TB0153

April 28, 2003

Planet Starbucks (B): Caffeinating the World

Ten years ago, we had 125 stores and 2000 employees. [Today,] we have 60,000 people working in 28 markets outside North America, serving approximately 20 million customers a week. Our core customer is coming in about 18 times a month. With the majority of adults around the world drinking two cups of coffee a day and with Starbucks having less than 7% share of total coffee consumption in the U.S. and less than 1% worldwide, these are the early days for the growth and development of the company. Weve got a model that has been well tested from market to market. Q&A With Starbucks Howard Schultz BusinessWeek Online, September 9, 2002

Peter Maslen, President of Starbucks International, had just returned from Greece where the company had opened its first caf in downtown Athens. He had logged thousands of miles over the past few years shuttling from country to country extending the boundaries of the Starbucks empire. In anticipation of stagnating growth in North America, the company had embarked on a global expansion strategy with the objective of becoming a great, enduring company with the most recognized and respected brand in the world. Starting with Japan in 1995, the company had blazed through several key markets in Asia and Europe. The company looked to move into more of the emerging world, including Latin America. While much of the developed world had been conqueredor at least attackednew growth potential had shifted to the less-developed regions. Although the company had already established beachheads in several emerging markets, many believed that the infrastructure and disposable income in these regions would present forbidding obstacles for Starbucks expansion strategies. As Peter Maslen sipped his cup of steaming espresso, his mind wandered to the challenges his company faced in global markets. Did it make sense for Starbucks to continue expanding globally at such a breakneck pace? Would the firm be able to meet the markets insatiable appetite for earnings growth with its ventures into European and emerging markets?

History
Starbucks was founded in Seattle by Gerald Baldwin, Gordon Bowker and Ziev Siegl in 1971 as a gourmet coffee bean roaster and distributor. In 1982 Howard Schultz joined the company as a member of their marketing team. After a visit to Italy for a trade show, Schultz urged the partners to consider opening espresso bars in conjunction with their coffee sales. In 1984 Starbucks opened its first espresso bar in a small corner of the companys downtown Seattle Starbucks store, to rave reviews. Although Schultz urged the company to expand the espresso bar line, the controlling partners, now Baldwin and Bowker, were unwilling to enter what they considered the fast food business, wishing to focus on the coffee roasting niche market.
Copyright 2003 Thunderbird, The American Graduate School of International Management. All rights reserved. This case was prepared by Professors Michael Moffett and Kannan Ramaswamy for the purpose of classroom discussion only, and not to indicate either effective or ineffective management. This case draws upon information presented in Planet Starbucks (A) by the same authors.

Howard Schultz then left Starbucks, and with the financial backing of his former partners, opened Il Giornale in 1985, an espresso bar that sold coffee and assorted coffee beverages made exclusively with Starbucks beans. Two years later, Schultz bought the former Seattle Starbucks company, six stores and roasting plant, for $3.8 million from Baldwin (who wished to focus on managing Peets Coffee) and Bowker (who wished to cash out of the business). Schultz now was in control of Starbucks, and with new investors, began building a global business which reached sales of $3.28 billion by 2002 and was acclaimed one of the top 100 growing global brands.

The Starbucks Experience

Howard Schultzs dream was to take the concept of the Milan espresso bar to every corner of every city block in the world. Captivated by the sense of community and neighborliness that he had seen in the cafes in Milan, Schultz wanted to transplant a similar ambience into each Starbucks store. This desire originated in the very first coffee experience that Schultz had in Milan. While attending a housewares show in the city of over a thousand cafes, Schultz was quite impressed by the way in which the baristas (coffee brewers) prepared a cup of espresso. It was pure theater to see a barista move effortlessly as he ground the beans, pulled the espresso, and steamed the milk, seemingly at the same time and all the while carrying on a conversation with the customer. It was precisely this experience that Schultz wanted to bring to each of the Starbucks cafes. He envisioned each caf as a gathering place for neighbors and friends or a place of quiet contemplation and perhaps even a neighborhood office for the work a day customer who might stop by to catch up on work and a steaming espresso at the same time. The Starbucks caf was indeed a destination. The Starbucks Experience had been designed to be pleasant, uplifting and diverse.1 Experience and ambience were central to the Starbucks strategy. As Schultz observed,
We certainly dont ignore the product, but it is something we always knew we had and a lot of others didnt. But we built the business through experience, not through the product. Schultz Caffeinated Crusade, Brandweek, July 5, 1999 I tried to build an environment and a place that could provide our customers with an oasis, a Third place away from home or work, that would exceed their expectations. M. Pendergrast, The Starbucks Experience Going Global, Tea and Coffee Trade Journal, Vol. 174, Issue 2, Feb. 20, 2002

The cafs exuded a sense of chic and featured comfortable seating, sometimes even sofas, a selection of leading newspapers and magazines including Starbucks own in-house weekly, and the strong aroma of rich coffee wafting through. In addition to a broad selection of coffee and Italian style espressos, the cafes offered several blends of special teas, localized pastries, and coffee brewing equipment. The stores themselves were designed to be bold and striking in their color palettes, often using primary colors. The ambience of the cafes was accentuated by piping selected music to complement the atmosphere of warmth and comfort. Employees were trained to not only provide advice on coffee selection and appropriateness to potential customer needs, but to engage the customer.

