McDonald's Shakes Up Coke, Tries New Drinks

The move threatens Coca-Cola's long-standing position as the exclusive supplier of sodas, juices and water at the world's largest fast-food chain.

Yet, if McDonald's (MCD) wants to keep what it calls its "relevance with consumers" on an upward trajectory, it is finding that it has to be able to serve up more than eight spigots of fountain drinks.

That means turning to bottled and canned beverages -- which consumers can grab and carry around with them the entire day if they wish -- and substantially increasing the number of choices.

"The industry has grown the [beverage] category and continues to do so," said Ralph Alvarez, president of McDonald's North America, in an interview with MarketWatch. "Plus consumers are in love with bottled beverages. They can seal and unseal them as much as they want. We need to be part of that," he said.

McDonald's, in conjunction with Coca- (KO) , is testing a variety of competing bottled products at 15 restaurants in Texas. Slightly more than two months into the test, the results have been "promising," both McDonald's and Coca-Cola spokesmen have said.

Should that continue, McDonald's will put coolers full of Coca-Cola's products as well as competing brands in its restaurants.

"This could let competitors get a foot in the door at McDonald's," said Morningstar food and beverage analyst Matthew Reilly. "And if you're Coca-Cola, you don't like seeing anyone else's feet there."

The only non-Coca-Cola soft-drink beverages McDonald's now sells are Dr. Pepper and Diet Dr. Pepper. With the exception of milk, juice and coffee, all McDonald's beverages are fountain drinks.

At the Texas test sites, coolers both behind and in front of the counters are carrying bottles of core Coca-Cola brands such as Coke Classic and diet Coke, as well as cans of the Dr. Peppers. Other Coca-Cola products sold in cans include Vault, Full Throttle and Tab Energy. Coca-Cola's Powerade and Dasani waters also are being sold in bottles.

"We are looking at customers' favorites," Alvarez said of the types of beverages McDonald's is testing and considering. He is searching across all brands, but was quick to note that "Coke is our preferred supplier."

McDonald's and Coca-Cola's relationship stretches back to the fast-food company's start in 1955 when founder Ray Kroc shook hands with a top executive at Coca-Cola to sell the soft drinks with his popular burgers and fries. That handshake still covers the Coca-Cola "contract" with McDonald's.

The Arizona teas are stocked in cans. Coca-Cola competes with the flavored Arizona teas with its growing line of Nestea products. A Coca-Cola spokesman said the new Nestea products will go into the coolers later this month but they won't be replacing the Arizona teas.

"We're the beverage captains for McDonald's," said spokesman Ray Crockett. "We're working with them to find out what the optimum beverages are for their customers."

Still, selling beverages is a customer-driven activity. If the Hansen Natural Corp.'s (HANS) Monster energy drink will turn faster than Coca-Cola's Full Throttle, retailers want to stock Monster.

But competitors at McDonald's aren't necessarily all bad for Coca-Cola, Reilly said. "If Coke dominates, say, 75% of the cooler, this could create another purchasing opportunity to pick up more business both in bottles and fountain" because McDonald's becomes a destination for grab-and-go beverages."

Alvarez said that McDonald's also wants to try its hand at smoothies, including creating its own mixtures, similar to how fast-food restaurants sell their own milkshake creations. Though Coca-Cola already sells Minute Maid smoothies, the company could create a private-label brand that is sold only in McDonald's restaurants.

If these Texas tests prove successful, they could be a big boon to both McDonald's and Coca-Cola.

Alvarez said that McDonald's is losing a chunk of beverage sales when consumers -- and there are a lot of them that do this -- go to the drive-thru for fries and burgers or salads, but stop by a convenience store for carbonated and noncarbonated drinks.

Each McDonald's store sells only eight fountain choices that franchisees can select from a limited list. The choices are dominated by Coke, Diet Coke, the Dr. Peppers or Mr. Pibb, Sprite, Hi-C Orange, Fanta Orange or Grape, Minute Maid Lemonade, Barq's Root Beer, Fruitopia and Powerade.

