Starbucks

Fighting Back Against Disruption: Has Starbucks Gone Far Enough?

'Bean' there before

A little over a year ago, Howard Schultz, then chairman of Starbucks wrote an internal memo lamenting the loss of Starbucks' distinctiveness. He wondered openly whether in the mad rush to expand and grow ever more operationally efficient (as measured by speed and same-store sales increases, rather than quality of experience), the company had lost a bit of its soul.

This memo was reported in all the major business papers and spurred a flood of blog postings from Starbucks critics and fans as Schultz seemed to have captured what was on everyone's minds, although still at that time, a largely unspoken feeling.

I too wrote an article taking a very different slant and documenting how and why Starbucks had allowed itself to evolve from being the market disruptor to the disruptee as a number of major foodservice chains began to compete on many of the now commoditized (and watered-down) features of the Starbucks experience -- better quality coffee, much lower price, more inviting workspaces to stay the afternoon and work or lounge, free WiFi, faster service and so on.

Through the remainder of 2007, it became increasingly clear that the days of heady growth, at least in North America, were indeed over, and that Starbucks competitors were taking direct aim at the weaknesses in Starbucks' business model armor that had crept into their operations over the preceding 10 years.

The company still looked healthy on paper, with year-over-year revenues in 2007 22% ahead of 2006 and record net income (profit). But, trouble signs included dramatically slowing same-store sales growth which had clearly reached a limit, and a large number of customers opting for the improved, more widely available and cheaper coffee solutions of the competition as I predicted in last year's article.

Additionally, by the end of 2007, long-time Starbucks loyalists were increasingly grumbling about what was wrong with the company and voting for change by going less frequently, or going elsewhere entirely.

Hello. My name is Howard. Remember me?

As if sensing that the tide of success was turning against his prodigy, Schultz moved back into the driver's seat at the company he built in January 2008, reassuming the CEO role and announcing a return to the basics of Starbucks vision and identity. While acknowledging that the competitive landscape was different, Schultz asserted that the problems at Starbucks were internally generated for the most part, and that the solution lay in self-examination, putting the primacy of the customer experience first again, and getting back to the core mission that had made Starbucks successful in the first place.

Since January, Schultz has been busy righting the ship with a number of dramatic changes, many of which were easy to predict and well-designed to rally the faithful. Last week, the most significant (economic) announcement was made, with 600 store closings and up to 12,000 layoffs coming, and it caught the attention of the business media, partly as a bellwether indicator of the down economy. Certainly that's the way Starbucks spun it, but is it the whole story (or even the right story)?

Slow train coming

Starbucks pre-bagged beans. Might be fresher, but that sweet coffee smell just isn't the same when you walk in the door.

Starbucks pre-bagged beans. Might be fresher, but that sweet coffee smell just isn't the same when you walk in the door.

In last year's article I identified several signs of disruption and difficult decisions for Starbucks to avert or at least parry with the competition disruption that Starbucks own mistakes had enabled (although in their defense and viewed from an internal "operations" perspective, these would have been perfectly logical innovations to improve efficiency, profitability and leverage the brand through extensions). These included:

  • pre-bagging coffee beans to preserve freshness (in the process, killing the distinctive coffee smell of an authentic neighborhood coffee bar, and the sensuality of sounds and sights such as scooping of beans, weighing and pouring them into custom bags, etc.)
  • expansion of chain to be almost as ubiquitous as McDonalds (turning them into a "true chain" experience, common but still expensive)
  • conversion from manual expresso machines to automatic to improve speed, efficiency and consistency of coffee making (at the expense of smells, theatre and "hand-made" quality)
  • dilution of brand experience due to rapid expansion, higher staff turnover and lower training standards, resulting in surly and uncaring baristas
  • introduction of warmed breakfast sandwiches and other foodservice items as a further brand extension (more brand and customer experience dilution)
  • expansion of music retailing operations (more brand and experience dilution)
  • expansion of branded non-food and non-music retail operations (more brand and experience dilution)
  • new "low end" competitors entering market serving "good enough" coffee options (upgraded coffee roasts, espresso and capuccino, "third place" alternatives) at significantly lower prices

