Planet Starbucks

To keep up the growth, it must go global quickly

The Starbucks (SBUX ) coffee shop on Sixth Avenue and Pine Street in downtown Seattle sits serene and orderly, as unremarkable as any other in the chain bought 15 years ago by entrepreneur Howard Schultz. A little less than three years ago, however, the quiet storefront made front pages around the world. During the World Trade Organization talks in November, 1999, protesters flooded Seattle's streets, and among their targets was Starbucks, a symbol, to them, of free-market capitalism run amok, another multinational out to blanket the earth. Amid the crowds of protesters and riot police were black-masked anarchists who trashed the store, leaving its windows smashed and its tasteful green-and-white decor smelling of tear gas instead of espresso. Says an angry Schultz: "It's hurtful. I think people are ill-informed. It's very difficult to protest against a can of Coke, a bottle of Pepsi, or a can of Folgers. Starbucks is both this ubiquitous brand and a place where you can go and break a window. You can't break a can of Coke."

The store was quickly repaired, and the protesters have scattered to other cities. Yet cup by cup, Starbucks really is caffeinating the world, its green-and-white emblem beckoning to consumers on three continents. In 1999, Starbucks Corp. had 281 stores abroad. Today, it has about 1,200--and it's still in the early stages of a plan to colonize the globe. If the protesters were wrong in their tactics, they weren't wrong about Starbucks' ambitions. They were just early.

The story of how Schultz & Co. transformed a pedestrian commodity into an upscale consumer accessory has a fairy-tale quality. Starbucks has grown from 17 coffee shops in Seattle 15 years ago to 5,689 outlets in 28 countries. Sales have climbed an average of 20% annually since the company went public 10 years ago, to $2.6 billion in 2001, while profits bounded ahead an average of 30% per year, hitting $181.2 million last year. And the momentum continues. In the first three quarters of this fiscal year, sales climbed 24%, year to year, to $2.4 billion, while profits, excluding onetime charges and capital gains, rose 25%, to $159.5 million.

Moreover, the Starbucks name and image connect with millions of consumers around the globe. It was one of the fastest-growing brands in a BusinessWeek survey of the top 100 global brands published Aug. 5. At a time when one corporate star after another has crashed to earth, brought down by revelations of earnings misstatements, executive greed, or worse, Starbucks hasn't faltered. The company confidently predicts up to 25% annual sales and earnings growth this year. On Wall Street, Starbucks is the last great growth story. Its stock, including four splits, has soared more than 2,200% over the past decade, surpassing Wal-Mart (WMT ), General Electric (GE ), PepsiCo (PEP ), Coca-Cola (KO ), Microsoft (MSFT ), and IBM (IBM ) in total return. Now at $21, it is hovering near its all-time high of $23 in July, before the overall market drop.

And after a slowdown last fall and winter, when consumers seemed to draw inward after September 11, Starbucks is rocketing ahead once again. Sales in stores open at least 13 months grew by 6% in the 43 weeks through July 28, and the company predicts monthly same-store sales gains as high as 7% through the end of this fiscal year. That's below the 9% growth rate in 2000, but investors seem encouraged. "We're going to see a lot more growth," says Jerome A. Castellini, president of Chicago-based CastleArk Management, which controls about 300,000 Starbucks shares. "The stock is on a run."

But how long can that run last? Already, Schultz's team is hard-pressed to grind out new profits in a home market that is quickly becoming saturated. Amazingly, with 4,247 stores scattered across the U.S. and Canada, there are still eight states in the U.S. with no Starbucks stores. Frappuccino-free cities include Butte, Mont., and Fargo, N.D. But big cities, affluent suburbs, and shopping malls are full to the brim. In coffee-crazed Seattle, there is a Starbucks outlet for every 9,400 people, and the company considers that the upper limit of coffee-shop saturation. In Manhattan's 24 square miles, Starbucks has 124 cafes, with four more on the way this year. That's one for every 12,000 people--meaning that there could be room for even more stores. Given such concentration, it is likely to take annual same-store sales increases of 10% or more if the company is going to match its historic overall sales growth. That, as they might say at Starbucks, is a tall order to fill.

Indeed, the crowding of so many stores so close together has become a national joke, eliciting quips such as this headline in The Onion, a satirical publication: "A New Starbucks Opens in Rest-room of Existing Starbucks." And even the company admits that while its practice of blanketing an area with stores helps achieve market dominance, it can cut sales at existing outlets. "We probably self-cannibalize our stores at a rate of 30% a year," Schultz says. Adds Lehman Brothers Inc. analyst Mitchell Speiser: "Starbucks is at a defining point in its growth. It's reaching a level that makes it harder and harder to grow, just due to the law of large numbers."

