Originally published on CNBC on Jan. 30, 2012.
About 14 years ago, I met an entrepreneur who wanted to open up coffee shops around China. I never thought the coffee business would work in the country. The Chinese would not easily give up their tea drinking culture for a bitter, overpriced drink, I told him.
Starbucks (NASDAQ:SBUX) has proven me wrong. Howard Schultz, the CEO of Starbucks, announced that China will soon become its largest market outside the United States. It has opened over 500 outlets in the country, which are more profitable per outlet than in the US according to the chain's Chief Financial Officer, Troy Alstead.
What did Starbucks do to succeed in a market where so many other western food and beverage brands like Dunkin Donuts (NASDAQ:DNKN), Krispy Kreme (KKD) and Burger King (BKC) have failed to live up to expectations? What Starbucks did right in China is a great case study how food brands can succeed despite rising labor and real estate costs and increased competition on the mainland.
Instead of trying to force onto the market the same products that worked in the U.S. like regular coffee, Starbucks developed flavors, such as green tea flavored coffee drinks, that appeal to local tastes. Rather than pushing take-out orders, which account for the majority of American sales, Starbucks adapted to local consumer wants and promoted dine-in service.
By offering comfortable environments in a market where few restaurants had air conditioning in the late 1990s, Starbucks become a defacto meeting place for executives as well as gatherings of friends. In other words, Starbucks adapted its business model specifically for the Chinese, rather than obstinately trying to transplant everything that worked in America into China, as so many brands like Best Buy (BBY) and Home Depot (NYSE:HD) have done. (See my article Why Global Brands Fail in China.)
The challenge with pushing dine-in service in large, comfortable outlets rather than take out is that revenue per square meter is less than in the U.S. The average revenue per outlet in China is one-third to two-thirds that in the US, according to the CFO Alstead.
To counteract this, Starbucks positioned itself as an aspiration buy. The average coffee sold in China is more expensive than in the U.S. Carrying a cup is now seen as a status symbol, a way to demonstrate sophistication, a little personal luxury for middle class Chinese.
Starbuck's high pricing strategy of specialty drinks allows it to have its Chinese outlets to be more profitable per store in China despite the lower volume. Overall in Asia, its operating margins were 34.6 percent in 2011 versus 21.8 percent in the U.S. Too many brands push for market share by cutting prices but in reality they should be aiming for margins.
Not only does Starbucks' premium pricing strategy fit market demands but it also allows it to regularly roll out higher margin specialty products like gift sets that offset rising commodity costs. As China's urbanization rate nears 52 percent, companies need to put into place strategies to handle rising commodity costs.
Starbucks has also done an amazing job at recruiting, retaining, and training employees. 30 percent annual turnover is common in China according to data compiled by my firm. Yet, Starbucks has far lower turnover than the industry average by good compensation packages, work environments, and career paths. One barista who has been working at Starbucks for five years told me, "I feel taken care of by management. I enjoy my job and I enjoy working here so I expect to stay longer." That is a rare comment in a country where job hopping is the norm among younger workers.
Starbucks' service is on par if not higher than many 5-star hotels. In consumer interviews with several hundred consumers in Shanghai, the majority told my firm they actually preferred the taste of products from competitors but continued to go to Starbucks because of the service.
Far too many multinational companies treat their Chinese employees as second-class citizens with little career development. Their senior management ranks are full of foreigners, Taiwanese or Hong Kongers without any mainland Chinese representation.
Starbucks understood that the value proposition it was offering Chinese was different than in the U.S. They were able to adapt their business model to fit China while keeping their core values. Truly great global brands adapt to different markets as Starbucks has done.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.