Our recommendations included:

  • undoing the conversion of coffee bars into retail emporiums, restoring the "third place" ambiance and experience
  • improving training
  • getting rid of automatic espresso machines that made Starbucks just equal (in perception) to the lower-priced competitive options for many consumers
  • acknowledging that new "low-end" disruptors (McDonalds, Dunkin Donuts, local gas stations) selling fresh-brewed espresso at 25% of Starbucks price changed the game and required a specific competitive response
  • closing stores because the "coffee aficionado" market was already over-served (in the US market) given "good enough" competition at much lower price points

It's important to note that a few of these are counter-intuitive (at least to most by-the-book MBAs), and options that most businesses wouldn't consider.

For example, when I discussed the installation of automatic espresso machines last year, it was noted that the original decision to do this had cost millions of dollars. Replacing them would potentially both slow down service and retire perfectly good equipment before it was fully depreciated and had reached its natural end of life. (Although the equipment was a "sunk cost", most businesses that had made such a decision in the first place would not easily reverse it and incur additional expenses to restore an "experience" and recreate the lost competitive differentiation.)

And what has Schultz done?

The Clover Coffee Machine will elevate the quality and freshness of regular brewed coffee to the premium level that coffee enthusiasts expect, but not so for Starbucks espresso coffees, which will be even more automated than before with the Mastrena, reducing baristas to button pushers. Click on the image to read how the Clover system works.

The Clover Coffee Machine will elevate the quality and freshness of regular brewed coffee to the premium level that coffee enthusiasts expect, but not so for Starbucks espresso coffees, which will be even more automated than before with the Mastrena, reducing baristas to button pushers. Click on the image to read how the Clover system works.

  • get rid of breakfast sandwiches by end of 2008 (announced Jan 30), to eliminate strong smells that compete with coffee
  • slow pace of new openings and close 100 underperforming stores in US (announced Jan 30)
  • stop reporting on year-over- year same-store sales growth (announced Jan 30), which could only be achieved in long term by continued dilution of brand experience through increased retailing options
  • upgrade "partner" (i.e. barista, counter clerks, store management) training to re-focus on exceeding customer expectations and improve the overall experience (announced Jan 30)
  • acquisition of The Coffee Equipment Company for its Clover brewing system -- a method which creates a vacuum to suck the steeping coffee through a filter to create an individually brewed cup similar to French press (which pushes the filter through the steeping coffee) to create a superior flavored cup of "traditionally" brewed coffee, with enhanced richness and body (announced Mar 19)
  • introduce Mastrena espresso makers to replace current generation of automatic machines. (Although Schultz announced this, development of this machine, exclusive to Starbucks, was underway for 5 years.) Billed as enhancing the theater (because you can once again see the barista over its lower profile, and offering more control, it is still an automatic machine whose exclusivity doesn't address the quality and theatre lost with the old manual machines. (announced Mar 19)
  • Loyalty rewards added to Starbucks cards. (announced Mar 19)
  • Close 600 under-performing stores (up from only 100 under-performing stores in January).  12,000 employees will lose their jobs.  (announced July 01)

Overall, the emphasis of these changes is essentially the same as the recommendations I made last year, with the exception of two key points, which I'll discuss below.

The stated purpose has been to:

  • bring back the sense of theater
  • enhance the Starbucks experience consistent with brand expectations
  • put the emphasis back on coffee and hopefully undilute the brand identity

Unquestionably for drinkers of traditionally brewed coffee, the use of Clover machines to individually brew whatever you want from fresh ground beans (rather than chose from one of the three pre-selected coffees of the day) is a large improvement. Closing stores was expected because Starbucks was overbuilt, although Starbucks is blaming closures on the economy.

Is it the economy stupid, or is it really disruption?