Most of the fountain beverages are carbonated. That's by far the biggest sector of the $100 billion soft-drink industry, but it is also one that has lost at least some of its appeal. Last year, for the first time in more than two decades of tracking, volume sales of carbonated sodas turned south, down 0.7% to 10.2 billion cases, according to Beverage Digest, the industry trade publication.

People aren't drinking fewer beverages, said Beverage Digest Editor John Sicher. "It's the migration from soft drinks to bottled water and noncarbonated beverages," he said.

Indeed, sales from energy drinks like Red Bull, Monster and Full Throttle surged 80% from 2004 to 2005 to about $650 million, a small but fast-growing sector of the market. And sports drinks like Gatorade and Powerade, not to mention the various flavored and vitamin-laden waters on the market, have been draining carbonated soda sales for some time.

Also telling is this statistic: In the U.S., 77% of all soft drinks are sold in bottles and cans, leaving only 23% in fountain sales.

"There are a lot of beverages with 1% and 2% share that we couldn't justify as fountain drinks," Alvarez said. "But if we have them in bottles, we can be a destination for those drinks."

If customers use the drive-thrus -- which currently account for nearly 60% of all McDonald's sales -- to buy individual bottles of diet Coke or Arizona Tea, it's likely they will order fries, an apple pie or a yogurt parfait too.

CIBC analyst John Glass said it also could create an ongoing traffic flow of customers during slower times of the day, such as mid-morning or late afternoon. "It's like adding another day part," Glass said.

"There are many times when the drive-thrus aren't crowded," he said. "Customers probably won't wait in the lunch queue for just a Powerade, but they'll go through during" the slower periods.

What's more, a broader menu of choices in containers customers will go out of their way for puts McDonald's on better competitive footing with convenience stores.

"It could be like putting a little 7-Eleven in a McDonald's," said Morningstar's Reilly.

Sicher said that consumer preference for bottled drinks over fountain beverages isn't necessarily the only issue that many fast-food restaurants face. "Consumers are looking for a greater variety of beverages and there are a limited number of spigots on a fountain at a McDonald's or a Burger King," he said.

"McDonald's and Coke appear to have designed this test to respond to that," Sicher added.

This also pushes Coca-Cola to make some meaningful changes and additions to its beverage portfolio, which has been lagging rival PepsiCo. (PEP) for nearly a decade.

Some bidding wars between the two dominant soft-drink companies have been won by PepsiCo, giving it a distinct advantage in certain categories.

In 2000, PepsiCo pre-empted Coca-Cola with what was considered a new-age category then by purchasing SoBe, the fruit blends, exotic teas and other herbal-inspired drinks created by the South Beach Beverage Co. Coca-Cola still does not have a comparable drink line to compete against SoBe.

PepsiCo also became a power-hitter in the jock-drink category in 2001 after a protracted battle with Coca-Cola for Quaker Oats Co. and its coveted Gatorade. The first drink aimed at rehydrating and replenishing athletes at game time, Gatorade still holds a commanding 80.3% market share to Coca-Cola's 18.5% share.

Today, Coca-Cola still leads in carbonated soft drinks with a 43.1% market share to PepsiCo's 31.4%. But in the burgeoning noncarbonated category, PepsiCo's market share of 48.9% is nearly double Coca-Cola's 25.4%, according to Beverage Digest.

Both beverage companies have tea lines -- Nestea at Coca-Cola and Lipton at PepsiCo -- that compete with Arizona teas. Dependent on the tests' results and the popularity of Coca-Cola's new "Gold Peak" line of premium teas, Arizona teas may not have a long life in McDonald's coolers.

On the other hand, other competitors such as SoBe or Snapple, could also join the fray. The same hold true for energy drinks.

"We want to give our customers what they want," Alvarez said. "It's all about the customer. I don't care which one they buy. I want them to buy them all."