Starbucks' Success Is Not So Simple

| About: Starbucks Corporation (SBUX)

Summary

Although Howard Schultz will remain as executive chairman and be involved in new initiatives, that he is once again stepping down as CEO raises the question of strategic continuity.

While focus is on global growth, the US accounts for more than 60% of Starbucks' sales, but customer traffic is down YOY.

The company has strong financials that are both evidence of and potential drivers for business development.

Starbucks' success is not about the effective execution of well-considered strategies or even operational excellence, it is the ability to adapt to competitive challenges.

While a believer in Occam's razor, the argument that Starbucks' (NASDAQ:SBUX) growth is easily explained and thereby almost guaranteed is a bit too simple of an explanation. If unfamiliar with the concept of Occam's razor, in keeping with its belief in simplicity, here is a definition from a simple site.

Introduction

While I would agree that Starbucks is an incredibly well-run business that is increasingly making money, I would disagree with the premise that the explanation is a simple recitation of numbers or that growth is guaranteed.

Yes, Starbucks has growth. New stores have almost doubled over the past 10 years and revenues have more than doubled (though we need to point out this is total revenues, not merely store revenues). And, if you thought you would have to search another couple of blocks to find a local Starbucks store, you need not worry. Starbucks is planning to develop another 12,000 locations over the next five years.

In fact, not willing to rest on its laurels, Starbucks' aggressive five-year plan noted here includes

"Double-digit percentage growth projections for sales and earnings per share, with a rising presence in China playing a key role in driving expansion. Perhaps, most interesting is the opportunity that Starbucks sees in the ultra-premium space, with its Reserve Roastery concept potentially appealing to high-end customers wanting a luxury experience while also promoting innovation that could filter down to Starbucks' conventional stores. Combine that with opportunities for greater penetration in grocery-sold consumer products, and the tuck in plan to double sales of food by 2021 to almost $5 billion, and Starbucks' growth prospects look very promising."

Well then, success is in the bag! Or not. Whether these plans are realized is not as dependent on operational excellence as it is on whether Starbucks has made good strategic choices and is able to adapt as it goes. Allow me to explain why this matters.

It is clear that in the past, Starbucks has been very deliberate in its choice of strategies. But, what has emerged has not always proven its intent was on target. Rather, what has saved the day is often more associated with the ability for adapting and overcoming emergent challenges. For example, its initial effort into serving wine, beer and small food plates really did not find a foothold in its customer base. Branding expert Carlos Pena doesn't understand Starbucks' decision. He says the company has already spent millions marketing itself as a coffee chain. Why change now? "Given all the money they've already spent, I think it's a bad idea for the long term because they are going to spend a lot more money trying to reposition people's minds," he said. "Go back to your original roots. Solidify that."

This was wise counsel when offered and, while it did not take hold at the time, Starbucks' effort did serve as a laboratory for learning; a skill the company has developed since being acquired by Howard Schultz.

Starbucks lacked vision until Schultz provided it

While working as director of marketing for what was then a coffee bean seller, Howard Schultz returned from a business trip to Italy and sought to convince the founders of Starbucks that rather than merely selling bulk beans to customers in Seattle's Pike Place Market, they should vertically integrate by opening stores selling coffee drinks. This revolutionary idea of the coffee shop as the gathering place he saw in Italy (and, as travelers will note, in France and most of Europe) fell on deaf ears. So Schultz left the company and started il Giornale. As a business, it was "meh" but the concept proved Schultz correct. Ultimately, he made an offer to buy Starbucks from the owners (who, in a turn of fate, ended up buying Peet's Coffee) and Schultz injected his enthusiasm and vision into the bean seller, and began to open stores with the mission of Starbucks being the "Third Place" for customers (after home and work, just like in Europe).