For the first time ever, Starbucks has experienced a year-over-year decline in same store sales. The economy explanation has been picked up and widely reported in the media (because it fits the story that they want to report), but we have a hard time believing that Starbucks drinkers are consuming less coffee because of the price of gas.

More likely the economy is providing an incentive to the most price sensitive of Starbucks customers to switch to cheaper McDonalds or Dunkin Donuts alternatives, accelerating a trend that would have inevitably have happened anyway, due to the increasing availability of good enough low-end alternatives. Starbucks claims to have done research that disproves this, but we think they'd be wise to ignore the research, which is harder to prove than this more rational explanation.

The problem with drinking your own koolaid on something as strategic as protecting erosion of the customer base is that once people make peace with the mental switch from a high-end to low-end disruptive product, rationalizing that the low-end low cost alternative is good enough, they rarely go back.

The two things in the list of strategic changes that Schultz has implemented that are still at odds with "undisrupting" Starbucks are the switch to Mastrena ultra-automatic machines and not fully addressing the low-end threat for what it is. While the Mastrena may be an improvement in visibility of the barista, enabling them to participate in the experience for the customer, it is still an automatic machine. In fact, it automates more of the process, not less.

The supposed expertise of the barista is therefore non-evident -- they can't do any more to improve the espresso shot than can the cashier at McDonalds. The emphasis of the Mastrena is on higher volume (operating efficiency), and any qualitative difference in the cup of coffee between it and the Verisimo machine is so minimal, it is unlikely to be noticed by the majority of caffeine addicts patronizing Starbucks.

Starbucks closes 600 stores. Did too fast growth make them less exclusive as a brand? Did we really need new Starbucks in Starbucks parking lots?

This is a key element, because in no way does the replacement of old machines with the Mastrenas differentiate the end product or in the consumers' mind justify the higher price for Starbucks versus their competition.

Proprietary is not equal to different, and this is a sustaining innovation that reinforces that Starbucks has overshot the needs of their customers, but yet still underperforms on a key dimension -- the expectation of a quality hand-crafted coffee. An expectation that Starbucks created, but has now walked away from.

Secondly, Starbucks gives the appearance of continuing to be in denial that speed and price are performance criteria that a large percentage of their customers deem important, and that many will sacrifice the brand image of Starbucks to get a good enough cup at McDonalds.

Admittedly, this is a very tough line to hold, since through its chain-store ubiquity, Starbucks has ceased to be a unique neighborhood place, becoming instead the middle-of-the-road McDonalds of premium coffee. The only problem is, McDonalds is better suited and better able to be the McDonalds of premium coffee.

How then can Starbucks respond? Can it be different enough to continue commanding a huge price premium over its competition? If not, will business continue to siphoned off by low-end disruptors?

Is there a counter-disruptive response that allows Starbucks to not concede the low-end to McDonalds and Dunkin Donuts while maintaining its higher end niche for hard-core loyalists? Will Starbucks realize that the Mastrena is masking the real problem and that by positioning it as an improvement to the coffee experience, may actually lose more customers as it rolls out (if there is no taste difference, has Starbucks reached the limits of innovation in the core experience).

Will they recognize that purists want a manual shot pulled, or minimally a semi-automatic (because the barista has more control than with a fully automatic)? Can all these needs co-exist?

While we must praise Schultz for the aggressive return to Starbucks origins and a stronger vision, the question now is has he gone far enough, or is the past year a harbinger of much greater disruption to come? Or, has he recognized that disruption is the problem, and there are more surprising announcements to come as a result?

More importantly for investors, is this the end of Starbucks as a growth stock (SBUX - click to see performance over past year compared with Dow Jone and S+P 500), or at about 1/2 the valuation of a year ago, and still dropping, is it a buying opportunity?

Wall Street has been betting against a return to the days of heady growth, but does it have to be that way? I don't think so, but it requires disruptive imagination to see a way out. Perhaps Schultz sees it too.

What do you think?

Related Stories

Starbucks: Ripe for Disruption, or Already Disrupted?

