Still Perking After All These Years The skeptics say that Starbucks has run out of room to grow. The chain's surging stock price suggests they're wrong.
By Nelson D. Schwartz

(FORTUNE Magazine) – At home, in an antique mahogany desk where Starbucks Chairman Howard Schultz often works in the hours before dawn, a bundle of clippings is piling up. Although the charismatic Schultz gets his share of accolades, they don't find their way into this particular collection. No, the top right drawer is reserved for the brickbats, the stories warning that Starbucks' future is souring faster than a week-old Frappuccino and the analyst reports predicting a long, downward slide in the coffee chain's stock. "Not a week goes by when I don't look at those pieces," Schultz explains. "They're a humbling reminder of what other people think."

Maybe so. But they also serve as a pretty satisfying reminder of how wrong the conventional wisdom can be. In spite of a slew of stories in recent months criticizing everything from Starbucks' food to its seeming ubiquity, along with persistent sniping by Wall Street bears, Starbucks is on a roll. For starters, the stock is at an all-time high, up nearly 40% in just the past two months. What's more, the company is in the thick of its biggest wave of store openings ever, with plans to add at least a store a day, every day, for the next two years. And that's just in North America. Like McDonald's and Coca-Cola before them, Starbucks is convinced it can export its American-brewed concept around the world, especially to Asia. Starbucks already has 102 outlets in Japan, Taiwan, Thailand, Malaysia, Singapore, and the Philippines, and this year the company opened its first three locations in China. Ever the salesman, Schultz has also been talking up the company's e-commerce plans. His still-vague notion of making Starbucks "the first brick-and-mortar retailer to convert physical store traffic onto the Web" helped goose Starbucks' stock from $32 to $37 in a matter of days in late April.

All this sounds properly ambitious and aggressive, but to some investors it may have an ominous ring. The late 1990s are littered with the wreckage of restaurant chains that expanded too fast for their market and eventually collapsed. Two years ago Planet Hollywood, with high-profile backers like Bruce Willis and Arnold Schwarzenegger, was an investor darling. The stock hit $25 a share. Today it trades for just over $1. Shares of the eco-themed Rainforest Cafe have fallen victim to Wall Street's version of slash-and-burn cultivation, dropping nearly 70% in the past 12 months. Still, that's better than Boston Chicken, the once-highflying IPO that declared bankruptcy last October.

On the other hand, one restaurant stock has proved to be a spec- tacular long-term investment: McDonald's. Goldman Sachs analyst Steve Kent, for one, sees similarities between Starbucks and the company that rode the humble hamburger to a market capitalization of nearly $60 billion: "The singular focus on one product, the overseas opportunities, the rapid emergence as the dominant player in a new niche"--all this applies to Starbucks too.

Whether Starbucks turns out to be the next McDonald's or the next Boston Chicken depends very much on how well Schultz and his team execute their growth strategies. Schultz has to break into new markets while continuing to squeeze more of his traditional retail emporiums into an arguably overcaffeinated landscape. Even tougher, he has to pull all that off without diluting the cachet that makes customers clamor to pay $1.40 a cup for Starbucks' joe, when the generic stuff goes for 50 cents at the diner next door.

Going in, Starbucks does have one significant advantage over predecessors like Boston Chicken or Planet Hollywood: loyal customers. Many of the theme restaurants were done in by their inability to get clients to come back once the novelty wore off. But unlike broiled chicken or restaurants festooned with celebrity rubbish, good coffee is not a fad. If anything, it's the last socially acceptable addiction, and there's no more faithful customer than one who's hooked. So, it's unlikely that the nine million people who visit Starbucks each week are going to quit their habit in favor of, say, bottled water. "Ten percent of their customers come in twice a day," says Goldman Sachs analyst Kent. "That's a pretty remarkable figure for a retailer."

Even so, Starbucks' strategy acknowledges that the only way to sustain the Seattle company's phenomenal growth rate is to open more and more stores. Over 85% of the company's $1.3 billion in revenues came from its stores last year, even though it has been expanding into supermarkets and other retail channels. While it may seem as if there isn't a corner in a metropolitan area without a Starbucks, the stores are actually harder to find than you might think, once you get outside the biggest cities. Kansas City, for example, has only two. The entire state of Indiana has one. The Deep South, Texas, Florida, and the rest of the Sunbelt are especially ripe for expansion. There are no Starbucks at all in Arkansas, Tennessee, Mississippi, or Alabama.

Besides, Schultz insists, there's plenty of room for new outlets even in the heart of Starbucks' current urban territory. He has plans for dozens more locations in crowded markets like New York and San Francisco. "Three years ago, when I said we were going to have 100 stores in New York, people thought it was crazy," says Schultz. "Well, now we have 70, and we're going to go to 200." The company adds that fears of saturation are overblown, citing the example of Vancouver, Canada, where two Starbucks actually face each other on Robson Street. Both stores generate over $1 million in annual sales, well above the $800,000 level of the typical Starbucks.

