• by Karlene Lukovitz  @KLmarketdaily, June 2, 2008

Starbucks has taken to lowering its prices in test markets where McDonald's has launched its major specialty coffee initiative, according to recent analyses from Deutsche Bank Global Markets Research.

The trend was spotted through price-checks in 125 Starbucks outlets in markets where McDonald's has unleashed its strategy of offering specialty coffees at lower prices, "suggesting some competitive concern" on Starbucks' part, reported DB analyst Jason West.

West added that "hands-on testing" indicated that the quality of McD's coffees "stacks up well" against the offerings of Starbucks and other competitors.

McDonald's has so far rolled out the platform in about 1,300 of its 14,000+ restaurants, according to the analysis, which also offered these insights on the Battle of the Beans:

• McDonald's "important competitive advantages" include an 18% discount on pricing and the convenience of having 9,000 drive-throughs versus Starbucks' 2,400.

• While Mickey D's overall coffee business is still small--just 11% the size of Starbucks'--DB projects a "meaningful sales contribution" and potentially "very attractive" profits and returns once the chain has fully rolled out the new coffees, although the ramp-up will take time.

• Deutsche estimates that specialty coffees are currently contributing 1% to 2% in McDonald's same-store sales in test markets, and notes that this is likely to rise as national advertising kicks in.

• Deutsche's detailed, store-level analysis suggests a potential 14% increase in EBIT per McD's restaurant and a 50% cash return on investment once rollout is complete, assisted by gross margins in the high 70s on the specialty beverages (versus overall company margins averaging in the high 60s).

In a separate report focusing on Starbucks, Deutsche analyst Marc Greenberg characterized the McD's coffee push as a "material competitive threat to Starbucks' core business," adding that the three-pronged strategy of lower price points, massive distribution and speed/convenience presents up to a $0.05 incremental EPS risk for Starbucks over the next year.

Greenberg reported that based on traffic, pricing and other analyses, McDonald's new-coffee sales currently total about $500 million, or about 6% to 6.5% the size of Starbucks' total coffee sales. McDonald's is so far selling about 30 to 40 units per day in test-market restaurants (about 30% of the company's long-term target range), equating to about $35,000 per store, or $490 million on a company-wide basis--even prior to "advertising or word-of-mouth build," he pointed out.

The data point toward an eventual Deutsche Bank 2009 total coffee sales estimate for McDonald's of $1.4 billion ($900 million existing, plus the $500 million new), growing closer to $2 billion, or about 25% the size of estimated Starbucks U.S. coffee sales, over time.

Greenberg also believes that Starbucks' current plan to add 400 new stores annually (3.4% growth on 2009) "remains likely to exacerbate weak same-store trends" because "cannibalization" could drive same-store sales down by 1% to 3%.

Bottom line: West recommended buying McDonald's stock, and Greenberg recommended holding Starbucks stock.