Photo: Starbucks
Amy Sancetta  /  AP
A Starbucks on every corner? The company plans to add 2,400 in the next fiscal year — including 700 outside the U.S.
By Allison Linn Senior writer
updated 7/30/2007 7:39:34 PM ET 2007-07-30T23:39:34

There’s no question Starbucks Corp. is one of America’s legendary success stories, having convinced millions of people to trade the basic 50-cent cup of coffee for a mocha Frappuccino or gingerbread latte costing $3, $4 or even $5.

But even the most storied companies have their growing pains.

Starbucks shares have fallen more than 20 percent this year as the company has grappled with issues including rising dairy costs, flat traffic in its U.S. stores and an increased threat from big potential competitors like McDonald’s and Dunkin’ Donuts.

“I still think the company is in good shape, although they are facing some headwinds right now,” said John Owens, equity analyst with Morningstar.

Analysts don’t expect such woes to derail the Seattle-based coffee retailer in the long term, but they say it could take time for investors to feel renewed confidence in its short-term prospects.

“The sentiment’s certainly down,” said Dan Geiman, an analyst with McAdams Wright Ragen.

Starbucks executives conceded this summer that they might have difficulty reaching the high end of earnings estimate for the fiscal year ending Sept. 30. Then, last week, the company said it would raise drink prices by an average of 9 cents to compensate for rising dairy and other costs.

Analysts say the company had little choice, even though it is the second hike in less than a year, because rising expenses were squeezing profits.

“It’s certainly an understandable move on Starbucks’ part,” Geiman said.

Many doubt it will cause a substantial number of Starbucks’ customers to change their coffee-buying habits. But amid high gas prices and economic jitters stemming from the housing market downturn, Owens notes that the timing is not ideal. Even among Starbucks’ relatively affluent customers, he said, some may respond by ordering less pricey drinks or coming in less often.

“It comes at a time when customers are feeling more and more pinched,” he said.

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Starbucks, which reports fiscal third-quarter earnings Wednesday, also is finding that there can be a downside to the kind of tremendous growth and popularity it has experienced over the past few years. The company has warned that same-store sales, a key measure of a retailers’ health, are slowing from the record 10 percent increase in its 2004 fiscal year. For the current fiscal year, executives expect same-store sales to rise 3 to 7 percent.

Starbucks also is grappling with soft growth in the number of transactions per customer at its stores. Traffic to the company’s U.S. stores was essentially flat in its fiscal second quarter ending April 1.

Getting people to come in more often
Analysts laud the company for adding plenty of offerings to try to entice people to come in more often and buy more items, including hot breakfast sandwiches, lunch foods and even CDs and books. Still, convincing people to increase their caffeine runs can get harder.

“In some ways that’s the challenge that the company has faced from day one: How do you drive people to come to the store more often?” said James Maher, a research analyst with ThinkEquity Partners.

Starbucks is grappling with these challenges amid an aggressive growth plan that calls for opening 2,400 stores this fiscal year — about one every three and a half hours — including about 1,700 in the United States and 700 international locations.

In the next few years, Starbucks has said that it hopes to continue adding about the same number of stores in the U.S., which will translate into slightly lower percentage growth.

Maher said he thinks that’s a smart strategy that should allow the company to pick out the most lucrative locations and negotiate better lease agreements. It also may help mitigate the problems other retailers, such as Krispy Kreme Donuts, have faced by building out at too feverish a pace.

Still, even at that pace Starbucks faces the risk that its increasing ubiquity will make its brand less enticing. Starbucks Chairman Howard Schultz fretted about the tradeoffs the company has made in the pursuit of growth in an internal memo earlier this year, although the company has sought to downplay those concerns.

The coffee retailer’s massive expansion has allowed it to dwarf direct competitors such as Peet’s Coffee & Tea and Caribou Coffee. But increasingly, Starbucks is facing threats from other big, established brands that are moving to upscale coffee, including McDonald’s and Dunkin’ Donuts.

Owens said those companies do represent some competition for Starbucks, but he noted that they generally do not offer the ambience, including comfy chairs and other amenities, that are part of Starbucks’ draw.

“There’s not a significant overlap between their customer bases,” he said.

Maher also notes that Starbucks is combating the competition on their turf as well, by offering hot breakfast sandwiches and other food items that compete with those outlets.

International business potential
As the U.S. business grows more mature in coming years, the international market still holds potential, as Starbucks Chief Financial Officer Michael Casey recently told analysts.  Starbucks currently operates about 10,000 U.S. stores and about 4,000 international stores. Company executives hope they eventually will have 20,000 international locations and the same number in the U.S.

Starbucks has said it sees enormous opportunity in developing areas such as China. Still, the company has hit some stumbling blocks as it navigates that expansion. Recently, it had to put its highly anticipated move into India on hold.

Owens says he does see long-term potential overseas, noting that the company has been highly successful in building its brand in the United Kingdom.

“I think the Starbucks brand actually translates well,” he said.

But a real payoff could take years. For now, the U.S. operations accounts for about 80 percent of the company’s profits, compared with less than 10 percent for overseas operations. The rest of its profits come from sales of coffee beans, bottled coffee drinks and other items sold at grocers and other retailers.

“I do think ... that investors and analysts see a lot of potential internationally, but they see it as coming quite a bit further down the road,” Geiman said.

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