50-The Future of Starbucks

This high-end competitor, with the industry’s highest prices, did the implausible, if not the impossible. It held off large, capable competitors who offered much lower prices. This pricing approach finally caught up to it. Then it compounded its problems by trying to do too much. Its profitability declined. Can it recover?

Posted 9/29/08

In 1903, Horatio Nelson Jackson did something remarkable. He made the first automobile trip across the United States, from San Francisco to New York City. His trip took 64 days. This time includes the waits for parts after the car had broken down. There were few roads in those days. Automobile travel was challenging in the extreme. Jackson drove a Winton Tourer automobile that he had named the “Vermont” after his home state.

Not many of us today know of the Winton and its producer, the Winton Motor Carriage Company. Winton was one of the first American companies to sell motor cars. It incorporated in 1897. By 1900, the company was the largest manufacturer of gas-powered automobiles in America. In its day, the “Vermont” was state-of-the-art.

The company continued successfully through the 1910s, focusing its marketing on upscale consumers. However, during that period, dozens of new automobile companies started up, creating intense competition. New competition led to falling sales for Winton in the early 1920s. The Winton Motor Carriage Company stopped automobile production in 1924.

Winton’s experience has something to say to Starbucks. Starbucks is the dominant leader in today’s coffee café market. They have shown the world how to make a lot of money on a product that had heretofore been a commodity. For years the company grew its revenues and profits by opening new stores and by raising prices with impunity. Those days are now at an end. Its fancy coffees can cost $3 to $5 each, and now it has real competition.

After dithering for a number of years, major fast-food companies, such as McDonald’s, Burger King and Dunkin’ Donuts, attacked the premium coffee market with a vengeance. (See the Symptom & Implication, “Competitors in formerly undeveloped markets have begun meeting one another” on StrategyStreet.com.) This attack was easy. Starbuck’s prices were so high that each new competitor had margin enough to provide an excellent drink at much lower prices than Starbucks.

This competition is now a serious challenge. The new competitors have pushed Starbucks into the Performance Leader category, at the high end of its own industry. The new competitors have become the Standard Leaders in the industry. (See the Symptom & Implication, “While still growing, some competitors are losing share” on StrategyStreet.com.) Even worse, the new Standard Leaders are comparable to, or better than, Starbucks in quality. Recently, Consumer Reports hired tasters to sample medium cups of black coffee from several competitors, including McDonald’s, Burger King, Dunkin’ Donuts and Starbucks. McDonald’s, not Starbucks, won that test.

The Winton Motor Carriage Company, too, was pushed into the Performance Leader end of its industry as companies such as Ford, Oldsmobile and others produced good quality cars for far less money. It lost out on economies of scale. Winton could not command enough of a price premium against its larger competitors to make a good profit.

Any high-end, Performance Leader, competitor should look at Price Points below them for competition. This lower-end competition may not offer the same quality but its much lower price for “acceptable” quality will skim off a significant part of the Performance Leader’s business. The lower-end competition will force more restrained pricing and real attention to unit costs on the Performance Leader.

Starbucks is not going the way of the Winton Motor Carriage Company. It will survive, and even thrive, because it has established itself as a quality brand name. But in order to thrive, it will have to be a very different company in the future. Its growth will be moderate, at best. In the future, its new stores will meet much tougher criteria for segments that have the need for, and are willing to pay for, high-end coffee drinks. Its pricing is virtually certain to decline to close some of the gap with the new Standard Leader competitors. It will evolve into a company who understands its unit costs far better than it does today. (See the Symptom & Implication, “Competition is beginning to focus resources on market segments as market growth slows” on StrategyStreet.com.)

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Update 2022:

There have been 2 opposing forces affecting the premium coffee market over the last 10 years. First, there is the entrance of several new competitors, in the coffee shop, quick service restaurant and grocery markets. Second, the premium coffee segment has grown far faster than the market as a whole. Throughout this time, Starbucks has grown profitably and faster than the overall market. It has continued to garner good reviews for the quality of its coffee, though it is not alone in that virtue.