The aspirational "Third Place" was a critical distinction because what that meant was Starbucks' strategy for growth required it to commit resources to develop those stores in a manner that made customers feel both welcome and comfortable. That not only meant furniture and accouterments for such an environment, it also meant they were going to be counter-cultural (no pun intended) to the restaurant industry, which focused on serving customers quickly and getting them out the door, so there would be room for the next set of customers. In fact, with the addition of comfy furniture and then Wifi, Starbucks most assuredly was inviting customers for an extended stay. The real purpose was to get more customers in the doors by selling an image of the café as a gathering spot. It is with this strategy of differentiated vertical integration, with its creation of a welcoming and comfortable store environment, that Starbucks was able to appeal to customers to buy coffee products (and what little food it sold) and spend time relaxing, talking with others or working, often online.

But things started to change, consumers wanted more food choices with their coffee (perhaps because they were hanging around long enough to get hungry). However, Schultz was fearful that the smell of cooking food would detract from the pervasive smell of coffee (anyone spending time in a Starbucks store knows you have to launder your clothes if you spend more than an hour there). Despite its obvious revenue potential, Starbucks' senior management resisted adding anything more than a limited number of cold items, a marketing argument its competitors often used against it. Nonetheless, over time, Starbucks was able to grow its store base, add food items warmed not cooked in the stores, and increase total revenues effectively based on that strategy. That is, until it was presented with a significant opportunity for adaptive change.

Strategic surprises

While it might be pointed out where Starbucks commitment to certain products has not always realized the financial benefit anticipated, these are merely tactical considerations. With the relatively low price points of its products ensuring customers could purchase daily (compared to autos, clothing, or chain saws) Starbucks is not likely to be strategically hurt or helped by a particular product. Again, products are inherently tactical. The concern for any company must be with their strategies because they are the basis for achieving success. Without effective strategies, success can be elusive. And, Starbucks has made its share of strategic mistakes.

One strategic mistake was born of hubris by Howard Schultz who, during the early 2000s, indicated he did not think that the planned exponential development of stores would result in the cannibalization of sales. This ignored the basic "laws" of retail development that struck even the great McDonald's (NYSE:MCD).

As a consequence of seeking growth through scale, Starbucks probably didn't anticipate how much it would be hurt by the down economy during the Great Recession, which was further impacted by poor real estate decisions in its go-go growth period.

However, adapting to the environment, Starbucks did pare down its aggressive development plan and closed or did not develop more than 600 units. It also recognized the need to slow down what remaining development had been planned. That it ultimately achieved the initially planned store growth is the point and helps set the table for a discussion about adaptive strategy.

Post Great Recession, Starbucks was experiencing some continued softness in same store sales and its new product development was not going as well as it would have liked (among others, its much marketed "drinkable chocolate dessert" was a failure). So Starbucks did some research and was startled by its findings, in no small part because it ran counter to the internally held beliefs that were the genesis of Starbucks' strategic focus on innovative products and the "Third Place".

In the world of strategy, the biggest waste of time and money is on strategies that do not work. Just so we are clear, despite efforts by some to make it mysterious, a strategy is simply defined as goal-oriented plans and actions. Not too complicated by definition, very much so in its execution. Consequently, when your strategy is innovative products, there is tremendous effort and expense put forward in developing new products.

Starbucks' focus on innovation created new drinks, but it also meant a complicated menu. Because the truism remains that structure follows strategy, R&D and planning were the primary focus of the business, as the company continually researched and applied various metrics to determine customer attitudes about new beverages. Implicitly, this meant that operational management was subservient to product innovation. The thinking at Starbucks was - We give you what you need, just sell it without too much fuss. But, ignoring the importance of the customer interface at the site of actual revenue generation was a mistake and caused the company to recognize that if it builds it they will not always come.

So there is an unexpected (or at least unrecognized and certainly unplanned) cost to complex, innovative offerings. One such outcome was that serving a wide range of complex beverages that were made upon demand meant increasing customer wait times. Correspondingly, it also increased labor demands in the stores (it is worth noting that, even in operationally well-controlled food shops, fully 33-38% of the cost of restaurant operations is labor). Conversely, over time, the demand for labor-intensive drinks in Starbucks stores declined. Beyond conflicting the unit labor schedule, it confused those in higher-level positions, particularly in R&D, who continued to focus on developing innovative drinks and wondered why they were not selling as well. Now, here is where it got even more interesting.