I suspect most people have heard by now of the kerfuffle about an internal memo, leaked through a popular Starbucks fan blogsite and ultimately covered by BusinessWeek, The Wall Street Journal, Forbes, CNN, etc., which was penned by the founder and chairman of Starbucks, Howard Schultz. Certainly the blogosphere is a-buzz with the come-to-Jesus nature of Schultz's personal revelation that Starbucks may have lost its mystique. I counted hundreds of blog postings - right up there with Britney Spears haircut and Anna Nicole Smith in popularity.

The memo itself was an interesting document that raises eyebrows and questions: although addressed to the president and other senior execs, was it always intended to be leaked via social media, into the mainstream press and back to the blogosphere?  It has certainly created a lot of passionate commentary and free advertising for Starbucks.

Was it really intended to tell the public that Starbucks knows that people are complaining and that the competitive sands are shifting? Was it a message to investors that the company needs to slow growth and fix the experience to save the brand and that it's going to cost a bundle?

Or was it just the confessions of a founder and Chairman, purging feelings of guilt about a loss of soul, and a plea to executives for salvation? (Which, incidentally made Starbucks look good while rallying those who are still passionate about the brand experience to Starbucks' defense?)

No matter which of these it was, it was a brilliant document, but it may be too little too late.

Too Little, Too Latte? Starbucks is the World's Pre-eminent Coffee Brand: How Can it Be So?

It really depends on whether the executives realize that disruption is afoot, and that there's much more going on here than the diminution of brand experience. To properly address this question, and explain why disruption is the real problem, it helps to go back to the beginning, and define the innovation that led to Starbucks becoming a household name approaching 15,000 stores around the world.

What problem did Starbucks solve for its customers?

Anyone who travelled in Europe BS (Before Starbucks) would have marvelled at the quality and variety of coffee, and the cafe culture there. Especially in places like Italy and France.

The coffees were strong, but fresh, well-prepared and a perfect complement to a day of sitting on a sidewalk under an umbrella people-watching, or to end a perfect meal, or a delightful jolt to start the day with a pain chocolat or even just toast and eggs. You would have wondered how everywhere you went, coffee could taste so strong, yet be so delicious and universally good.

On this side of the pond (outside of your favorite Little Italy restaurant), it was almost impossible to get a decent cup of coffee, and especially to get a strong cup that was drinkable. I remember wondering after every trip why it was that good coffee on our side of the pond was an oxymoron whilst on their side, it was impossible to get a bad one.

It wasn't just that most (North) American coffees were made from Robusta versus the superior Arabica beans. It also had to do with poor roasting, poor quality control, and the fact that we got used to crappy coffee during the second world war when everything was rationed and/or watered down.

By the 50s, everything was about speed and automation, and so we made matters worse by going from percolated to instant to freeze dried to Coffee-Mate powdered creamer (another oxymoron). We drank it by the gallon, rotting our stomachs, taste buds and brains in the process.

It was purely about the caffeine and the speed. (Wonder why we never distilled out the caffeine and dispensed it straight via injection?). Yes, in a few big cities, you could find that rare place that would serve a great European-style coffee, and sometimes even with a bit of the ambiance, but that was so small a percentage of consumption that it barely qualified as an exception to the rule.

The story is apocryphal, and published on Starbucks website, and in Schultz's book, about how Schultz felt exactly this way on visits to Milano, and decided that it was time Americans got to upgrade their coffee experience. And, not just create a better cup of coffee, but the same smell and feel and cultured experience and ambiance that you felt in a great Italian coffee bar. That was the beginning of Starbucks as we know it.

We'd been upgrading the experience for ourselves, as much as we could with drip coffee becoming more the norm in the 70s and 80s versus instant, but the vast majority of Americans had never had a quality cup of coffee nor enjoyed the sensuality of the European coffee culture. So, when Starbucks hit Seattle, we were ready for something different.

So What About Disruption?

Disruption theory says that products or services evolve incrementally to better meet the needs of the most demanding customers, but eventually overshoot the needs of most consumers. In this process, the incumbents that dominate the existing market build processes and operational efficiencies that enable them to maximize profitability and continually introduce new "sustaining innovations".