The new store openings in the U.S. are just one part of a multipronged effort to grab a larger piece of the country's $18 billion coffee market. Thanks to a deal with Starwood Hotels, you'll find packets of Starbucks' brew in thousands of Westin and Sheraton rooms. In addition, Starbucks' kiosks operated by Host Marriott are already in 30 of the nation's airports. Then there's Barnes & Noble, which operates 375 cafes in its bookshops, all serving Starbucks' coffee. Believe it or not, Barnes & Noble is now among the nation's largest retailers of specialty coffee.

The company's boldest departure from its traditional business model, though, may be its push into the aisles of America's supermarkets. In some ways, this is a natural target--the vast bulk of coffee in America is bought in stores and sipped at home--but it is a market that has long been dominated by giants such as Procter & Gamble (Folgers) and Kraft (Maxwell House, Sanka, Yuban). Figuring that if you can't beat 'em, join 'em, Starbucks launched a partnership with Kraft last fall to distribute whole beans and ground coffee to more than 20,000 grocery stores.

Why would Kraft, a unit of food and tobacco giant Philip Morris, join forces with a potential rival like Starbucks? Demand for premium beans is piping hot, while sales of plain old coffee are, well, lukewarm. According to the National Coffee Association, the number of daily drinkers of gourmet coffee has jumped 50% in the past year, rising from 7.5 million to 11.5 million. "This is clearly the fastest-growing segment of the coffee business," says the National Coffee Association's Gary Goldstein. "Millions of occasional drinkers of gourmet coffee are now becoming daily drinkers."

The key to all these ventures--from serving coffee in bookstores to selling it at the local Winn-Dixie--is creating a premium-priced brand where there was only a cheaper commodity-type product in the past. Or, to put it another way, think "Coke," vs. plain old "cola." Indeed, Schultz cites the Atlanta beverage giant, along with other corporate brand masters like Gap, Disney, and Nike, as a company he wants to emulate. Starbucks international president Howard Behar even takes to quoting Coke's legendary former CEO, Roberto Goizueta, when he describes Starbucks' ambitious overseas plans.

Already there are signs that the Starbucks-as-Coke strategy is working. In some West Coast supermarkets, packaged Starbucks has grabbed a 35% share of specialty-coffee sales. Starbucks' ice cream, introduced in a joint venture with Dreyer's in 1996, is now the nation's top-selling brand of coffee ice cream. In fact, some people now talk about grabbing "a cup of Starbucks," rather than a cup of coffee. That's what branding is all about.

While all these brand extensions are nice, the strength of the name ultimately depends on the quality of its roughly 2,100 retail outlets. That's where the image of the Starbucks brand meets reality. And with everyone from Dunkin' Donuts to Wal-Mart getting into the coffee-as-indulgence market, it's clear that Starbucks can't afford to sacrifice service for size.

Naturally, the company insists that customer attention hasn't suffered because of its rapid expansion. Same-store sales growth remains healthy, rising from 3% last fall to 6% in the first three months of 1999. But Wall Street analysts and others see signs of slippage, especially in the Northeast. When I mention some of the less than optimal experiences I've had in New York--tepid coffee, gruff employees, long waits--a look of pain crosses Schultz's face. "I'm from New York, and New York is tough," says Schultz. "I've spent a fair amount of time in our New York stores, and we think the service is improving."

For all his concern, it's clear that Schultz is now focused on the big picture, rather than on store-by-store execution, as he was a decade ago. That job falls squarely on the shoulders of John Richards. The no-nonsense veteran of McKinsey & Co. and the Four Seasons hotel chain was brought in a year and a half ago to run Starbucks' North American retail division. Fifty-year-old Richards, who holds a Wharton M.B.A., eschews the New Age talk that Schultz and Behar occasionally spout. While Behar declares, "We're not in the business of filling bellies, we're in the business of filling souls," Richards is more comfortable talking about what percentage of sales come before 11 A.M.--40%--or noting his stores' average ticket--$3.50.

The point man in Starbucks' North American expansion plans, Richards is also a big believer in moving headlong into the Sunbelt. Although you might think a double skim latte would be a tough sell in the land of Denny's, beef jerky, and the blue-plate special, the South and West actually offer Starbucks some special advantages.

For starters, says Richards, warm weather brings higher evening sales. In addition, Starbucks' iced beverages--which offer much fatter profit margins than regular drip coffee--have been big sellers in the South and Southwest. The early evidence suggests the Southern strategy is paying off. Florida and Arizona are the company's two fastest-growing markets, Richards says, with sales growth in the mid-teens. That's more than double the rate of sales growth for the chain overall.

