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Starbucks (NASDAQ:SBUX) has had an impressive run over the past three years. Since shuttering a number of underperforming stores in the United States, revenue, profit, and financial metrics have strengthened across the board. Net income tripled from FY 2009 to FY 2011 and investors have been richly rewarded, with shares quintupling over that time frame.

Recently, Starbucks described plans to expand vertically by acquiring La Boulange bakery and establishing its own baking operation. This follows its trend of recapturing value added across their product lines, as it did in 1998 by purchasing Tazo Tea, taking back in-house their retail coffee distribution agreement with Kraft in 2010, and acquiring Evolution Fresh in 2011. Although Starbucks has a spotty record when it comes to diversifying away from their core business (see: past experiments at online furniture sales, chat rooms, and music publishing through HEAR Music), they have an excellent history integrated acquisitions central to their core business. Many view improving food offerings at Starbucks a defensive maneuver, to protect against growing competition from food-focused Panera (NASDAQ:PNRA).

However, Starbucks has not been fully recognized for its skill at integrating acquisitions. Starbucks has absorbed a number of smaller coffee competitors, first with a purchase of United Kingdom-based Seattle Coffee Company in 1998 to gain an international foothold and then swallowing up Seattle Coffee Company (no corporate relationship to the U.K. firm) in 2003. It is interesting then that Starbucks has recently announced the opening of new stores under their Tazo Tea brand instead of acquiring a smaller competitor. It is not only taking on established competition in Peet's (NASDAQ:PEET), but also upstart Teavana (TEA), which has a strong roster of over 200 outlets across the United States and went public in August of 2011. For a retailer so synonymous with coffee, opening new outlets focused on tea for Starbucks raises two key questions for investors:

1) Is the extension into tea an appropriate extension of the retail brand?

The question regarding extending the retail brand is a function of expense and positioning. Starbucks has been careful historically to have tea on offer as a part of the broader framework of retail offerings in the coffee house. Opening tea-focused locations marks a major shift in branding away from Starbucks and toward a brand that has relatively little consumer loyalty beyond its role as Starbucks flagship tea offering. Developing Tazo as a stand-alone brand, both in terms of physical retail and in terms of brand intangibles, will require major marketing outlays. For now, Starbucks has only released plans to open one Tazo Tea location.

2) Is opening new locations the prudent strategy, rather than through acquisition?

Starbucks is choosing to develop Tazo independently, rather than take the opportunity to merge with a competitor in Peet's, Teavana, or any number of smaller operators across the country. Intriguingly, Starbucks has only committed to opening one Tazo Tea location at present. This is curious, in the sense that the Tazo opening represents a major extension of their retail concept. The limited expansion may indicate that Starbucks is testing the waters with a Tazo branded location as a means for assessing whether an acquisitive strategy or continued expansion of Tazo will be more operationally advantageous. Starbucks has the capability to absorb either Peet's or Teavana with ease. Peet's has a market capitalization of $750 million, while Teavana's is $500 million. Starbucks sits on a net cash position of $1.5 billion. The compelling value that Starbucks would get via acquisition of Peet's or Teavana at those levels may be too great to ignore. I anticipate that Starbucks will determine that the synergies and competitor reduction benefit will be sufficient to motivate them to acquire either Teavana or Peet's within the next two years.

Whichever approach Starbucks takes is likely to benefit Peet's and Teavana in the long-run. Although tea is a $95 billion business, the United States lags most countries in retail tea consumption. Starbucks largely created the specialty coffee category in the United States over the past two decades, and its entrance in the tea retail market enhances, rather than threatens, the other major players in the space. As such, all three principal players in the tea space deserve a strong look going forward.

Source: Starbucks And Teavana: A Match Made In Heaven?