Starbucks' Move Away From Coffee Will Pose Challenges

We believe US-based coffee company Starbucks' strategy to develop its higher-value non-coffee products could expand its consumer base; however, this could risk pushing away part of its existing customer base (especially if it limits innovation and quality in that segment). We see clearer growth opportunities coming from the company's channel development via other retailers and from expansion into high-growth markets where it is currently under-represented.

Starbucks' focus on diversifying into food and non-coffee drinks will help to grow its customer base in existing markets. The company recently acquired companies in the non-coffee business in order to benefit from their expertise and rapidly build up capacity in these segments, where it has little presence at the moment. In 2011 Starbucks bought Evolution Fresh Juices, an upscale juice maker whose products are distributed mainly on the West Coast of the US, and is in the process of rolling out these products through its stores. Similarly, the company acquired Teavana in 2013 and has indicated that it will open tea shops under the brand, complementing its coffee offering. The company also bought La Boulange bakery to develop its baked goods and breakfast offerings, taking advantage of a new trend among consumers to eat out more for breakfast and look for healthier options. Finally, Starbucks has slowly expanded its alcoholic offerings at its stores. The chain first tested selling alcohol in a single Seattle store in October 2010. Since then, the company has expanded sales across a couple dozen stores in Illinois, Washington, California, Georgia, Oregon and Washington DC.

The company has also pushed to move towards higher-value products. We believe targeting specialty teas makes sense for Starbucks given its historical positioning within high-quality coffee. In terms of food, however, the new bakery products have received criticism from some customers because of higher prices and generally smaller portions. As a result, the company announced it would not roll out all of La Boulange's products in its shops (in the US especially) and would bring back some of its best-selling products. The company will also focus on premium alcohol products, with glasses of wine sold for USD8-10.

Profits Increasing Faster Than Revenues
Starbucks - Operating Income & Revenue Growth (% y-o-y)

We believe US-based coffee company Starbucks' strategy to develop its higher-value non-coffee products could expand its consumer base; however, this could risk pushing away part of its existing customer base (especially if it limits innovation and quality in that segment). We see clearer growth opportunities coming from the company's channel development via other retailers and from expansion into high-growth markets where it is currently under-represented.

Starbucks' focus on diversifying into food and non-coffee drinks will help to grow its customer base in existing markets. The company recently acquired companies in the non-coffee business in order to benefit from their expertise and rapidly build up capacity in these segments, where it has little presence at the moment. In 2011 Starbucks bought Evolution Fresh Juices, an upscale juice maker whose products are distributed mainly on the West Coast of the US, and is in the process of rolling out these products through its stores. Similarly, the company acquired Teavana in 2013 and has indicated that it will open tea shops under the brand, complementing its coffee offering. The company also bought La Boulange bakery to develop its baked goods and breakfast offerings, taking advantage of a new trend among consumers to eat out more for breakfast and look for healthier options. Finally, Starbucks has slowly expanded its alcoholic offerings at its stores. The chain first tested selling alcohol in a single Seattle store in October 2010. Since then, the company has expanded sales across a couple dozen stores in Illinois, Washington, California, Georgia, Oregon and Washington DC.

Profits Increasing Faster Than Revenues
Starbucks - Operating Income & Revenue Growth (% y-o-y)

The company has also pushed to move towards higher-value products. We believe targeting specialty teas makes sense for Starbucks given its historical positioning within high-quality coffee. In terms of food, however, the new bakery products have received criticism from some customers because of higher prices and generally smaller portions. As a result, the company announced it would not roll out all of La Boulange's products in its shops (in the US especially) and would bring back some of its best-selling products. The company will also focus on premium alcohol products, with glasses of wine sold for USD8-10.

We believe Starbucks will have to test different offerings at different stores before deciding on relevant sales mixes (and eventually expanding this strategy to other countries). At the moment, it is looking to increase traffic from customers that have never been to a Starbucks store before. However, there is a risk it could easily lose part of its current customer base as it moves away from its core coffee business, especially if it limits reinvestment on quality and innovation in its coffee offering.

Ultimately, Starbucks' focus on channel development (i.e. distribution of products through other retailers, grocery stores, hotels, foodservices) and continuous expansion in markets where it is currently under-represented will provide strong opportunities, regardless of the company's diversification in non-coffee products. The company's channel development segment saw tremendous revenue growth over the past few years (50% in 2012 and 10% in 2013, before it was included in a wider segment was and became more difficult to track growth). We believe there will be more room to boost this category in the near term, as Starbucks is still under-represented in other retailers' offerings at the moment.

Brazil And Costa Rica Left Behind
Starbucks - Number Of Stores In Selected Latin American Countries

Moreover, we believe the company still has strong growth potential in Latin America and, over the longer term, in Africa. Starbucks is over-represented in Mexico, operating 415 stores despite the fact that consumption per capita in the country is low by regional standards (at 1.0kg in 2012). In contrast, Brazil has 74 stores, with per capita coffee consumption of 6kg, and Costa Rica only has three stores and per capita consumption of 5.3kg. We believe there is strong potential for Starbucks to expand in the region, based on a growing middle class and fairly cheap local supply, as the region is the world's largest producer of coffee. In fact, the company has historically tied up with local farmers to buy their coffee output (as it is the best-quality arabica variety) and export it back to various locations to grind and use in its beverages. This would put Starbucks at an advantage in terms of supply chain management.

That said, the country is likely to face challenges in its aim to expand in Latin America given the already existing coffee culture and competition with local chains. First, some of the largest producing countries in the region already consume coffee but in very different forms than what Starbucks is offering. The time-honoured Costa Rican chorreado is still very popular and involves pouring hot water into a coffee-filled cloth bag hanging from a wooden stand. Second, successful local operators such as Manuel Dinarte in Costa Rica or Juan Valdez Café will make it more difficult for Starbucks to penetrate these markets, especially if it keeps its beverages at prices higher than the competition (which it has done in many other locations).

No Starbucks For Africa
Starbucks - Number Of Stores In Selected MENA Countries

The company has largely ignored Africa given its less mature consumer markets. It has trialled the sale of Starbucks-brewed coffee in limited locations in South Africa (mainly through retailers, hotels and casinos in big cities). We believe the company could replicate this method in other countries in the region and eventually open its own stores in the long term.

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Related sectors of this article: Food & Drink, Drink
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