In the short term, these series of decisions that improve processes and efficiency are seen as good management, delivering better profits. In the long term, however, they create the opportunity for a disruptive innovator to enter the scene.

At the time when Starbucks began, the big coffee suppliers had enormously overshot the needs of their customers for a cheap, fast cup of coffee. Yet, each "innovation" they introduced kept on making the product either cheaper or faster to prepare, stripping the product of the original reasons we became addicted to it - its flavor first and foremost, but also its ability to facilitate social interaction, savor a great meal, sit and relax, etc.

So Starbucks was a disruptive innovator. It brought flavor, a friendly social setting (the "third place"), quality, plus the consistency that only a chain can do. They brought back the smells, the sensuality, and introduced to Americans a "European experience" -- and, what Schultz has described as the sense of theater.

But isn't disruptive innovation "low-end"? How does a $5 cuppa disrupt?

starbucks_beans.jpg

But, you might be saying, Starbucks introduced a high-end innovation -- disruptive innovations typically are aimed at the low-end markets and low-end needs.  Well, you'd be right, usually, but the question is: what needs were low-end, or more accurately underserved?

The characteristic that initially made Starbucks a small niche disruption was the speed. The big producers were optimized for speed above all else, not flavor and certainly not the organic pleasure of a gathering place with great smells where you hang out with your friends.

The characteristic of Starbucks' innovation that was just good enough for the original niche of coffee culture appreciators was the speed.  They were happy to sacrifice the speed of picking up a pot of coffee off the Bunn burner (ironic that they called these things burners, because that's what they did/do to most pots left longer than 5 minutes) and pouring it straight to the cup and from there to the lips, in order to drink something they truly enjoyed, and to experience the coffee bar ambiance.

Initially, potential competitors to Starbucks ignored them because the market wasn't big enough for Dunkin Donuts or McDonalds to care about. To them, Starbucks coffee drinkers were aficionados -- a tiny specialized segment that had nothing to do with the mainstream, who they perceived still mostly wanted speed.

This ignorance is typical (and logical) to mainstream vendors who aim to maximize profit by serving the largest market as efficiently as possible. It also allowed Starbucks to "fly under the radar" for a long time -- over 20 years of strong growth -- allowing them to build their market unimpeded by real competition.

Yes, there are smaller chain coffee brands, like Caribou and Peets, etc., but their presence serves to expand the market for all specialty coffee vendors, and benefits the leader, i.e. Starbucks, disproportionately. But, Starbuck has become mainstream, and they can no longer hide -- they are officially perceived as a real threat to the foodservice business of other big companies.

But Starbucks is the leader and still growing. Are you seriously saying they might be "disrupted"? By who, and how?

As noted, disruption can take a long time to play out, and the seeds are sown long before the heavy damage is done.

As Starbucks has grown, they have focused on operational efficiencies to grow faster and more profitably. Efficiencies such as automatic espresso machines, flavor-sealed packaging (which eliminates the great smell of a real coffee shop), and expanding merchandise options ("would you like some fries with that doppio mocha latte half-caf with low fat milk?") to extract every last penny of same-store sales growth.

In the process, they have incrementally sacrificed seemingly small parts of the experience -- the smell, the theater, the ambiance (who wants a line snaking around the tables while you're trying to relax or have a conversation over a cuppa?), the service quality (rapid growth almost always comes with higher turnover and poorer training -- by now, we've all experienced the surly baristas who won't go the extra mile, but still make too many mistakes), etc.

The endgame: they've reduced themselves to serving a pretty-good-but-not-outstanding cup of coffee, too slowly and at too high a price. And, more importantly, they've overshot the needs of their customers, and are ripe for disruption.

To speed up coffee service in order to sell everything else too, they installed automatic machines. Automatic machines can be more consistent, especially for inexperienced operators, but they also reduce the flavor and the authenticity of the experience, and show competitors how they too can produce a cup just as good as Starbucks (i.e. open themselves to commoditization). This was an unnecessary and ill-advised "innovation". 