To duplicate the staggering returns of its first decade, Starbucks has no choice but to export its concept aggressively. Indeed, some analysts give Starbucks only two years at most before it saturates the U.S. market. The chain now operates 1,200 international outlets, from Beijing to Bristol. That leaves plenty of room to grow. Indeed, about 400 of its planned 1,200 new stores this year will be built overseas, representing a 35% increase in its foreign base. Starbucks expects to double the number of its stores worldwide, to 10,000 in three years. During the past 12 months, the chain has opened stores in Vienna, Zurich, Madrid, Berlin, and even in far-off Jakarta. Athens comes next. And within the next year, Starbucks plans to move into Mexico and Puerto Rico. But global expansion poses huge risks for Starbucks. For one thing, it makes less money on each overseas store because most of them are operated with local partners. While that makes it easier to start up on foreign turf, it reduces the company's share of the profits to only 20% to 50%.

Moreover, Starbucks must cope with some predictable challenges of becoming a mature company in the U.S. After riding the wave of successful baby boomers through the '90s, the company faces an ominously hostile reception from its future consumers, the twenty- or thirtysomethings of Generation X. Not only are the activists among them turned off by the power and image of the well-known brand, but many others say that Starbucks' latte-sipping sophisticates and piped-in Kenny G music are a real turn-off. They don't feel wanted in a place that sells designer coffee at $3 a cup.

Even the thirst of loyalists for high-price coffee can't be taken for granted. Starbucks' growth over the past decade coincided with a remarkable surge in the economy. Consumer spending has continued strong in the downturn, but if that changes, those $3 lattes might be an easy place for people on a budget to cut back. Starbucks executives insist that won't happen, pointing out that even in the weeks following the terrorist attacks, same-store comparisons stayed positive while those of other retailers skidded.

Starbucks also faces slumping morale and employee burnout among its store managers and its once-cheery army of baristas. Stock options for part-timers in the restaurant business was a Starbucks innovation that once commanded awe and respect from its employees. But now, though employees are still paid better than comparable workers elsewhere--about $7 per hour--many regard the job as just another fast-food gig. Dissatisfaction over odd hours and low pay is affecting the quality of the normally sterling service and even the coffee itself, say some customers and employees. Frustrated store managers among the company's roughly 470 California stores sued Starbucks in 2001 for allegedly refusing to pay legally mandated overtime. Starbucks settled the suit for $18 million this past April, shaving $0.03 per share off an otherwise strong second quarter. However, the heart of the complaint--feeling overworked and underappreciated--doesn't seem to be going away.

To be sure, Starbucks has a lot going for it as it confronts the challenge of maintaining its growth. Nearly free of debt, it fuels expansion with internal cash flow. And Starbucks can maintain a tight grip on its image because stores are company-owned: There are no franchisees to get sloppy about running things. By relying on mystique and word-of-mouth, whether here or overseas, the company saves a bundle on marketing costs. Starbucks spends just $30 million annually on advertising, or roughly 1% of revenues, usually just for new flavors of coffee drinks in the summer and product launches, such as its new in-store Web service. Most consumer companies its size shell out upwards of $300 million per year. Moreover, unlike a McDonald's (MCD ) or a Gap Inc. (GPS ), two other retailers that rapidly grew in the U.S., Starbucks has no nationwide competitor.

Starbucks also has a well-seasoned management team. Schultz, 49, stepped down as chief executive in 2000 to become chairman and chief global strategist. Orin Smith, 60, the company's numbers-cruncher, is now CEO and in charge of day-to-day operations. The head of North American operations is Howard Behar, 57, a retailing expert who returned last September, two years after retiring. The management trio is known as H20, for Howard, Howard, and Orin.

Schultz remains the heart and soul of the operation. Raised in a Brooklyn public-housing project, he found his way to Starbucks, a tiny chain of Seattle coffee shops, as a marketing executive in the early '80s. The name came about when the original owners looked to Seattle history for inspiration and chose the moniker of an old mining camp: Starbo. Further refinement led to Starbucks, after the first mate in Moby Dick, which they felt evoked the seafaring romance of the early coffee traders (hence the mermaid logo). Schultz got the idea for the modern Starbucks format while visiting a Milan coffee bar. He bought out his bosses in 1987 and began expanding. Today, Schultz has a net worth of about $700 million, including $400 million of company stock.

Starbucks has come light years from those humble beginnings, but Schultz and his team still think there's room to grow in the U.S.--even in communities where the chain already has dozens of stores. Clustering stores increases total revenue and market share, Smith argues, even when individual stores poach on each other's sales. The strategy works, he says, because of Starbucks' size. It is large enough to absorb losses at existing stores as new ones open up, and soon overall sales grow beyond what they would have with just one store. Meanwhile, it's cheaper to deliver to and manage stores located close together. And by clustering, Starbucks can quickly dominate a local market.

