Is Japan Losing Its Taste for Latte Already?

Losses climb as Starbucks Japan's growth grinds down

When Starbucks Coffee Japan Ltd. offered its shares to the public 13 months ago, Japanese consumers couldn't seem to trade in their cups of green tea for trendy mugs of caffe latte fast enough. Profits were up, sales hit new highs, and Seattle-based Starbucks' (SBUX ) Japanese affiliate was adding stores at an espresso pace. But about the time its shares peaked at $690 a year ago, the buzz began to wear off, and the piping hot profit growth cooled.

The extent of the decline became clear on Nov. 20, when the company reversed its earnings forecast for the year: Instead of a $7.9 million profit, Starbucks Japan now expects a $4.2 million loss. The Japanese company also cut projected sales by 10%, to $467 million, and cancelled a promised dividend payment to shareholders. "We have been adversely affected by the economy," says Starbucks Chairman Howard Schultz. The company has also opened 103 new stores so far this year--some within a few hundred meters of existing shops--and they are stealing business from older locations. Still, Schultz says, "there is no flinching whatsoever in our commitment to the Japanese market."

The turmoil has knocked all the froth off the stock price. On the day of the grim revision, investors pushed down the company's shares to a record low of $82, although the stock has since rebounded to $101. Despite strong revenue growth, the worry is that profits will continue to suffer as consumers' thirst for cappuccinos-to-go wanes. And Starbucks is no longer the only purveyor of lattes in Tokyo. Rivals such as Doutor Coffee Co. and Peet's Coffee & Tea Inc. (PEET ) are flooding Japan with upscale java. "Starbucks needs to find a way to be profitable in a slower-growth mode," says Kiyoshi Mori, an analyst at Okasan Securities Co. in Tokyo. He's not alone. A recent Goldman, Sachs & Co. report says it will be tough for the company to post a profit unless it cuts back expansion plans and personnel costs.

So far, Starbucks Japan's woes haven't dented profits at its American parent, which owns 40% of the venture. But if the company fails to get back in the black next year, it could cast a shadow over its global business. Foreign operations are the gourmet coffee chain's fastest-growing segment--and Japan is its single biggest market outside the U.S.

Starbucks execs insist a drop in existing store sales in Japan is part of a carefully thought-out plan to expand the number of shops in the country to 1,000 by 2007. The rapid run-up in the number of outlets, they say, will relieve congestion and boost earnings. In U.S. cities such as New York and Chicago, higher profits from new stores have indeed offset slowing sales at older outlets. But coffee drinking is an ingrained part of U.S. culture. In Japan, Starbucks is fighting 1,000 years of green-tea-sipping tradition. That has prompted local officials to re-evaluate Starbucks' tactics. "Everyone realizes we cannot continue at this pace," says Johanna Metzger, chief marketing guru at Starbucks Japan. "We've downshifted a bit."

In an attempt to broaden its appeal, Starbucks last spring added food items such as rice-and-salmon wraps and white peach muffins to its menu. But they haven't caught on, and the sales trend is going the other way. Beverages today make up 76.8% of total sales, up from 75% last year. Now Starbucks hopes to goose purchases of food and knickknacks such as coffee mugs in Japan by introducing prepaid cards to take the place of small change. And late next year, it may add bottled Frappuccino coffee drinks to the mix.

To cut costs, the company is looking for new suppliers. Mugs will now come from a low-cost vendor in Japan, and Starbucks is buying more of its paper goods from Southeast Asia instead of importing them from the U.S. Most important, Starbucks will slow its expansion, adding just 80 stores in 2003, down from 115 this year. And execs say they'll close as many as 10 money-losing locations. Cutting back on the number of stores and curtailing costs, analysts say, may be the only way to stop losing money--and inject some steam back into the stock price. Starbucks shareholders may like their coffee with plenty of hot milk. But they like the bottom line black.

By Chester Dawson in Tokyo, with Stanley Holmes in Seattle

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