According to Starbucks' own research in 2009, a "highly satisfied customer" spent $4.42 on average per visit and visited an average of 7.2 times per month, translating into an average spending of $31.82 per month and $381.89 per year. By contrast, "unsatisfied customers" spent $3.88 per visit and visited an average of 3.9 times per month, translating into a monthly average of $15.13 and $181.58 on a yearly basis.

It is obvious the "unsatisfied" customer spent less than half of what a satisfied customer did on an annual basis. This is real money when extrapolated on a system-wide basis (a couple of billion dollars or more). And it got even more interesting when the remainder of the research was analyzed.

In what had to be a shock to its system, it was found that 75% (fully three-quarters) of Starbucks' customers placed a high value on friendly, fast, convenient service, while only 15% (fifteen percent!) considered new, innovative beverages to be highly important. This had to be a Wednesday-Thursday-Friday realization for senior management. It meant that the strategy was wrong, that the incumbent costs of developing novel, innovative drinks were not a driver of customer traffic; in fact, it was detrimental to what the customer actually wanted - to get their drink, perhaps from a smiling employee, and get out the door fast!

If we return to the belief that Starbucks aspired to be the Third Place, we can see the strategic decision about the developmental costs for stores and products did not make financial sense on a go-forward basis. So Starbucks did what it does well, it adapted.

Among the strategic moves Starbucks made in response to its research findings was to cut back on its menu items and, in a bit of good theatre (and smart operations), announced it would close all its units for a "development day" that would enable it retrain all of its associates in the proper manner of customer service, including drink preparation (which did require a greater investment in more expensive equipment, but it did reduce labor costs). On August 1, 2009, Starbucks closed the units and retrained its staff. In a flurry of efficiency and cost savings, the company reduced service times 18% across its system. In so doing, Starbucks refocused on product quality, reduced its menu, re-focused on customer service, and sought to reignite a pleasant store atmosphere, albeit with a new interior design that promoted faster service rather than cushy seating and relaxing ambience. And, it started creating more drive-thru units. A great idea borrowed from the experience of McDonald's, a company that gets about 68% of store revenues through drive-thru windows versus dine-in.

Without question what made Starbucks successful was the ability to react to drivers of change in the competitive environment, mimic an industry leader, and create a more optimal strategy for growth; against which it executed operationally.

What was clear was that Starbucks' success was not because of its ability to predict the future accurately and create effective strategies, but because of its ability to adapt its strategies to the present; which is an easier way to address uncertainty. How did it do this? It would appear by:

  1. Identifying the range and limits of uncertainty and determining what was possible.
  2. Investing in and executing on the chosen strategies.
  3. Adapting the strategic choices as the situation changes.

Working toward strategic flexibility

Does past success predict future success? While academics and practitioners take various positions on the issue, the evidence supports the premise that, as it relates to organizations (as opposed to individuals), past success is a predictor of future success. Based on the evidence to date, there is little to suggest Starbucks will not continue on its upward trajectory toward revenue growth, even with Schultz no longer in the CEO role; though let's not lose sight of the fact that he will be the executive chairman and his fingerprints will remain on the company, as its recent pronouncements indicate.

But, I would caution those who want to claim Starbucks' future is unquestionably clear. It is not. As noted earlier in this article, the coffee Roastery effort is not without precedent. Starbucks tried to expand into wine, beer, coffees and food for a later night crowd (a good idea when considering the sunk costs of development and that most business in its stores occurs before 2 PM), but it did not work out. So, will the coffee Roastery be a business success? This remains an unanswered question because it will require creating an appeal to a different customer base for a very different day part. One might suggest it will require an argument that Starbucks should aspire to be the "Second Place".

When we look at Starbucks' system-wide sales, it is all too easy to conflate the success of the company. For example, when looking at McDonald's, it is only by effectively analyzing its business that it becomes apparent that a large portion of its revenues and growth are from the rent it receives as landlords of its licensees. This reality is not lost on Starbucks because it has mimicked McDonald's more than it would be willing to admit. So it is that Starbucks needs to employ a very different set of strategies to run its stores.