The company is still capable of designing and opening a store in 16 weeks or less and recouping the initial investment in three years. The stores may be oases of tranquility, but management's expansion tactics are something else. Take what critics call its "predatory real estate" strategy--paying more than market-rate rents to keep competitors out of a location. David C. Schomer, owner of Espresso Vivace in Seattle's hip Capitol Hill neighborhood, says Starbucks approached his landlord and offered to pay nearly double the rate to put a coffee shop in the same building. The landlord stuck with Schomer, who says: "It's a little disconcerting to know that someone is willing to pay twice the going rate." Another time, Starbucks and Tully's Coffee Corp., a Seattle-based coffee chain, were competing for a space in the city. Starbucks got the lease but vacated the premises before the term was up. Still, rather than let Tully's get the space, Starbucks decided to pay the rent on the empty store so its competitor could not move in. Schultz makes no apologies for the hardball tactics. "The real estate business in America is a very, very tough game," he says. "It's not for the faint of heart."

Still, the company's strategy could backfire. Not only will neighborhood activists and local businesses increasingly resent the tactics, but customers could also grow annoyed over having fewer choices. Moreover, analysts contend that Starbucks can maintain about 15% square-footage growth in the U.S.--equivalent to 550 new stores--for only about two more years. After that, it will have to depend on overseas growth to maintain annual 20% revenue growth.

Starbucks was hoping to make up much of that growth with more sales of food and other noncoffee items, but has stumbled somewhat. In the late '90s, Schultz thought that offering $8 sandwiches, desserts, and CDs in his stores and selling packaged coffee in supermarkets would significantly boost sales. The specialty business now accounts for about 16% of sales, but growth has been less than expected. A healthy 19% this year, it's still far below the 38% growth rate of fiscal 2000. That suggests that while coffee can command high prices in a slump, food--at least at Starbucks--cannot. One of Behar's most important goals is to improve that record. For instance, the company now has a test program of serving hot breakfasts in 20 Seattle stores and may move to expand supermarket sales of whole beans.

What's more important for the bottom line, though, is that Starbucks has proven to be highly innovative in the way it sells its main course: coffee. In 800 locations it has installed automatic espresso machines to speed up service. And in November, it began offering prepaid Starbucks cards, priced from $5 to $500, which clerks swipe through a reader to deduct a sale. That, says the company, cuts transaction times in half. Starbucks has sold $70 million of the cards.

In early August, Starbucks launched Starbucks Express, its boldest experiment yet, which blends java, Web technology, and faster service. At about 60 stores in the Denver area, customers can pre-order and prepay for beverages and pastries via phone or on the Starbucks Express Web site. They just make the call or click the mouse before arriving at the store, and their beverage will be waiting--with their name printed on the cup. The company will decide in January on a national launch.

And Starbucks is bent on even more fundamental store changes. On Aug. 21, it announced expansion of a high-speed wireless Internet service to about 1,200 Starbucks locations in North America and Europe. Partners in the project--which Starbucks calls the world's largest Wi-Fi network--include Mobile International, a wireless subsidiary of Deutsche Telekom, and Hewlett-Packard. Customers sit in a store and check e-mail, surf the Web, or download multimedia presentations without looking for connections or tripping over cords. They start with 24 hours of free wireless broadband before choosing from a variety of monthly subscription plans.

Starbucks executives hope such innovations will help surmount their toughest challenge in the home market: attracting the next generation of customers. Younger coffee drinkers already feel uncomfortable in the stores. The company knows that because it once had a group of twentysomethings hypnotized for a market study. When their defenses were down, out came the bad news. "They either can't afford to buy coffee at Starbucks, or the only peers they see are those working behind the counter," says Mark Barden, who conducted the research for the Hal Riney & Partners ad agency (now part of Publicis Worldwide) in San Francisco. One of the recurring themes the hypnosis brought out was a sense that "people like me aren't welcome here except to serve the yuppies," he says. Then there are those who just find the whole Starbucks scene a bit pretentious. Katie Kelleher, 22, a Chicago paralegal, is put off by Starbucks' Italian terminology of grande and venti for coffee sizes. She goes to Dunkin' Donuts, saying: "Small, medium, and large is fine for me."

As it expands, Starbucks faces another big risk: that of becoming a far less special place for its employees. For a company modeled around enthusiastic service, that could have dire consequences for both image and sales. During its growth spurt of the mid- to late-1990s, Starbucks had the lowest employee turnover rate of any restaurant or fast-food company, largely thanks to its then unheard-of policy of giving health insurance and modest stock options to part-timers making barely more than minimum wage.

