Is Starbucks Pushing Prices Too High?

The upscale coffee chain may have reached the ceiling on what its increasingly budget-conscious customers will pay for a latte

Editor's Note: This is an update to a story originally published on July 31. This update incorporates third-quarter results announced Aug. 1.

Ali Zouaouid enjoys watching the Starbucks on 49th Street and Seventh Avenue in Manhattan get busy. He runs the coffee and pastry cart on the street nearby. When the lines inside Starbucks get long, customers flock to his cart instead, where a small cup of coffee is only 75¢. At 9:45 a.m. on July 31, as four headset-clad baristas scramble to take orders, about 20 people are in two lines that snake around the inside of the Starbucks store. That morning, Zouaouid also got an extra helping hand: Starbucks had just raised prices by an average of 9¢ a cup. "It's very good business," he says, grinning widely.

Certainly most of the customers stayed inside to wait for their Starbucks drink. But as Starbucks (SBUX) prepares to announce its third-quarter earnings on Aug. 1, the company is struggling to continually boost the amount each customer pays at the cash register while it tries to add new customers. Some on Wall Street wonder whether, after 15 years of blockbuster growth, Starbucks will finally be unable to show an increase in the number of transactions at the cash register—the prime indicator of customer numbers. "That's the big unknown, the big question," says John Glass, analyst with CIBC World Markets. More troubling, now there may be signs that Starbucks, famously the purveyor of the $4 latte, won't be able to raise prices much higher.

Margin Squeeze Pulls Down Stock

After the bell on Aug. 1, Starbucks announced its third-quarter results. Earnings were in line with analyst estimates, with revenues rising 20%, to $2.4 billion, and net income increasing 9% to $158.3. Investors cheered the news, bidding up Starbucks' stock by 3% to more than $28 a share in after-hours trading.

Still, the stock has dropped by 20% over the past 12 months and many concerns remain. Operating margins declined to 10.4% from 10.9%, because of increased expenses such as building costs and renovations. And same-store sales growth remains a tough challenge. Sales at stores open more than a year increased by 4% for the period. But 3% of that came from an increase in the value per customer transaction, including price hikes. "Less than 1%" of the same-store increase came from the number of transactions in store, said Michael Casey, the company's chief financial officer, in a conference call with analysts. "'[Foot traffic] continues to be impacted by a number of factors," he said. "There is an increased competitive environment, there is increased pressure on consumers from macroeconomic factors." Casey also said that while he thought there was a possibility that the latest price increase "could have a modest negative impact on transaction growth," he said the company didn't expect it to have a significant impact on next quarter's same-store sales.

To improve same-store sales growth, Starbucks has said it will slow new-store growth to avoid cannibalizing customers from existing stores. Instead of increasing the number of new stores added each year, Starbucks will build 1,700 each year for the foreseeable future.

Starbucks has raised prices seven times since 1997. Each time, there has been little effect on demand, according to analysts, and they say they expect the July 31 price increase to be the same. However, with increased competition and new growth coming from less-affluent customers, that could change in the near future.

Fast-Food Java Joints

First, there's vastly increased competition in the coffee market. McDonald's (MCD) recently entered the fray with its own "Premium" coffee, which it sells for $1.39 for a small size, compared with Starbucks' $1.75. A juggernaut with 13,794 stores that spends roughly $782 million in advertising in the U.S., McDonald's has been aggressively marketing its coffee to win breakfast-time customers, even giving it away in some regional promotions. And it's been winning plaudits for quality. Consumer Reports conducted head-to-head comparisons with the coffee from Starbucks, Dunkin' Donuts, McDonald's, and Burger King (BKC)—and McDonald's won the top prize.

Longtime competitor Dunkin' Donuts has also made moves to grab the market of affluent women and professionals, two strong bases for Starbucks. That's included a partnership to distribute coffee on JetBlue Airways (JBLU) and hiring chef and talk show personality Rachael Ray, who is featured in ads grabbing a cup of Dunkin' Donuts iced coffee while racing around between her high-profile jobs. "Rachael [Ray] has a tremendous following with women 18 to 49," says Will Kussell, chief operating officer of Dunkin' Brands. "There's a great opportunity to grow that part of the business.… We've believe we've taken market share from all our competitors."

Declining Customer Affluence

Second, new Starbucks customers—who provide a significant amount of sales growth—are increasingly less affluent and less educated than its current customer base. That makes them more sensitive to price increases in the future. According to a Oct. 5, 2006, presentation to analysts, customers who shopped Starbucks for the first time in the last year had an average income of $80,000 a year, vs. the $92,000 a year average for those who first visited five years ago. Some 30% of the new customers had finished college, vs. 45% in the past.

"The Starbucks customer five years ago shrugged everything off, because [the company] had such an affluent base," says Joe Buckley, Restaurant Analyst for Bear Stearns (BSC). "Starbucks has been very successful broadening their customer base, but one result of doing that is that their customers aren't quite as indifferent to what's going on around them.… Marginal customers might be peeling out based out higher costs and budgetary issues."

All this is exacerbated by the amount of scrutiny Starbucks is under. Because it is famous for high coffee prices, consumers immediately notice any shifts. Customers visit the stores every day, and "every time they raise prices, it's been front-page news," says Glass. "It's never front-page news on any other company."

What's the Limit?

So what price increase will finally drive customers away? Analysts demurred. "I have no idea," says Glass. "Demand elasticity or inelasticity is the kind of thing where you'll never know until you step over it."

Not everyone agrees. Hugo Sueiro, a 40-year-old lawyer in line at the Midtown Starbucks, says he's indifferent to the current price increase because he rounds up the total to the nearest dollar to give a little tip to the baristas. If it ever increased beyond that dollar ceiling, though, that's another story. "That's it—I'm going to Dunkin' Donuts," he says.

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