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What's Behind Starbucks' Price Hike?

Starbucks has had a strange spate of troubles this summer—from tepid same-store sales, to a bungled foray into movies, to bad PR on some of its promotions. Such stumbles are entirely atypical of America's favorite coffee shop, and Starbucks (SBUX) came up with an unconventional response: It raised its drink prices.

Starting on Oct. 3, the prices on lattes, cappuccinos, drip coffee, and other drinks will go up 5 cents at company-operated stores in North America. Starbucks is also jacking up the price of its coffee beans by roughly 50 cents per pound, or an average of 3.9%. This is the first price hike on drinks in two years, and the first on beans since 1997.

The timing is certainly odd. For a while now, Starbucks has been struggling with labor disputes. Rivals McDonald's, Dunkin' Donuts, and Canadian restaurant chain Tim Horton's are steaming into its turf. Starbucks' much-touted national roll-out of Music Bars never materialized, and its first movie production, Akeelah and the Bee, has been a financial flop. In July, same-store sales grew just 4%, raising fears that Starbucks' incredible growth engine was beginning to sputter. And in August, the company bungled a promotion for free iced coffee—failing to honor coupons they'd already issued.

A CONFIDENT COMPANY. If Starbucks were really worried about any of these issues, the last thing its senior execs would consider is a price hike. In fact, Starbucks' dominant market position gives it unique pricing flexibility. Every week, the company succeeds in persuading nearly 40 million people to buy pricey espresso drinks.

"The company is selling a product that has become part of our daily lives, said Kristine Koerber, an analyst at JMP Securities. "Raising prices by a nickel is not going to meet any resistance."

Company officials say the higher prices are intended to offset higher labor and fuel costs. And while the price increases are small, they underscore just how confident Starbucks remains about its growth prospects and its ability to fend off new competitive threats. Koerber and many other analysts seem to support this optimism. "You're not going to raise prices if you have the competitive or macroeconomic environment going against you," she says.

GLOBAL DOMINATION. How optimistic is Starbucks? Executives have said revenues should grow 20% to 25% a year for the next several years. The only way to get that kind of growth is by opening more coffee shops. Right now, Starbucks operates about 8,500 stores in the U.S., and has been opening about 500 new ones a year. Starbucks aims to double that to 1,000 new stores in fiscal 2007. Nearly 60% will be drive-through units, which generate about 30% higher revenues and profits than ordinary walk-in shops, analysts say. (Starbucks currently operates about 1,400 drive-through units in the U.S.) Long term, the goal is to run about 15,000 stores in the U.S.

International growth is where the real money may lie. Currently, Starbucks operates just 3,500 units in 36 countries. But company managers would like to expand that to 15,000 stores outside the U.S., for a total of 30,000 stores worldwide. "The big target of opportunity is in the international market," says Goldman Sachs (GS) analyst Steven Kron. And the business has become highly lucrative.

Operating profit margins for the international division over the past four quarters averaged 9.1%, compared with negative margins in fiscal 2003, Kron says. China, where Starbucks currently operates barely 200 stores, is already profitable at the store level and presents enormous growth opportunities.

WEAK SALES. Innovation doesn't seem to be a stumbling block for Starbucks. The company is now experimenting with breakfast-warming ovens. It plans to install them in 600 stores by the end of the fiscal year. And for every failed new drink concoction such as Chantico, the company is coming up with popular new ones. Banana Cream, Banana Caramel, and green tea Frappuccino drinks have been big hits this summer. "Nobody thought they would be successful," Kron says.

Despite all of that, in July, Starbucks posted its weakest monthly same-store sales increase since 2001. Analysts feared that the slowing overall economy and higher fuel prices had finally caught up with the coffee chain, and that its customer were starting to cut back. Starbucks execs blamed an unusually strong summer demand for its cold Frappuccino blended drinks, which take more time to prepare.

Analysts were skeptical. "We cannot fully commit to the company's belief that July's sales weakness is due to increased Frappuccino sales," wrote JPMorgan (JPM) analyst John Ivankoe. He went on to say the sales weakness is due to emerging competition and a broadening customer base that includes people affected by the price.

SUMMER SLUMP. Later, Starbucks execs announced they would accelerate unit growth in the U.S. to a 1,000 units for fiscal 2007, surprising some analysts. "Such a rate of development is unprecedented to our knowledge for a largely company-operated system and raises issues with regard to potential new unit volume cannibalization," Ivankoe wrote. "We traditionally struggle when companies have modest margin issues and make up potential earnings shortfalls with increases in unit development."

While analysts are still debating the ultimate meaning of the company's tepid summer same-store sales (August climbed back to 5%), most agree that Starbuck's foray into the world of music, movies, and now books has been mixed. But as long as the investment remains modest, most analysts are accepting. They view this entertainment strategy as more about building and enhancing the brand than about generating serious sales and profits.

The key is to keep it relatively small and exclusive, analysts say. "Akeelah and the Bee didn't do well at the box office," Kron says. "If there are a couple failures like this, how will it affect the public perception of the brand? I still view this as another platform to keep them relevant, but if they make this too big, it could become a distraction."

MORE MISFIRES. Starbucks misfired in a couple of other areas that certainly sullied the usually bright sheen on the brand. It didn't create much goodwill when Starbucks e-mailed a coupon on Aug. 23 that offered a few large iced coffee drinks to selected employees with encouragement to forward the coupon to friends and family. The offer was valid through Sept. 30. But because of the overwhelming response due to people photocopying and distributing the coupon across the Internet, Starbucks abruptly rescinded it—a bad PR move, at best.

Other troubles that could harm Starbucks' brand include its recent legal battles with Starbucks union members in New York. The labor tussles have led to Labor Dept. rulings in favor of the union and more bad press.

But none of these hassles really alter the basic proposition for Starbucks. Even if growth slows modestly, the company still outperforms its peers. And with the help of its price hike, investors will probably see the yearly 20% growth in profits they have come to expect. For Starbucks, it's still full-steam ahead.

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