For Starbucks, There's No Place Like Home

Its overseas expansion is running into trouble

When Starbucks (SBUX ) Corp. opened its first Japanese café in Tokyo's fashionable Ginza shopping district in 1996, it was an overnight smash. Today, with 467 Starbucks stores -- 117 opened last year alone -- Japan boasts Starbucks' biggest foray outside the U.S. And it is the centerpiece of the company's critical overseas expansion strategy. Trouble is, after just two profitable years, Starbucks is no longer making money in Japan. On May 20, Starbucks' Japanese business, a joint venture with the tea-shop and interior-goods chain Sazaby Inc., announced an annual loss of $3.9 million on revenues of $467 million.

It isn't just Japan. From Zurich to Tel Aviv, Starbucks' overseas expansion is running into trouble. Now operating in 30 countries beyond the U.S. and Canada, Starbucks cafés have encountered a host of problems, from high startup costs to stiff competition, and, in many cases, resistance to the Starbucks experience. While it has scored big in the U.S. as a hip purveyor of better coffee, it is often seen abroad, especially by European café-goers, as an overpriced imitation of the real thing. To date, Starbucks' 1,532 overseas stores, which account for 23% of its stores, yet only 9% of sales, are a net money loser.

The lukewarm overseas performance is a setback for Starbucks Chairman Howard Schultz, who had been counting on foreign expansion to keep growth percolating once the torrid pace of U.S. expansion cools down. That hasn't happened yet. For the first half of 2003, net earnings increased 31%, to $130 million, while sales jumped 23%, to $2 billion. But with a Starbucks seemingly at every other intersection in America, Schultz knows the chain will eventually run out of room in the U.S.

Yet overseas expansion has been tricky. Unlike in the U.S., Starbucks faces big rivals in Europe and Asia. In Britain, where Starbucks has about 330 locations, Chief Financial Officer Michael Casey says tough competition is the problem. Rivals often charge lower prices: In London, a Starbucks tall latte sells for $2.93, while the same drink goes for $2.12 at the rival Caffè Nero Group PLC. In Germany, imitators have saturated Frankfurt and Berlin with Starbucks-like coffee bars.

Likewise in Japan, coffee sippers are increasingly finding their caffeine fix elsewhere. Tokyo secretary Ritsuko Oomi started frequenting the Ginza Starbucks in 1996. Now, she says, "I never go to Starbucks if I can help it. The coffee tastes artificial." Her favorite brand now: Tully's Coffee Corp., a Seattle rival. She has company: Starbucks' same-store sales in Japan fell 17% last year.

Another reason Starbucks hasn't been as successful abroad as in the U.S. may be the complex series of joint ventures Schultz agreed to in order to expand quickly. While the company gets a slice of revenues and profits as well as licensing fees for supplying its coffee, it has been harder than in the U.S. to control costs. One profit killer: real estate and labor costs far higher than those in the U.S.

Can Starbucks freshen its performance overseas? It's a double tall order, but doable. Starbucks execs insist the international rollout, after making adjustments, is on track. The company bought out partners in its troubled Swiss and Austrian stores. It's closed six unprofitable Starbucks in Israel and cut international expansion by 50 stores, to 400 this year. Says CFO Casey: "We're meeting our financial targets."

But some industry experts disagree. They say rethinking the joint-venture strategy will be key. The company also needs to become more competitive on price. Says Mitchell J. Speiser, an analyst at Lehman Brothers (LEH ) Inc.: "The expansion strategy internationally is not bulletproof as it is in the U.S."

The company has time to get things right. Starbucks is nearly debt-free and has more than $300 million in annual free cash flow, part of which it can use to finance its overseas ambitions. Casey predicts Starbucks' international business will turn a profit in fiscal 2004. But there's a big difference between crawling back into the black and driving future growth. And that's a bitter brew for Starbucks to swallow.

By Stanley Holmes in Seattle, with Irene M. Kunii in Tokyo, Jack Ewing in Frankfurt, and Kerry Capell in London

    Before it's here, it's on the Bloomberg Terminal.