Location, Location, Location

The company displayed remarkable business savvy in choosing its locations. It focused on spots that provided ready access to consumer foot traffic, typically in densely populated neighborhoods. Stores were located in such a way to blanket a neighborhood and often several stores competed for patronage on the very same street. Starbucks had however been both admired and criticized for these marketswarming expansion techniques that were used to proliferate within defined market locales. This approach to first-mover advantage in a market space gave Starbucks sufficient time to establish itself while holding competitors at bay. The downside however was the cannibalization of revenues across stores
1

Schultz Caffeinated Crusade, Brandweek, July 5, 1999.

TB0153

located in close proximity to one another. Between 1995 and 1998 Starbucks had averaged $0.69 million per store per year. Beginning in 1999, this revenue per store value had continuously declined, falling to $0.56 million per store in 2002. The company had leveraged multiple channels to sell its coffees and related products. Its wares were available through mini-Starbucks cafes located within grocery stores, at airports, on all United Airlines flights, and in Barnes and Noble bookstores. Its roasted coffee beans, and ice cream products were sold through both specialty and mass-market retail grocery chains. It entered several distribution agreements with well established companies such as Kraft Foods for distribution of coffee related products. Despite these systematic attempts to proliferate through multiple channels and multiple locations, sales in North America had shown signs of slowing. It was against this backdrop that Starbucks started looking East.

The World Market For Coffee

Coffee was the second most widely traded commodity in the world behind crude oil. Despite this pride of place amongst commodities, most of the worlds coffee was grown in small farms encompassing just a few acres. Like most commodity products, the prices for green beans (unroasted coffee) fluctuates wildly with changes in demand and supply which in turn is driven by growing conditions. Latin America, Central America, East Africa, and parts of Indonesia and Vietnam were the leading coffee growing regions. The price of coffee in 2002 reached record lows of $0.42 per pound for robusta grade, the lowest price in a century. The robusta grade was considered an inferior grade of coffee with a fairly high level of bitterness. The arabica grade was the premium coffee and commanded a price premium typically about $0.20 per poundover robusta. Arabica was much more aromatic and full flavored and preferred by coffee connoisseurs worldwide. Starbucks exclusively used arabica beans in its cafes. The market for coffee was decidedly global. Most of the intermediate buyers were large transnational packaged foods companies. The top four firmsNestl (Switzerland), Kraft Foods (USA), Proctor & Gamble (USA), and Sara Lee (USA) collectively purchased roughly 50% of the coffee produced globally. Given their product mix and development of new roasting techniques, many of these buyers were able to make do with robusta grade. Buyers such as Starbucks, and its Italian competitor Illy, however, specialized in gourmet coffees which accounted for only about 10% of global coffee production. The consumer market for coffee was quite concentrated: 20% of the worlds population accounted for 65% of global consumption. Exhibit 1 provides an overview of the structure of the global coffee market in the year 2000. The Swedes clearly had the highest per capita consumption in the world, quaffing 1097 cups per year, while the Chinese averaged per capita consumption of less than one cup. Yet, there were only a little more than eight million Swedes, and there were over a billion Chinese. The coffee market was subdivided between retail sales (instant coffee and roasted and ground coffees purchased in supermarkets for home consumption) and out-of-home coffee purchase and consumption (the coffee cafs like Starbucks). The differences in consumer preferences across countries were dramatic. For example although the Swedes and Swiss were the top two consuming populations, instant coffee was extremely unpopular with the Swedes, making up only 9% of retail sales, while a full 35% of all retail coffee purchases by the Swiss was for instant coffee. The extremes in retail sales purchases and consumption were the Italians, 96% of all retail purchases being roasted and ground to 4% instant, and the Philippines, where 100% of retail purchases were for instant coffee. Only Japan and the United States to date had any real markets in ready to drink products (like Starbucks Frappucino product). The second major distinction, and the one of most immediate interest to Starbucks, was the propensity of some national populations to consume their coffee outside the home. Out of home coffee consumption was the highest in absolute consumption (average cups consumed per capita per year) in Switzerland, Spain, Sweden, and France. Many of the emerging markets, countries like Mexico, Chile,
TB0153 3

Exhibit 1

Global Coffee Consumption, 2000 Retail Coffee Sales Roasted Ready and to Instant Ground Drink 80 777 220 415 80 565 145 363 100 207 15 323 30 298 305 24 108 155 57 207 4 290 24 125 55 45 166 5 222 14 125 26 137 2 127 110 9 78 8 0.8 Out of Home as Percent of Total 22% 26% 12% 23% 41% 29% 29% 28% 40% 38% 26% 42% 40% 17% 17% 13% 11% 8% 10% 20%

Per Capita Consumption Country (cups/year) Sweden 1097 Switzerland 855 Germany 735 France 658 Spain 517 Italy 478 Brazil 463 Australia 459 Canada 438 United States 424 United Kingdom 424 Japan 360 Korea 286 South Africa 286 Mexico 181 Chile 159 Philippines 142 Russia 129 Thailand 96 China 1

Out of Home 240 220 90 150 210 140 135 130 175 160 110 150 115 50 30 20 15 10 10 0.2

Source: Nestl S.A.s Nescafe Division, as quoted by Merril Lynch, May 20, 2002. Total annual per capita consumption is the sum of instant, roasted and ground, ready to drink, and out of home. Instant coffee is also frequently termed soluble.

Russia, and Thailand, demonstrated extremely low levels of out of home coffee consumption, posing a significant challenge to the Starbucks business model. Much to the dismay of coffee marketers, consumption in the developed world was declining with the markets migrating to the developing countries. It was estimated that the sophisticates (people consuming one or more cups of coffee a day) accounted for 65% of total coffee consumption but they represented only 17% of the worlds population.2 In contrast the beginners (people consuming one cup or less per week) accounted for 57% of the worlds population but only 2% of coffee consumed. Although it would make sense to target beginners with the hope of turning them into sophisticates, the challenges were formidable. Much of this population lived in countries that had not developed a taste for gourmet specialty coffee.

