Pepsi products, it could chip away at Coke's profitable fountain drink business, which accounts for an estimated one-third of the company's U.S. profits.
For years, Coke has dominated the U.S. fountain drink market. The company now controls an estimated 70 percent share, according to industry newsletter Beverage Digest. Pepsi's share is about 20 percent.
McDonald's, with its nearly 14,000 outlets, sells more Coke than any other fast-food chain.
Coke sells large volumes of fountain syrup to McDonald's directly. For bottled and canned drinks, on the other hand, Coke sells concentrate to its bottlers, who mix the drinks with carbonated water, pour them into bottles and cans and sell them to retailers. That middle-man bottler soaks up part of the profit.
In Kansas City, the McDonald's test includes Mountain Dew, Gatorade, Propel Fitness Water, Lipton tea and Tropicana Pure Premium juice, all of which lead their categories in the United States. Pepsi's regular and diet colas have not been brought in to compete with the bottled Coke and Diet Coke in the test. A Pepsi "strategic initiatives team" has collaborated with McDonald's to price, promote and display the drinks, which are delivered by Pepsi trucks.
The test has included Coke competitors Arizona tea and Red Bull energy drink, as well as Coke's own canned energy drinks.
The drinks are kept in coolers like those you might find at the grocery checkout aisle or at the front of a convenience store. Customers can choose to have a bottled soda instead of a fountain drink with their combo meals -- costing them about 10 cents extra for a medium-sized meal.
The 16.9-ounce bottle sells for $1.29 to $1.39, about the same price as a medium fountain drink at McDonald's or a 20-ounce bottle in a convenience store. The 16.9-ounce bottle holds about as much as McDonald's small fountain cup, which costs $1 in Texas. Clearly, customers are paying for convenience and portability.
McDonald's is testing the bottles for the same reason Coke and its competitors have developed a panoply of new drinks and packages in recent years: People want variety and convenience, said Matthew Reilly, a Chicago-based stock analyst for Morningstar.
"Consumers want the brands they know, and they want them wherever they are buying," Reilly said. "It's not going to be, 'Coke is the only thing,' anymore."
If customers like Josie Mejia of College Station want Pepsi's category-leading Gatorade and Mountain Dew, McDonald's may want them, too.
"That's my favorite drink," said Mejia after ordering a bottle of Mountain Dew with her McChicken sandwich.
Wall Street analyst William Pecoriello of Morgan Stanley recently warned that an expansion of the McDonald's test "could have significant profit implications for Coke" because it could open the door to Coke rivals. He also said that noncarbonated options could erode demand for traditional carbonated soft drinks, which are already on the decline in North America even though they are still a significant part of Coke's overall business.
McDonald's is so important to Coke it has an entire division devoted to the burger company. When McDonald's executives visit, a flag goes up in Coke's atrium.
Coke is important to McDonald's, as well. Coca-Cola has spent years developing a system that can service drink fountains at a moment's notice. If a fountain breaks down, Coke gets there fast to keep the profitable drinks flowing.
The relationship has been lucrative enough for both sides that Coke's pouring rights at McDonald's aren't sealed with a contract. It's a handshake deal held together by years of successful innovation and profit. The companies together developed the successful "extra value meal," for example, to drive up sales of Coke and hamburgers.
A spokeswoman for McDonald's wouldn't say whether the bottle test will be expanded to other parts of the country.
"We've certainly been encouraged by what we're hearing from customers, but it's still too early to speculate about test results or whether the tests will be expanded," said McDonald's spokeswoman Danya Proud.
In Texas, the test shows signs of permanence. McDonald's has built drink coolers right into the walls in some locations. At others, McDonald's has installed drive-up vending machines stocked with Coca-Cola products for people who want to grab and go.
The bottled drinks were heavily and consistently marketed in the half a dozen stores visited by The Atlanta Journal-Constitution. And McDonald's had just begun radio ads touting the bottled drinks, according to one manager.
Coke North America spokesman Ray Crockett deferred most questions about the test to McDonald's, saying, "Companies routinely test their products against competitors to better understand how their products interact in their product category.
"The beverage tests in McDonald's are no different," he said.
Fast-food restaurants have experimented with bottled drinks during recent years. Subway carries them, for example, and most McDonald's already sell bottled water marketed by Coke.
Dawn Hudson, president and CEO of Pepsi-Cola North America, said fast-food chains can't afford to ignore the trend, which they already are coming to late.
"They make a majority of their revenue not from what's in the center of the plate, but what's around the side," she said at an industry conference in New York last month.
But the higher-margin fountain drinks still rule. The McDonald's test includes a new strategy to boost those sales, too.
The fountains at the Texas stores have been fitted with spigots that allow customers to add a shot of flavor, such as vanilla or cherry, to their drink. The restaurants also are experimenting with smoothies.
Joe Cunningham, manager of a McDonald's off George Bush Drive next to Texas A&M, said his morning rush includes customers who pull up to the drive-though window for a fountain soft drink and nothing else. So far he hasn't seen a clear shift to bottles during the test.
But on football game days, students often choose bottles because they are easier to carry to the stadium across the street.
Isiah Montemayor, a 20-year-old Texas A&M sophomore, said he prefers bottles.
"You don't have to worry about ice," he said as he climbed into a Mustang for a road trip home last month.
Montemayor, who ordered a Powerade with his Big Mac meal, said he doesn't like the way the ice melts and waters down a fountain drink when you take it with you.
Recently released research by Morgan Stanley found that 62 percent of people ages 13-65 would drink something different at quick-service restaurants if given the choice. Teens were most likely to move away from fountain drinks, primarily in favor of energy and sports drinks.
So what is Coke's next move in this latest phase of the Cola Wars?
For now, like its famous formula, the company is keeping its strategy a secret.
McDonald's test could cost Coke at the fountain.
--Fountain beverages account for 23 percent of all U.S. carbonated soft drinks sales.
--Coca-Cola holds a 70 percent share of the U.S. fountain soft drink business, driven in large part by exclusive deals with fast food giants McDonald's, Burger King and Wendy's.
--Coke gets roughly one-third of its U.S. profit from fountain drinks. (U.S. profit accounts for 20 percent of Coke's worldwide business.)
Source: Analysts, Coke