Customers didn't ask for it, would probably agree that they didn't need it, and in general would feel that they are getting less for their money. Do I really need a bacon and egg (McMuffin) breakfast with my espresso?

Again, the more I overlap with my competition, the more I illustrate to them how to compete with me.  And now I smell eggs cooking, not coffee beans and fresh espresso.  Not wise.

Most fanatical customers who still are, were more fanatical 10 years ago, so what have these innovations added?

In becoming ubiquitous, the mystique is demystified, the coffee which was the central feature has become a means to sell myriad other food items and irrelevant merchandise (t-shirts anyone?), and the taste and smell and comfort have all been diminished. Yet, the high price remains. And, therein lie the seeds for potential disruption.

Because now, wanting a good cup of coffee has become mainstream, and Starbucks has become focused on speed (but not really), and efficiency, and foodservice, and add-on sales and rapid growth, they now face a new reality.

It's easy to add a pretty good cup of coffee to the menu. Especially for companies like McDonalds and Dunkin Donuts who already served coffee.  All they have to do is add middle-of-the-road or better automatic machines to their operation, and they're almost as good.

But, they excel at real speed and efficiency, and are optimized to process customers in seconds or at most a minute or two, whereas Starbucks will never get that fast without redesigning every store and adding a lot more baristas. Moreover, they are value-oriented -- i.e. cheap. For McDonalds, $1.25 for coffee is an improvement in margin, but for Starbucks, it's impossible to go that low.

So, if I can get something almost as good for 1/3 the price, is that 'good enough'? Heck, even the the local QuikTrip service stations can create a relatively decent cup of coffee or espresso now.

And, more than commoditization, Starbucks' real problem now is that the competition is 'good enough' to be disruptive and undermine their business. But here's the real conundrum Starbucks faces. It will be almost impossible to go back.

Replacing the automatic machines with better quality semi-automatic or manual, and fresh ground and hand-tamped shots means throwing out a lot of expensive machines. It means they will go a bit slower for each coffee, which also means they'll need more people and more space for brewing. And, they'll need to increase their training expense enormously.

It will be hard to explain to investors why all the superfluous merchandise needs to come out of the stores, and why same-store sales will likely decrease. It will be even harder to recognize that for the mainstream coffee consumer, a $1.25 cup of coffee is good enough, even if I can't quite bring myself to visit McDonalds, and so there will be increasing downward pressure on price.

And, if they don't want to compete on price, then they probably already have too many stores, because the average consumer won't continue to spend a premium price for a commodity that is only marginally better than the competition.

Coffee Customization at Its Finest

Coffee art from danyrolux on Vimeo.

To Schultz's credit, he recognizes that all is not well. And, he's recognizing it at a time of apparent strength. Starbucks just announced another record year where revenue grew 23%, 1177 new stores were added, and same-store sales increased 6% over the previous year (although the rate of increase is slowing, these are still impressive numbers for a $6.7B company.

If he can convince his executives and board and investors that a strategic overhaul is required to address the looming disruption, then he may well be able to avert it, but it isn't as simple now as returning to the good old days of better quality machines, better service, less merchandise, whole beans scooped out of bins rather than prepackaged in flavor-sealed bags, more uniqueness in each store, etc. They will need a plan designed specifically to address the disruption Starbucks faces from new competitors, or else the disruptor will become the disruptee.

Acknowledging that the market has changed irrevocably, and is now attracting disruptive 'good enough' solutions for quality coffee, but at a lower price and faster pace, what would you do to re-energize Starbucks and fend off a loss of leadership position in the coming years?

Links for coffee fans

Koffee Korner - coffee history and culture
CoffeeResearch.org - the science of coffee
Wikipedia - coffee history
Wikipedia (2) - all about coffee
Starbucks Gossip - blog that broke the story

There is a follow up article to this post here: Has Starbucks gone far enough?