Such perks are no longer enough to keep all the workers happy. Starbucks' pay doesn't come close to matching the workload it requires, complain some staff. Says Carrie Shay, a former store manager in West Hollywood, Calif.: "If I were making a decent living, I'd still be there." Shay, one of the plaintiffs in the suit against the company, says she earned $32,000 a year to run a store with 10 to 15 part-time employees. She hired employees, managed their schedules, and monitored the store's weekly profit-and-loss statement. But she was also expected to put in significant time behind the counter and had to sign an affidavit pledging to work up to 20 hours of overtime a week without extra pay--a requirement the company has dropped since the settlement. Smith says that Starbucks offers better pay, benefits, and training than comparable companies, while it encourages promotions from within.

For sure, employee discontent is far from the image Starbucks wants to project of relaxed workers cheerfully making cappuccinos. But perhaps it is inevitable. The business model calls for lots of low-wage workers. And the more people who are hired as Starbucks expands, the less they are apt to feel connected to the original mission of high service--bantering with customers and treating them like family. Robert J. Thompson, a professor of popular culture at Syracuse University, says of Starbucks: "It's turning out to be one of the great 21st century American success stories--complete with all the ambiguities."

Overseas, though, the whole Starbucks package seems new and, to many young people, still very cool. In Vienna, where Starbucks had a gala opening for its first Austrian store last December, Helmut Spudich, a business editor for the paper Der Standard, predicted that Starbucks would attract a younger crowd than the established cafés. "The coffeehouses in Vienna are nice, but they are old. Starbucks is considered hip," he says.

But if Starbucks can count on its youth appeal to win a welcome in new markets, such enthusiasm cannot be counted on indefinitely. In Japan, the company beat even its own bullish expectations, growing to 368 stores after opening its first in Tokyo in 1996. Affluent young Japanese women like Anna Kato, a 22-year-old Toyota Motor Corp. worker, loved the place. "I don't care if it costs more, as long as it tastes sweet," she says, sitting in the world's busiest Starbucks, in Tokyo's Shibuya district. Yet same-store sales growth has fallen in the past 10 months in Japan, Starbucks' top foreign market, as rivals offer similar fare. Add to that the depressed economy, and Starbucks Japan seems to be losing steam. Although it forecasts a 30% gain in net profit, to $8 million, for the year started in April, on record sales of $516 million, same-store sales are down 14% for the year ended in June. Meanwhile in England, Starbucks' second-biggest overseas market, with 310 stores, imitators are popping up left and right to steal market share.

Entering other big markets may be tougher yet. The French seem to be ready for Starbucks' sweeter taste, says Philippe Bloch, cofounder of Columbus Café, a Starbucks-like chain. But he wonders if the company can profitably cope with France's arcane regulations and generous labor benefits. And in Italy, the epicenter of European coffee culture, the notion that the locals will abandon their own 200,000 coffee bars en masse for Starbucks strikes many as ludicrous. For one, Italian coffee bars prosper by serving food as well as coffee, an area where Starbucks still struggles. Also, Italian coffee is cheaper than U.S. java and, say Italian purists, much better. Americans pay about $1.50 for an espresso. In northern Italy, the price is 67 cents; in the south, just 55 cents. Schultz insists that Starbucks will eventually come to Italy. It'll have a lot to prove when it does. Carlo Petrini, founder of the antiglobalization movement Slow Food, sniffs that Starbucks' "substances served in styrofoam" won't cut it. The cups are paper, of course. But the skepticism is real.

As Starbucks spreads out, Schultz will have to be increasingly sensitive to those cultural challenges. In December, for instance, he flew to Israel to meet with Foreign Secretary Shimon Peres and other Israeli officials to discuss the Middle East crisis. He won't divulge the nature of his discussions. But subsequently, at a Seattle synagogue, Schultz let the Palestinians have it. With Starbucks outlets already in Kuwait, Lebanon, Oman, Qatar, and Saudi Arabia, he created a mild uproar among Palestinian supporters. Schultz quickly backpedaled, saying that his words were taken out of context and asserting that he is "pro-peace" for both sides.

There are plenty more minefields ahead. So far, the Seattle coffee company has compiled an envious record of growth. But the giddy buzz of that initial expansion is wearing off. Now, Starbucks is waking up to the grande challenges faced by any corporation bent on becoming a global powerhouse.

By Stanley Holmes in Seattle, with Drake Bennett in Paris, Kate Carlisle in Rome, and Chester Dawson in Tokyo, with bureau reports

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