Beyond the actual operations is the question of customer awareness and interest. When an iconic brand like Starbucks comes to a city near you, in your country, it is a big deal. Lines can extend around the corner. But, as has been discovered by many, including Krispy Kreme Doughnuts, it does not mean there is sustainability. It does mean, however, that investors need to recognize the difference in performance of international stores versus domestic US locations. For Starbucks, there is international growth, but the US growth is stagnant and it appears prospective on future locations being opened. But, let's be clear, while opening more locations can generate sales volume, it does not mean greater profitability. Yes, Starbucks' revenues have been growing at an average rate of 12.76% over the past five years and its financials are nothing but admirable. But nothing is forever, adaptation has its limits, and the future is uncertain.

As evidence, consider that Starbucks reported Q4 2016 same store sales in US was up 4%, but it did not do that organically by growing customer traffic. In fact, customer traffic was down 1%. How it grew profit was unsustainably mechanistic through the benefits of lower commodity costs, primarily from coffee, and an increase in product prices during the year.

It is also important to recognize that in no small part growth was attained by effectively targeting acquisitions of other retail shops that provided key benefits - line extensions of tea and food (Teavana, 2012, La Boulange, 2013) - as well as reducing competition and providing developed retail locations and experienced employees (Seattle's Best, 2003, Dierdrich's 2006). Without question, future acquisitions remain an opportunity to engender the growth envisioned.

A view of the future: Uncertainties abound

In the recent investor conference, we see an affirmation of its vision for growth. "Starbucks' boss Howard Schultz indicates he plans to open 12,000 more stores over the next five years, with target comparable sales growth in mid-single digits and profit growth of 15-20 percent a year.

The company also plans to open an outlet of its high-end coffee chain, Reserve Roastery and Tasting Room, in Europe, bringing the number to five globally. Details are to be revealed early in 2017. Starbucks opened its first Reserve coffee Roastery and Tasting Room in Seattle in late 2014, which roasts limited-supply Reserve coffees that sell for up to $50 per 8-ounce package. The company plans to open a Roastery and Tasting Room in Shanghai next year, followed by launches in Tokyo and New York City in 2018. Starbucks also said it would accelerate the opening of Reserve coffee "bars" selling premium coffee within Starbucks cafes to 7,400 stores by 2021. The company had set a target of opening these bars in up to 1,000 cafes by the end of 2017.

Schultz said that, in order to make this growth a reality, the company is banking on two strategies: 1) investing in digital that extends the brilliant loyalty program begun with the Starbucks Card and, 2) becoming a "destination". As Schultz noted, "[Companies] can no longer rely on interception traffic; they're going to have to become a destination," he said.

Great point. But did Starbucks not do that before, only to find its customers were looking for something else? Is this not inconsistent with what Schultz also stated?

"At the same time, brick-and-mortar is a dying breed. We're going to see a very major downturn in the fact that the country is over-retailed in lots of categories. We're going to see significant, major brands - as we've seen already - not open many stores as they have in the past and it's the beginning of lots of companies announcing store closures."

Even with such notable adaptiveness, the question is what makes Starbucks immune from such constraints? The reality is the challenges remain, as does the question whether Starbucks can generate real growth in the US as it further develops international locations. This is a salient question and was obvious in the market reaction found earlier this year.

"Starbucks Corp. shares plunged in after-hours trading, after the world's largest coffee chain missed revenue and store sales growth estimates for the first three months of the year. The company reported lower-than-expected global same-store sales growth compared with the same period last year, with flat year-over-year growth in the Americas, its strongest (and largest) geographic region."

Once again, we must note that Starbucks said it is planning to open 20 to 30 Roastery locations, which are the company's tourist-friendly locations that serve expensive drinks like the $10 Nitro Cold Brew Float and roast coffee in-house. But, Starbucks would not be the first brand that sought to transcend the differentiated product barrier and seek to move a company into premium branded sales. However, this is not so easy. The costs, the systems, the people, suppliers, the competition and the customers are very different and it is not a simple matter of trading on brand recognition. When a company steps up and seeks to compete in a different product area (through cost or differentiation) it does so at the peril of customer expectations.