Key Competitors
Although the traditional mass market coffee segment was dominated by the major transnationals, the freshly brewed coffee market and specialty coffees represented a far more fragmented domain with several companies operating a variety of local, regional and sometimes international chains. In addition to the ubiquitous Starbucks, the more popular chains were Tullys Coffee and Seattles Best Coffee (both headquartered in Seattle USA), The Coffee Bean and Tea Leaf Company (Los Angeles USA) and Tim Hortons (Canada). In addition to the national competitors there were several local and regional chains within national markets that enjoyed limited popularity such as Dutour (Japan), Trung Nguyen (Vietnam), Costa Coffee (U.K.), Dome (Australia) and Barista (India). Many of these local favorites were
Original data from Nestl S.A., Nescafe Division, presented in Starbucks Corporation Reference Book, Merrill Lynch, May 20, 2000.
4 TB0153
2

also eyeing the global market and some had selectively ventured abroad to set up cafs especially in countries such as Japan, China and the Southeast Asian region. Tullys Coffee operated over 100 stores in the United States, primarily focused on the Pacific Northwest region. It had expanded internationally through licensing agreements and had set up Tullys Coffee Japan. Tullys Japan operated more than 40 stores largely in the TokyoYokohama region. The company had also entered into franchising agreements with Ueshima Coffee Company to sell Tullys products in Asia (outside Japan). Ueshima had a presence in Southeastern China, Thailand, Singapore, Taiwan, Korea, Indonesia, Brazil and Paraguay. Tim Hortons, a subsidiary of the fast food chain Wendys, operated over 2100 stores in Canada and 150 in the United States. The companys strategy was to focus nearly exclusively on these two markets. Much of its expansion effort was through franchised operations. Seattles Best Coffee was a subsidiary of AFC Enterprises, an Atlanta-based food company with a fairly large footprint in the fast food business. AFC also owned Torrefazione Italia, Cinnabon, Churchs Chicken, and Popeyes Chicken & Biscuits. Seatlles Best had expanded to Japan, the Philippines, Saudi Arabia, the United Arab Emirates and Korea. Its largest presence outside the United States was in Japan where it operated 40 stores. The Coffee Bean and Tea Leaf Company, founded in Los Angeles, was engaged in significant international expansion both through its own network of stores as well as through franchise agreements. It had a total of 104 cafs in Singapore, Malaysia, Taiwan, Korea, Israel, the United Arab Emirates, Brunei, Australia and Indonesia. Trung Nguyen, a Vietnamese chain of coffee stores, operated 400 outlets in that country. It had franchise operations in Singapore, Thailand, China, and Japan and was looking for franchisees in the United States. The company was trying to cash in on its origins, promising to deliver a Vietnamese experience to its patrons. Initial reports showed that the companys cafs were performing well especially in the exotic blends.

Expanding the Starbucks Empire

Starbucks first foray into marketing coffees abroad began with operations in Vancouver Canada in 1987. However until 1995, much of its marketing focus was limited to building dominance in the U.S. marketplace. Beginning with its entry into Japan in 1995, the company had opened close to 1,000 locations in over 20 countries by 2002.

Mode of Entry
The rapid expansion overseas was built around joint ventures with local partners and rounded out through company owned stores. As illustrated by Exhibit 2, Starbucks international expansion was achieved primarily through joint ventures and licensing agreements. The frequent use of the joint venture form, however, was a bit misleading given the limited ownership held by Starbucks relative to its local partner. The exceptions were Australia (90% owned by Starbucks), South Korea (40% Starbucks), Thailand (97% Starbucks) and the United Kingdom (wholly owned as a result of the acquisition of a large existing coffee chain followed by rapid expansion). Even in this short list, Thailand was a reluctant majority ownership. In early 2002 Starbucks was forced to buy-out the interest of its local partner as a result of financial difficulties experienced by the partner, preventing it from undertaking the rapid expansion of stores per the joint venture agreement. Given the reliance on joint ventures and licensing as the preferred modes of foreign expansion, the company set forth fundamental qualifications it expected of its potential partners. These criteria included financial solvency, knowledge of local market conditions, prior retail experience, and creative
TB0153 5

Exhibit 2

Starbucks International Operations and Partnerships Starbucks Agreement Ownership majority-owned 90% jv 19.5% license jv 5% jv 19.5% jv 18% jv 5% license jv 19.5% jv-public 40% license jv 18% license license license jv 5% license jv 50% jv 18% jv 19.5% jv 5% majority-owned 97% wholly owned 100% April 2002 Stores 29 3 26 25 0 0 25 0 5 357 23 0 65 32 42 0 29 40 2 7 91 26 297 1,153 358 795 eoy 2003 Stores 60 15 45 45 21 5 70 5 12 570 30 5 98 42 57 6 35 82 13 20 137 37 470 1,912 572 1,340

Country Partner Australia --------Austria Bon appetit Group China (Beijing) Mei Da Coffee Co China (Shanghai) Shanghai President Coffee Co Germany KarstadtQuelle AG Greece Marinopoulos Brothers SA Hong Kong Maxims Caterers Limited Indonesia PT Mitra Adiperkasa Israel Delek Development Japan Sazaby Inc. Malaysia Berjaya Coffee Co Mexico S.C. de Mexico, S.A. de C.V. Middle East M.H. Alshaya Co. W.L.L. New Zealand Restaurant Brands Ltd. Philippines Rustan Coffee Corp. Puerto Rico MacNaughton Group Singapore Bonvests Holdings Ltd. South Korea Shinsegae Department Store Spain Grupo Vips & Europastry, SA Switzerland Bon appetit Group Taiwan President Coffee Co. Thailand --------United Kingdom --------System-wide Company-owned Licensed/JV
Source: Merrill Lynch, May 20, 2002, p. 19.