That doesn't mean Starbucks hasn't had to make some subtle shifts in order to adapt to these comparatively new markets. In the South, where customers tend to come later in the day and linger for a bit, it has meant adding more appealing dessert offerings, as well as designing larger, more comfortable locations.

Take the case of Atlanta. After Starbucks opened its first wave of stores there in 1995, says Richards, "business was okay, but we weren't setting the world on fire." Richards, though, had experience in Atlanta, having worked on the new Four Seasons hotel there. He pushed local Starbucks managers to improve service and opened bigger stores with such amenities as couches and outdoor tables, so that people would feel comfortable hanging out, especially in the evening.

It worked. The result has been double-digit sales growth, making Atlanta one of Starbucks' top markets. The Atlanta region is now home to 33 Starbucks stores, but Richards plans to double the presence over the next few years, adding locations in places like Marietta and Buckhead. "You might imagine that we just came up with one idea and never looked back," says Richards. "But it became apparent that if we didn't change, we'd be at a real disadvantage."

Building on its Atlanta experience, Starbucks is tailoring its stores to local tastes around the country. That's why you can find cafe au lait as well as toasted items in New Orleans, neither of which are available elsewhere. Or why coffee cake is featured prominently in the Northeast, where it's more popular. "We survey the competition and try to understand the nuances," says Richards. "In New Orleans we serve more cafe au laits than either cappuccinos or lattes. And bagel sales tripled once we started toasting them."

Boosting food sales, as in New Orleans, is one of Richards' top goals. Unlike its beverages, which account for just under 80% of store sales, Starbucks' pastries and other foods have never been anything to boast about. In fact, occasional stale scones and rock-hard cookies have led many customers to pretty much ignore anything that isn't served in a cup. But there are some signs of improvement. "The baked goods still aren't great, but the food is getting better," says Craig Bibb, a hedge fund manager and former restaurant analyst. Bibb, who owns more than 25,000 Starbucks shares, adds that after declining for years, the percentage of sales from food has begun to inch up in recent months.

Starbucks' other food-oriented ventures haven't gone over so smoothly. Last year the company opened three full-service Cafe Starbucks restaurants in Seattle along with a coffeehouse/bar in San Francisco called Circadia that's aimed at a younger, nocturnal crowd. Some Wall Street observers worried that expanding into food would prove a distraction for management as well as a threat to beverage profit margins, which at 70% are fatter than a caramel macchiato.

Press accounts of the new ventures, meanwhile, were downright harsh. While suggesting that food represented the company's next growth opportunity, the Wall Street Journal called Cafe Starbucks' dinner offerings "disappointing or worse.... The linguini marinara could have come from a can."

Schultz and Richards say the Journal and other skeptics have got the food story completely wrong. They insist that coffee and other beverages are--and always will be--the company's growth driver. Cafe Starbucks and Circadia are labs to experiment with new products, they say, not the vanguard of a push into the restaurant biz. "Food is a vehicle for us to sell more coffee," says Richards. "The last thing we want is to go into fast food."

Which brings us back to the traditional retail outlets that Starbucks plans to open in the next few years. They'll account for most of the growth in the near future, and Schultz, who owns more than nine million Starbucks shares and options, is especially optimistic about the potential for his company overseas. Lines are common at the 53 stores in Japan, and Schultz notes that the No. 1 Starbucks in the world is in Tokyo. "I see 500 stores in Asia by the end of 2003," he says. Meanwhile, on the other side of the globe, Starbucks now has 80 locations in the U.K. And despite Europe's age-old coffee culture, Schultz plans to invade the continent, beginning in mid-2000.

It would be easy to doubt him--just take a look at the pile of clips in his desk drawer, which date back seven years. But it's important to note that Starbucks has already outlasted many of its direct competitors. Brothers Coffee, which got out of the retail coffee business in 1996 to focus on the wholesale market, filed for bankruptcy last year. Procter & Gamble recently agreed to buy a big chunk of Brothers' remaining assets. Starbucks itself just absorbed another competitor, Pasqua Coffee, at what industry insiders say was a bargain-basement price. New World Coffee has shifted its focus to the bagel market, citing broader opportunities. "Going up against Starbucks is just not a wise strategy," says the head of one former rival. "Everybody who tried it is in trouble."

Moreover, it's clear that Schultz has an unusual aptitude for spotting opportunities the rest of us miss. Just look at his personal venture capital firm, Maveron. Since he founded it in June 1998, it has made only two investments. Both are already huge winners--online auctioneer eBay and, a private company that just invested in. Schultz and Maveron's eBay holdings are worth over $160 million.

Not bad for a boy from the Brooklyn projects. "People will always be skeptical, but that's one of the things that have always driven me," says Schultz. "Now the burden of proof is on the skeptics."