The new entrants in the coffee shop market had an effect on Starbucks and its approach to the market. The 2 largest new entrants were Dunkin and Tim Hortons. Still, Starbucks controls 40% of the coffee shop market, as measured by number of stores. One effect of these coffee shop competitors has been to hive off some of the price sensitive former customers of Starbucks, leaving the company with much less price sensitive customers. In recognition of the price pressure exerted by these new coffee shop entrants and by the other less expensive new alternatives, Starbucks restructured its pricing scheme. It retained skim pricing for non-price-sensitive consumers and introduced penetration pricing for its expansion into more price-sensitive market segments. Now, local Starbucks stores price their product mix in relation to the stores of their local rivals.

Starbucks has surely benefited from the fast growth at its end of the market. But, more than that, they have proven to be an astute company when it comes to pricing its products for various customer segments. See HERE for more thoughts on the impact of pricing.

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Update 1/25

Starbucks is in recovery mode in 2025. Many of its problems are self-inflicted. While trying to do some new things for customers, it overwhelmed its system and damaged its reputation for Reliability. Adding to this problem was a further hit to Reliability due to a tit-for-tat confrontation with its unionized workers. Finally, Starbucks’ aggressive pricing approach caught up with it, causing some customers to defect and enabling priced based competitive inroads, especially in China. We will examine each of these problems in turn.

Starbucks added several new products and services that added to its menu complexity while having relatively little effect on its transactions. Then, the company introduced mobile ordering. Mobile ordering certainly appealed to customers as it became the source of nearly 30% of orders. Unfortunately, these two changes overwhelmed Starbucks’ in-store operations. Customers often faced long or unpredictable wait times and improperly filled orders. The system degraded what once was an efficient and effective customer experience.

Starbucks labor union placed the company in another reputation damaging incident. The union posted a pro-Palestinian tweet. The company sued it for misrepresenting the company’s neutral position on politics.  This event and an NLRB decision against Starbucks caused the company’s Reliability to fall further. Several campuses closed their Starbucks locations.

Starbucks tried to use high prices to maintain its margins. Customers did not like it. Starbucks began losing foot traffic, especially those from “occasional” customers ( Small and Medium customers in our terminology ) who make up about 20% of a company’s sales volume. The price increases could not offset the fall in transactions. The high prices also set a high umbrella in the Chinese market, enabling competitors to undercut the company’s prices and take away some of its transactions. Chinese volumes flattened.

The result was an ugly hit to margins. Store revenues grew at least as fast as the market, the good news. Margins were another story. Store margins fell from roughly 24% to 19% over the last 10 years. Company operating margins declined from about 19% to 15% over the same period. Free cash flow fell from roughly $4.5 billion to less than $2 billion from 2015 to 2024.

Now, the company is in aggressive repair mode. It pared its menu by 30%. It introduced new operational technology to reduce backlogs and ease barista challenges. It added new store staffing to improve workflow and eliminate errors. It closed underperforming stores and eliminated over one thousand corporate positions. At the same time it began an extensive program to refresh many of its stores.

So what is the future for Starbucks? It may take a while but I believe it will return to its former stellar performance. We will take a look at how Starbucks can exploit the Customer Buying Hierarchy to solidify its long-term lead in the industry.  See HERE for a description of the Customer Buying Hierarchy and how it changes as an industry matures.

Function (benefits for the user of the product).  To retain its price sensitive customers, it introduced a low-cost cup of coffee, priced at the same level of its major competitors’ cup of coffee. It continues to experiment successfully with new products with its introduction of its new protein-based drinks.

Reliability (the quality of the product and services to the customer). Starbucks had developed the industry’s best reputation for delivering a product that was consistent in every store everywhere. The customer knew exactly what he or she would get at a retail store. No surprises, no disappointments, no failures. The company’s current system improvements should enable it to return to that standard relatively soon. Its relationships with its employees are improving as the company has increased wages and benefits and added staffing to reduce burnout.

Convenience (benefits for the purchaser/buyer of the product). The company has introduced new stores with smaller form factors and expanded in suburban locations. It has often paired these and their other stores with drive-through services. It has streamlined and invested in technology to smooth and speed its mobile ordering and pickup.

Price (the cash equivalent payment for the product). Throughout the last several years, Starbucks has raised its prices aggressively, well above inflation. Until the company resurrects its reputation for superb Reliability, it will have to moderate its rate of price increases. The price umbrella is simply too high.

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