ability. Before entering a new country, the company conducted rigorous quantitative market studies and extensive focus group interviews to get a pulse of the marketplace and potential. Despite the intensive process of market and partner selection, the company was constantly being courted for partnership ventures in many international cities. Winning a partnership agreement, however, took much tenacity in addition to the desirable financial strengths. Markus Hofer was a prime example of this. He had campaigned tirelessly to gain a Starbucks franchise in Australia. After having been rebuffed by Howard Schultz once, he persisted by sending frequent reports about the coffee business in Australia, changing trends and opportunities in the caf markets, and the potential demand for gourmet coffees in the country. Schultz eventually had a change of heart and signed on with Hofer to set up operations in Sydney and Melbourne, appointing him Managing Director of Australian operations. Hofer resigned his post in March 2002 when he decided to cash-out of the Australian business and sell his share back to Starbucks as a result of the generally sluggish performance of Australian operations.3 Starbucks involvement in the operations of its cafes, licensed or joint ventures, varied only in degree. It was constantly in touch with caf operators to keep abreast of the marketplace. Starbucks trained the management teams of all cafes at its Seattle facilities for a full 13 weeks. This training was an important part of the launch process because it helped the company imprint the values and meaning of the Starbucks experience on its new recruits. It was critical that the people who ran the front-end operations of the company exude the Starbucks spirit. As Starbucks International VP Peter Maslen
3

T. Liddle, How to Become a Starbucks Millionaire, Cup by Cup, Australia internet.com, February 7, 2001; and Bottom of the Harbour, J. Rolfe, Sydney Telegraph, March 15, 2002.
TB0153

remarked, Starbucks brand is built on passion, and you can easily feel the passion of our partners in any of our international stores.4 Once the cafes were up and running, inspection teams from Starbucks were dispatched every two months to make sure that the operations met company expectations and standards. This continuous involvement and training ensured that the Starbucks experience was indeed consistent across locations. The company standardized its menu of coffee offerings in most locations worldwide with some localization of its baked goods and pastries. The cafs were required to buy most of their coffee related supplies through Starbucks, but they could make mutually acceptable local arrangements for procuring baked goods. For example Starbucks Shanghai partner used an airline catering company and a bakery chain to buy pastries. The companys standards were so exacting that Starbucks even insisted on shipping its own roasted coffee back to coffee growing countries where it had operations. Even in its most recent expansion into Latin America, the company would not source locally, although many of the countries in the region were among the largest producers of coffee in the world and also frequently the original source of much of Starbucks coffee.

The Economics of Global Expansion

A Starbucks joint venture or licensing agreement required the payment of an up-front licensing fee, a royalty on sales after operations began and the purchase of all store furnishings and coffee-based materials from Starbucks itself. These terms did appear to vary somewhat by location and market potential. For example it was reported that Delek Fuel, Starbucks Israeli partner, paid $250,000 in licensing fees and a 6% royalty, while P.T. Mitra Adiperkasa, the partner in Indonesia, reportedly paid a $2 million licensing fee up-front. Although the companys equity position in its joint ventures varied across a wide range, there was a tendency to minimize its holdings and require the local partner to shoulder most of the capital cost. Even in the case of Japan, Starbucks first and largest international venture outside North America, Starbucks was guaranteed a 5.5% royalty on sales while its local partner earned only a 1.0% royalty, which then fell by 0.25% per year until reaching zero. Exhibit 3 provides a comparison of the cost structures of North American and International company-owned stores.

The Caffeine Crusade

Starbucks had ventured into Canada very early on but true international expansion of its caf concept was started in 1995 with its entry into Japan, the second largest coffee importing country in the world.5 At that time Starbucks believed that it was not ready to move into Europes well established caf scene. The companys first focus was Asia.

Asia and the Far East

The decision was made to go to Asia first because we felt that the maturity of the coffee market in Europe was very strong and was not going to change much over the years. The Asian market was in its developmental stage and we had an opportunity to position Starbucks as a leader in a new industry. Expanding the Coffee Experience: Starbucks Keeps Sales Brewing with New Products, Innovation, and Global Expansion, Beverage Industry, October 1, 2002

4 M. Pendergrast, The Starbucks Experience Going Global, Tea and Coffee Trade Journal, Vol. 174, Issue 2, February 20, 2002. 5 According to the Coffee Research Institute, the 10 largest coffee importing countries for the decade of the 1990s were the United States (25.6% of global imports), Germany (14.2%), Japan (7.7%), France (7.5%), Italy (6.3%), Spain (3.8%), Holland (3.4%), the United Kingdom (3.4%), Canada (2.8%), and Sweden (2.2%). Note that these are importation statistics, and not consumption. Source: www.coffeeresearch.org/ market/importations, accessed 10/6/02.

