Starbucks Competes for Market's Mellow Middle

Starbucks (SBUX) surprised both Wall Street analysts and skeptics like me Wednesday, by releasing first fiscal quarter 2010 results that were better than expected. Led by a 4% comparable-store sales growth, the company recorded 4% higher revenues of $2.72 billion. Earnings came it at $241.5 million, or 32 cents per share, topping expectations of 27 cents per share. Last year's first fiscal quarter earnings were only nine cents per share, before charges on store closings.On a conference call held after the earnings were announced, CEO Howard Schultz called the seasonal performance "among the best in our history" and praised the results of many new and specialty offerings, especially the company's darling, VIA instant coffee.

'Developed New Muscle'

"Our strong holiday performance continued the momentum we established in our stores during the fall with the North American launch of Starbucks VIA and as I said on our last call, we have developed new muscle in how to go to market at retail as evidenced by the fantastic customer and partner response to Starbucks VIA in our stores," he said, calling the brand a "powerful halo" for the company.

It's funny he should say that, as the chatter among partners on Twitter and StarbucksGossip is that this "new muscle" consisted of hard-selling tactics unusual for a company long committed to a comfortable, living-room atmosphere -- and a company long called one of the best places to work. This year, we learn, it's slipped to No. 93.

VIA sales, says StarbucksGossip creator Jim Romenesko
, were only achieved due to non-negotiable "goals" and tactics such as including offering customers free products to induce sales and the purchase of products by staff themselves to meet store goals. What's more, as commentators point out, if customers were truly buying VIA, it would be as a replacement for at least some of their regular purchases. Although VIA is expensive for an instant coffee, it's still much cheaper than a brewed coffee or latte beverage.

Some Analysts Puzzled

Analysts, too, seemed suspicious of the effusion. Goldman Sachs' Steven Kron wondered how the sales figures were really divvied up. The company credits VIA for its year-over-year growth, but isn't any more specific than that.

"Is there anything in your business that is giving you a little bit more of a cautionary tone specifically as it relates to VIA," he asks, "recognizing that sometimes when you launch a new product you may have a bit of spike based on the promotional activities surrounding that product in your stores?" The question wasn't answered.

Still, the company has big plans for VIA, specifically to increase the product's availability in grocery stores. It plans to launch outside of North America with availability "through North America and international channels" by the fiscal third quarter.

New Premium Varietals

In addition to the two original varieties and the decaf VIA launched later in the quarter, Starbucks is "also planning to introduce additional premium coffee varietals and form factors to aggressively go after the at home and office single serve markets, as well as the $21 billion instant coffee category."

This statement had me wide-eyed, given the huge problem Starbucks faces in this equally huge market: There is virtually zero overlap with its current market. This has long been a good thing. The taste of Starbucks coffee is considered too rich for the consumer who relies on instant coffee.

And then there's the price differential. Given regular retail prices for the most premium brands of instant coffee, VIA is still 13 to 16 times as expensive, per serving (about 6 cents for instant coffee versus 83 cents to 97 cents per serving for VIA).

A Tough Sell

Convincing a customer who would choose Dunkin' Donuts coffee in a taste test over Starbucks' regular brewed coffee -- which, the doughnut chain keeps reminding us the majority of surveyed Americans do -- to spend 15 times more for his coffee will be tough. Generally, consumers who choose instant coffee do so for three reasons of equal significance: The convenience, the economics and the taste. VIA, for the vast majority of this market, loses on two of those three decision points.

Given that the true premium coffee market is now beyond the reach of the vast majority of Starbucks' offerings, and the instant coffee market is unlikely to trade up to a taste they don't like, that leaves Starbucks, serving only the specialty coffee drinker. It's a consumer group that is becoming narrower, as independent roasters skim off those with more refined palates and the quick service chains like Dunkin Donuts and Tim Horton's pluck those who were drinking Starbucks for the cachet.

The company sees this, and its coffee shop concept is expanding to compete with the indies. Schultz was calling in to the call from London, where the company just opened a store on Conduit Street. But it also must battle the middle of the market with an old brand that's new again: Seattle's Best Coffee.

A Hometown Rival

Acquired in 2003, Seattle's Best was a hometown rival whose very name thumbed its nose at Starbucks, and it's irony indeed that the "flavor profile" of this coffee is, as Schutlz says, "more approachable," "a hidden treasure for the company in terms of its mass appeal." In other words, the people who think Starbucks tastes burnt -- the regular coffee drinkers of America -- love Seattle's Best. In a deal announced in late 2008, Subway began serving three blends of Seattle's Best Coffee, and the brand is now available in 9,000 Subway restaurants. This, says Schultz, will only be the beginning.

The company is launching SBC iced latte drinks in grocery and convenience stores, and is talking to other QSRs about offering Seattle's Best Coffee so they can better capture more of the breakfast business, says Schultz, "not unlike what McDonalds has done." In other words, in these past few years, McDonald's and Dunkin Donuts have been far keener competition than any company in the coffee business. The sharpest tool in Starbucks' belt is also its "mellowest," the mass-appeal Seattle's Best.

Will 2010 be the year we see Seattle's Best Coffee logos in KFC, Burger King, and Chedd's Gourmet Grilled Cheese? It's not as far-fetched as it may have once seemed. And for Starbucks, it may just work.
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