With the plan to open roughly 1,000 Reserve stores, essentially the Roastery minus the roasting, serving up small-batch coffee and a menu of food made in-house, Reserve stores will be twice the size of an average Starbucks. As a result, there will be increased development costs associated with both site finding and store ambiance. Moreover, Starbucks wants 20% of all its stores to have a Reserve Bar, which will serve more exotic, small-batch blends made in a wider variety of preparation methods.

Beyond the associated costs, the concern about this strategic initiative is the complexity and the differences of these two operations, compared to the "normal" Starbucks store; not the least of which is how it might confuse the customer, who would have established expectations that the company may not end up meeting because the customers will compare your new entry to your old self. In others instances, they will compare your new entry to expectations drawn from experiences with other similar upscale businesses. That comparison might not be favorable. This, of course, does not even begin to address the costs such a move would add to the value chain. Without getting into a complex value chain analysis, here is a simple look at how costs relate to the value chain activities. This is a "generic" view of costs for a typical mid-size coffee chain.

  1. Buying coffee from a coffee grower cooperative - $2.30
  2. Import fees, storage costs, freight costs - $0.73
  3. Labor costs of roasting and bagging - $0.83
  4. Cost of labels and bag - $0.45
  5. Average overhead costs - $3.03
  6. Total company costs - $7.34
  7. Average retail mark-up over company costs (operating profit) - $2.65
  8. Average retail price to consumer - $9.99

With the Roastery, Schultz seems determined to build a super-premium brand, with its incumbent higher profit margins, so as to prevent the erosion of sales from happening again - especially as customers have fewer and fewer reasons to shop in stores instead of online. But, the question will be whether it again leads to cannibalization of sales.

One interpretation of this initiative is that it does support a highly differentiated Roastery business as a growth strategy. But does it really? It is not so simple. This is not merely a version of the coffee business; this is a very different business. Many an automaker, retailer and other providers of consumer goods failed to consider this reality. That there is something more was noted by this commentary.

"Among true coffee lovers - the ones who appreciate not just the caffeine buzz, but the distinctive flavors of particular regions and roasts - Dusedau and Robinson are not alone in their skepticism of Starbucks. In the 2015 documentary Barista, which profiles a handful of industry standouts on their way to the annual National Barista Championship, disparaging references to the Seattle giant abound. "It's not just green aprons and pushing buttons," one contestant says of his work, "it's craft."

"Starbucks has come to represent the lowbrow end of coffee culture, which in some ways is ironic, given that the company almost singlehandedly brought that culture to this country in the first place. Barista recognizes three definitive eras in America's evolving relationship with coffee, the first epitomized by cans of freeze-dried Maxwell House. The second wave marks the arrival of the coffee house, pioneered by Starbucks. Now, according to the film, we're in the throes of a third wave: a moment when "coffee can be more than a commodity, something artisanal like wine, or sexy scotches."

"The representative coffee bars for this era are places like Intelligentsia and Blue Bottle Coffee (both originally based in the Bay Area), where preparation, pour and pedigree are all a part of the customer experience. In contrast, Starbucks starts to look like a fast-food joint, with its foolproof espresso machines - thus the "buttons" comment - and sugary flavor syrups. With Starbucks Reserve, the Seattle-based Corporation is likely hoping to regain ground in an area that at one time, it almost exclusively inhabited. It's not that the brand is floundering - far from it - but it's no longer at the cutting edge of the coffee market, either.

"It's hard to imagine that Starbucks will ever be able to compete with newer shops when it comes to flavor. Perhaps Starbucks, with these upcoming locations, is trying to capture not just the artisanal coffee market, but also a vestige of its past, by becoming a place where people actually want to hang out again - not just bark their go-to orders and use the semi-public bathrooms."

I could not have summed it up any better and it does raise the question upon which the premise of my article is based:

By increasing new stores and developing the high-end Roastery and Reserves, will there be organic sales growth? Or, because the context changes and the strategy no longer proves viable as conceived, will these choices merely provide another challenge requiring Starbucks' notable strategic adaptation?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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