TB0153

Exhibit 3

Comparative Cost Structures of Starbucks Company-Owned North American & International Stores, 2002 North American 100.0% 10.7% 4.0% 1.7% 4.4% 3.9% 3.0% 10.8% (38.3%) 61.7% 27.7% 4.3% 0.8% 2.5% 4.2% (39.5%) 22.2% (5.6%) 16.6% International 100.0% 16.3% 4.0% 2.4% 7.2% 4.4% 3.0% 12.6% (49.8%) 50.2% 27.8% 7.2% 1.4% 2.5% 5.7% (44.6%) 5.6% (8.0%) - 2.4%

Net Revenues Occupancy costs Roasted coffee: Green coffee Other (freight, shrink, etc.) Food Milk Retail media (newspapers, etc.) Other Total Cost of Goods Sold Gross margin Store Expenses Salaries & benefits Regional overhead Advertising Operating supplies Other (taxes, pre-open, etc.) Total EBITDA margin Depreciation & amortization EBIT margin

EBITDA = earnings before interest, taxes, depreciation and amortization. EBIT = earnings before interest and taxes. Source: Starbucks Corp, Merrill Lynch, May 20, 2002, pp. 26-29.

Japan. Much of Asia had a very strong tea culture that had been nurtured over centuries. Tea drinking held the pride of place in countries like Japan where elaborate rituals had been devised to both institutionalize the beverage and establish tea drinking as an inextricable way of life in those societies. Starbucks however set out to change these norms. Fortune came knocking on Starbucks door in the form of an unsolicited business inquiry from a Japanese group, Sazaby, which had been operating a chain, Afternoon Tea, and had a visible presence in the important locales of Japan. Sazaby had 180 outlets and was engaged in a variety of products ranging from lifestyle furniture and clothing to tea and confections. While on a visit to the United States, the founders of Sazaby became interested in the Starbucks concept and then approached Howard Schultz to explore a joint venture in Japan. Starbucks and Sazaby constructed a very traditional equal partnership, each with a 50% equity interest. The JV had opened its first store in Ginza in August 1996 and had immediately attracted a loyal following. The customers were educated about various coffee blends and exposed to an environment that was remarkably similar to the Starbucks cafs in the United States. In time the local venture, with the blessings of Starbucks, was introducing some variations that appealed to the local market, such as green tea frappucino, which were not available in the United States. The company instituted a no-smoking policy because it believed that cigarette smoke destroyed the natural aroma of coffee. It served its coffees in paper cups thus going against the grain on most of the conventional wisdom that had been passed down about retailing in Japan. The blue chip consultants that Starbucks had hired prior to entering Japan unanimously concluded that a no-smoking policy combined with service in paper cups would ring the death knell for Starbucks. However, within a few short weeks after entering Japan, it was quite clear that the consultants were wrong on both counts. The no-smoking policy did not seem to hurt and the Japanese seemed quite comfortable sipping their coffees from paper cups.
8 TB0153

Starbucks Japan priced its offerings much below the premier Japanese caf chains such as Ginza Renoir which were billed as havens for the harried executive seeking peace and quiet. These cafs charged roughly $7 for a coffee and the price entitled the customer to use its facilities for two hours. Many customers used the cafs for meetings as well. At the lower end of the spectrum were the low priced chains which usually served robusta coffees below $2 per cup. Starbucks sought to build a new niche, promising to deliver the vaunted Starbucks experience at the nominal price of $2.50 per cup. The joint venture grew rapidly, reaching more than 250 stores nationwide by 2002 and was projected to operate more than 500 stores by 2003. Although average Japanese store sizes were half that of the United States, they averaged nearly twice the sales. The joint venture proved so successful that it undertook an initial public offering (IPO) in October 2001, the only unit within Starbucks international network to be listed independently of the parent. Appendix B provides a comparison of Starbucks Japan with three major competitors at the time of the IPO.
Almost six years after we opened here [Japan], this is the best-performing market on a unit level for Starbucks in the world. Its also the second largest in the world [after the U.S.]. When we came here in August of 1996, we underestimated the size of the market just like we did in America. So were sitting here today with approximately 360 stores, and were opening two new stores a week in Japan. Well have 500 stores by September 2003, heading toward 1,000. Q&A with Starbucks Howard Schultz, BusinessWeek Online, September 9, 2002.

In the year following the initial public offering in Japan, the share price tumbled from a peak of $690 to $101 (U.S. dollar equivalents of Japanese yen share price). The companys sales forecast had been trimmed by 10%, and it had revised its earnings forecast downward from a profit of $7.9 million to a loss of $4.2 million. The company blamed the misfortunes on a faltering economy while analysts believed that competition had a role as well. Coffee chain competitors such as Dutour which had been content to sit on the sidelines and serve robusta coffees at low prices in the early years had now migrated upwards into the rarefied reaches of arabica and higher margins. U.S.-based chains such as Peets and Seattles Best had entered Japan with full vigor. Starbucks executives believed that the decline in same store sales was core to their strategy. Saturation of some market areas had led to cannibalization as expected and the competitive battles between stores was playing out. Everyone realizes we cannot continue at this pace, says Johanna Metzger, chief marketing guru at Starbucks Japan. Weve downshifted a bit.6 Starbucks had reacted by instituting a wide range of cost cutting measures that included procuring some supplies from Southeast Asia instead of from the United States. However many believed that these measures were unlikely to make a significant dent. Many critics felt that nothing short of slowing down new store openings could help Starbucks return to the black in Japan. China: Storming the Forbidden City. After years of studied disinterest, China opened its doors to foreign companies and Starbucks ventured in to test the waters. Given the ingrained Chinese disposition toward tea, Starbucks had entered in a measured way, first testing its coffee in major restaurants and hotels in Beijing before setting up cafs. It first negotiated a licensing agreement with Beijing Mei-Da, a wholesale distributor for Starbucks since 1995 in the city of Beijing. When it opened a caf within the walls of the Forbidden City, many of the traditionalists gasped at the seeming capitalist assault on the bastion of Chinese culture. The Palace of Heavenly Purity was after all the original residence of Chinese emperors and still the symbolic center of much of Chinese culture. Cultural criticism aside, the caf was a success.
Is Japan Losing Its Taste for Latte Already? Losses Climb as Starbucks Japans Growth Grinds Down, BusinessWeek Online, December 2, 2002.
TB0153 9
6

By early 2002 the company was operating 25 stores in Beijing. Although many Chinese consumers traditionally believed coffee to be foul tasting and bitter, many were now acquiring a taste for what they considered a luxury beverage. Heartened by the success in Beijing, Starbucks entered a joint venture with Shanghai President Coffee, the operator of Starbucks cafs in Taiwan, to enter the Shanghai market. Starbucks added Maxims Caterers as a partner at the same time, entering the Hong Kong market. It was widely believed that sales growth in Shanghai would outstrip Beijing in the near term. In the two years that the company operated in Shanghai, it increased the number of outlets there to 21. The company had adopted some novel ways of breaking down consumer resistance to coffee, including educational activities focused on potential customers. Starbucks Shanghai partner trained a staff of 300 people who aggressively went out into the market to introduce the public to the intricacies of coffee. The successful launch of a Starbucks caf directly across from one of the oldest tea houses in the country in Yu Gardens, (one of Shanghais premier historical sites) was testimony to its remarkable market entry efforts. Although many market experts predicted that Starbucks consumers in China would be predominantly Western expatriates, the first two years of operations saw a consumer base of roughly 70% local Chinese. This was somewhat surprising to some as the ambience in the Chinese cafs, the menu offerings, and the prices were extremely similar to outlets in the United States. A cup of coffee was priced between $2.50 and $3.50, an exorbitant amount in a country where per capita monthly income was only $84. Riding on the coattails of Starbucks success, many local entrepreneurs were opening competing coffee chains. In Shanghai for example, new entrants included Discovery Caf, Mr. Coffee, and U-Like Coffee, all hoping to garner a share of the coffee-smitten Chinese. While these were relatively small operations, they tried hard to duplicate the environment and offerings of Starbucks. Many of them were faithful copies of the Starbucks cafs, right down to the dcor, magazine racks, tables, and coffees. A manager at U-Like, Mr. Lu Yimin remarked Our coffee is better than Starbucks. Our coffee shop looks like Starbucks but in terms of service, they cant match us at Starbucks you always have to queue at the counter.7

Europe: The Coffee Bastion

We know that Europe has a long coffee tradition, so its with humility and respect that we come back to Europe. Peter Maslen, Tea & Coffee Trade Journal, February 2002 If the company succeeds in establishing a major foothold in Europe, it will indeed be the U.S. equivalent of carrying coals to Newcastle. BBC News, September 1998

The caf culture of Europe had been widely institutionalized over several generations. Many among the older generation had a favorite caf right in their neighborhoods that they patronized. Loyalties, it was believed were hard to change. It was, after all, Milan which had first inspired Howard Schultz. American coffee had never earned a respectable reputation in Europe. Italy, for example, already had over 120,000 cafs, an astounding level of saturation at one caf per 475 inhabitants. Even in Seattle, a city that Starbucks rated as saturated the number stood at one caf per 9400 people. Starbucks launched its European expansion with the acquisition of Seattle Coffee Company, a U.K. retailer with a chain of 64 cafs located in prime spots throughout the country in 1998. Although the U.K. market was in many ways very different from Continental Europe, the company was happily
7

Wake Up and Smell the Copy! B. McIntyre, http://www.chinanow.com/english/shanghai/city/features/ coffee.html.

TB0153

10

relieved by the initial success of the British cafs. Still the company saw entry onto the Continent as a very serious challenge. Its initial foray onto the Continent was via a flagship caf in Zurich in 2001. To Peter Maslens relief, long lines of people were waiting to get in even before the store opened on a cold March morning. Growing from strength to strength, the company proceeded to open chains of cafs in Austria, and Germany, seemingly flanking France and Italy for the ultimate assault. The obstacles to an entry into Italy and France were formidable. For example in Trieste, Italy, home of the world famous Illy brand of coffee, Ricardo Illy, the Mayor of Trieste and Vice President at Illycaffe had organized caf owners from Italy, Austria, Hungary, the Czech Republic and Germany into an association to preserve and protect the storied caf culture from foreign influence.8 Some believed that the price of espresso could also pose a problem for Starbucks. The average price of a cup of coffee at the local neighborhood cafs of Europe was about $0.30, while Starbucks charged closer to $2.00. There was also the problem of entrenched competition from the up-market cafs in many European cities. Much like Japan where there was a well established pecking order for cafs, the elegant cafs skimmed the top of the market with old world charm and ambience while the neighborhood cafs resonated with the locals who stopped by for local gossip, peace and quiet, along with a strong shot of espresso. Starbucks would have to pick its spot in the pecking order to be recognized.
In Italy, I dont think people feel the need to go to a place like Starbucks to sip coffee for hours, still less to buy take-away cappuccinos in paper cups. Alberto Bottalico, Founder of the Slow Food Movement Common wisdom would be that it has to failthat it would not, could not, catch on with Austrians because we have the best coffee in the world. When McDonalds arrived, everybody said, Whos going to eat those stupid hamburgers when we have our wienerschnitzel and sausage stands? Stefan Janny of Profil of Austria, as quoted inStarbucks Jolts Europes Coffeehouses, The Seattle Times, May 19, 2002

Latin America: Taking It to the Growers. Entry into the emerging economies of Latin America was a proposition quite similar to expansion in Western Europe. The main difference, however, was that many of these economies were the ones that were growing coffee. Technically Starbucks had opened its first Latin American coffee shop in Puerto Rico in August 2002, but for all intents and purposes, the Latin American experience had started in Miami several years before. Miami was well known for its vibrant Latin culture with a strong leaning toward the Cuban coffee influence that predated the rest of the United States by at least five decades. Neighborhood cafs that had originated in Latin neighborhoods around Calle Ocho and Sweetwater had spread like wildfire engulfing the entire city. In many ways Miami possessed a much more sophisticated taste for coffee compared to its new rival, Seattle. Miamis Cuban population had brought their centuries-old coffee tradition with them. The Cuban neighborhoods of Miami were complex networks of walk-up kiosks, neighborhood cafs, push carts, and take-aways. Many of these venues had become institutionalized over time. They were places in which members of the community gathered to discuss the news, politics and sports of the day. Many critics did not believe Starbucks could ever fill this role. As could be expected, Starbucks coffees were not getting good reviews from dyed-in-the-wool coffee fanatics here. Having become accustomed to a fairly strong, thick, and sweet potion known as caf cubano, one local proffered a review, Starbucksthats water. There was also bound to be some reverse competition from established Latin American players who wanted a piece of the U.S. market. An association of 274,000 Colombian growers, the Colombian Coffee Growers Federation, planned to open a chain of cafs in Miami shortly under the Juan Valdez label. Juan Valdez, a prototype fictional coffee grower, had been widely promoted in the U.S. for decades as a symbol for good quality Colombian coffee.
M. Prendergast, Starbucks Goes to Europe... With Humility and Respect, The Wall Street Journal, April 9, 2002.
TB0153 11
8

Starbucks insisted on holding prices at U.S.like levels throughout its stores worldwide, and Latin America would be no different. However, the price disparity between the local brew and the one that Starbucks offered was fairly steep, sometimes even four times as expensive. But would this high price work in markets where disposable income was not high by any standard? Expansion in Latin America would take Starbucks into the heart of coffee-growing country. Even here Starbucks planned to source centrally and have the coffee transported to its roasting facilities in the U.S. before shipping roasted beans back to the Latin American stores.
In countries where there is a culture of espresso, like Venezuela, Brazil and Argentina, Starbucks wont have any sort of success. There is no room for mediocrity. Jean Paul Coupal, Owner of Arabica Coffee franchise in Venezuela, K. Diagle. Associate Press Newswires, August 29, 2002

The Road Ahead

Starbucks was in a race for growth. It had always believed that the first mover advantage was a critical ingredient in its success. Staking new territory first meant that it could soon populate and perhaps saturate the markets with its cafs, creating insurmountable barriers to competitive entry. It had almost unflinchingly cannibalized its own sales through saturated store locations in the U.S. and appeared to be doing the same in other markets. There were rumors that Starbucks was looking at India as its next major market entry. Although India was a logical next step in the implementation of Peter Maslens international growth strategy, it presented challenges larger than those seen even in China. Monthly per capita income in India was a scant $24 compared to Chinas $84. Furthermore Starbucks was sure to face competition from relatively well-capitalized Indian coffee chains that had already established roughly 200 cafs in major cities. The front runner, Barista, had opened 100 cafs in Indias major cities in a span of only two years.9 Barista presented another competitive challenge, international expansion. Late in 2001 the company had concluded an agreement with the House of Tatas, a powerful Indian conglomerate, to expand cafes into foreign markets. The objective was to move into eastern Europe ahead of Starbucks. The venture had already established a roasting facility in Venice, and plans were being finalized for entry into Southeast Asia and the Middle East.10 With a distinct focus on the emerging economies, the company would be able to bring its homegrown knowledge to bear. Barista believed that its strategy would resonate very well with emerging markets which had a set of environmental, economic and social conditions that were quite similar to India. Barista had fitted its cafs with imported Italian furniture, vivid and vibrant colors and an ambience that rivaled that of Starbucksbut at a lower price. Most of its coffees were priced under a dollar. Since the company had addressed many of the larger developed markets, attention would inevitably have to turn to the emerging economies. What markets should they enter next? Would it make sense for them to shore up their leading positions in the markets they were already in before launching further expansionary moves? With much of the low hanging fruit already gone, it was now time for Starbucks to spell out a clear strategy of market selection and development that would continue to deliver superior performance into the future. Many wondered whether Starbucks was up to the challenge.

B. Kurian, Barista to Float Coffee Retailing Venture, Business Line, September 30, 2001. Managing in emerging markets could also be politically charged. Howard Schultz had learned this lesson the hard way, when he had voiced strong support for the Israeli cause and denounced the Palestinian position. Starbucks cafs in the Middle East were instantly confronted with an Arab boycott. The result was an Israeli partner who wanted out.
10

12

TB0153

Appendix A EUROPE

Retail Coffee Consumption and Population by Potential Market Retail Coffee Consumption (thousands of tons) 1999 2000 2001 31.0 30.6 30.3 31.9 30.4 30.7 26.0 27.1 28.4 30.2 28.4 31.3 192.6 191.8 190.2 350.6 352.0 353.0 20.9 21.1 21.4 14.1 14.5 14.7 160.0 165.1 168.4 28.4 29.2 29.8 85.3 85.4 85.6 46.7 53.0 61.3 65.6 70.6 71.3 58.9 54.8 57.2 38.7 39.5 40.3 48.3 48.2 48.2 Retail Coffee Consumption (thousands of tons) 1999 2000 2001 18.2 18.3 18.6 3.3 3.7 4.2 2.5 2.6 2.6 8.8 9.2 9.7 47.4 52.6 58.8 94.8 96.0 99.5 8.7 10.4 12.5 21.3 21.8 22.6 2.0 2.1 2.1 24.6 25.9 27.0 4.0 4.3 4.6 6.5 6.7 7.2 9.6 10.6 11.7 Y-o-Y* 97-01 (%) -10.9 -12.7 31.0 7.1 -1.8 3.2 5.3 58.4 6.3 10.9 4.9 22.5 1.2 -12.8 -0.2 -7.6 Y-o-Y 97-01 (%) 8.6 37.9 13.9 -1.1 52.0 11.8 89.8 36.6 5.6 14.4 9.0 42.4 48.6 CAGR* 97-01 (%) -2.8 -3.3 7.0 1.7 -0.5 0.8 1.3 12.2 1.5 2.6 1.2 5.2 0.3 -3.4 -0.1 -1.9 CAGR 97-01 (%) 2.1 7.8 3.3 -0.3 11.2 2.8 17.4 8.1 1.4 3.4 2.2 8.2 10.4

2001 Avg Monthly Population Earnings Country (millions) (US$) Austria 8.1 2,016 Belgium 10.3 2,267 Czech Republic 10.28 364 Finland 5.2 1,962 France 59.2 2,011 Germany 81.9 2,108 Greece 10.5 1,453 Hungary 10.1 364 Italy 57.8 2,396 Norway 4.5 2,919 Poland 38.7 418 Russia 145.0 105 Spain 39.5 1,486 Sweden 8.9 2,145 Switzerland 7.2 4,056 United Kingdom 59.5 2,223 ASIA & AUSTRALIA Country Australia China Hong Kong India Indonesia Japan Malaysia Philippines Singapore South Korea Taiwan Thailand Vietnam 2001 Avg Monthly Population Earnings (millions) (US$) 19.2 1,541 1,281.8 84 7.1 1,410 1,017.4 24 212.3 32 127.0 3,529 22.6 803 77.3 126 3.3 1,715 47.6 1,611 22.4 1,620 61.7 180 81.0 59

*Y-o-Y growth 97-01: Year-over-year growth rate for the 1997-2001 period (2001/1997-1). CAGR 97-01: Cumulative average annual geometric growth rate for the 1997-2001 period. Source: EuromonitorGlobal Market Information Database.

TB0153

13

Appendix A

Retail Coffee Consumption and Population by Potential Market (continued) 2001 Avg Monthly Population Earnings (millions) (US$) 63.6 405 6.3 1,640 21.9 1,974 2001 Avg Monthly Population Earnings (millions) (US$) 37.3 740 168.9 413 30.8 2,096 15.3 379 39.5 388 100.4 281 276.6 2,154 24.6 367 Retail Coffee Consumption (thousands of tons) 1999 2000 2001 4.2 4.2 4.1 19.3 19.1 18.8 12.0 12.4 13.0 Retail Coffee Consumption (thousands of tons) 1999 2000 2001 27.0 27.0 27.0 540.7 561.6 569.2 41.1 44.6 47.2 4.3 4.2 4.2 42.2 41.3 41.0 32.4 33.3 34.4 641.2 648.2 694.2 27.9 28.2 28.4 Y-o-Y* 97-01 (%) 39.7 9.2 26.3 Y-o-Y 97-01 (%) -5.9 34.9 3.6 7.0 46.6 66.4 8.1 50.4 CAGR* 97-01 (%) 8.7 2.2 6.0 CAGR 97-01 (%) -1.5 7.8 0.9 1.7 10.0 13.6 2.0 10.7

MIDDLE EAST Country Egypt Israel Saudi Arabia AMERICAS Country Argentina Brazil Canada Chile Colombia Mexico United States Venezuela

*Y-o-Y growth 97-01: Year-over-year growth rate for the 1997-2001 period (2001/1997-1). CAGR 97-01: Cumulative average annual geometric growth rate for the 1997-2001 period. Source: EuromonitorGlobal Market Information Database.

14

TB0153

Appendix B

Starbucks Coffee Japan & Competitors, October 2001 Starbucks Coffee 227 227 0 110 (0) 500 180-200 70-80 100.0 28.8 71.2 25.4 11.1 6.5 18.3 61.3 9.9 4.5 5.4 0.5 4.9 Tullys Coffee 23 19 4 15 (0) 400-450 60-80 20-35 100.0 36.9 63.1 18.5 13.0 0.0 18.3 49.8 13.3 5.4 7.9 2.7 5.2 Doutor Coffee 766 158 892 100 (18) 300-350 100-120 80-130 100.0 49.8 50.2 15.9 9.0 0.0 12.6 37.5 12.7 2.9 9.8 4.7 5.1 Ginza Renoir 121 121 0 1 (6) na na na 100.0 10.4 89.6 39.1 30.2 0.0 17.6 86.9 - 0.3 2.6 - 2.9 ---- 2.9

Number of stores Directly operated Franchises Number of openings (closings) Average purchase per customer Annual sales (million ) Capital expenditure (million ) Percent of Sales Comparison (%) Sales Cost of goods sold Gross profit Labor Rents Royalties Other Total SG&A EBITDA Depreciation Operating profit Taxes Net income

na = not available EBITDA = earnings before interest, taxes, depreciation, and amortization Source: Starbucks Coffee Japan, Daiwa Securities, October 15, 2001, p. 7-8.

TB0153

15