Starbucks chokes on its latte

After more than 35 years of growth, Starbucks has posted its first-ever loss. Rupert Cornwell reports

What has happened to the siren's magic? For more than two decades a long-tressed maiden – more decorous now than when she was first launched upon the world – has been the centrepiece of one of America's best-known commercial logos, that familiar green circle with "Starbucks Coffee" in white letters, to be found, seemingly, on almost every city block and main street in the land.

And until lately, the allure of the Starbucks siren had been irresistible. Howard Schultz, the visionary businessman who in effect founded today's Starbucks when he bought out its original owners in 1987, ran the company until 2000. In the process he created not just a runaway business success but a small revolution in American culture. A handful of outlets in Seattle have become a global empire of some 15,000 stores, generating annual sales of about $10bn (£5bn).

But the company that was a case study in business acumen and grew to be the largest coffeehouse chain in the world is now a case study of a less flattering variety – of how complacency and the laws of the marketplace can bring even the mightiest low.

This year the creeping crisis at Starbucks has exploded into full view. In January, it sacked its chief executive Jim Donald, and restored Mr Schultz to his former job. April brought a 28 per cent slump in quarterly profit, and news that the company would again cut the number of new stores it planned to open across the United States, to 600 less than initially planned, and trim its office workforce by up to 1,000.

Last month, the trickle of bad news turned into a flood. Some 500 stores across America are to be shut, with the loss of 12,000 full- and part-time jobs. And the rot has spread farther afield. Starbucks is closing 61 of its 85 stores in Australia – meaning that henceforth only the residents of Sydney, Brisbane and Melbourne will be able to sample its wares. This week brought the latest blow, the company's first quarterly loss in 15 years, of $6.7m, compared with a $158m profit a year before.

At one level the news is anything but surprising. The US is engulfed by its worst economic crisis in decades, and consumers are cutting back on non-essential spending, with expensive coffee among the first things to go. There is a symmetry too between the troubles of Starbucks and those of the plummeting US housing market, the epicentre of the crisis.

California and Florida, where the company has been opening new stores and which account for one-third of its domestic revenue, are two of the states worst hit by the housing slump. As demand has fallen, the cost of dairy products such as milk have been rising sharply. Not just Starbucks, but any similar business, would be having problems in these circumstances.

But there is far more to it than that. Starbucks' malaise long predates the downturn of 2007/2008. In a sense it is a victim of its very success. Consciously or subconsciously, a company that started life as an exotic shop in the Seattle landmark of Pike Place Market, selling beans and coffee-making equipment, and then developed into one of America's smartest global brands, must have felt it could do no wrong. In the process, however, it forgot where it came from.

From the outset, the key to Starbucks success was its upmarket image. Its coffeehouses were where yuppies went, and those who aspired to be like them. That the coffee itself was a mite expensive only added to its snob appeal: Starbucks was not for the hoi polloi. If you wanted cheap coffee, then go to a diner and choose between regular and de-caf. Its stores were chic and fashionable, where you could spend a little downtime between appointments or simply shoot the breeze with friends. Starbucks projected itself as "The Third Place" – between home and the office – and there was much truth to the slogan. Mr Schultz's genius was to grasp the market for the concept.

Have a good idea though, and others will copy it. For a long while Starbucks managed to keep ahead of the game, expanding at breakneck speed, buying up likely competitors and launching new products that rivals could not match. On top of lattes, grandes, mochas, espressos, frappuccinos and the rest it offered not just tea drinks, fruit smoothies ice creams and its own range of snacks. Starbucks sold its own franchised merchandise – T-shirts, even its own books and music.

But premium coffee remained the basic product – and one others could easily imitate. Of late that challenge has been picked up by Dunkin' Donuts and above all by McDonalds. In an age of belt-tightening the virtues of thift are again evident. McDonalds' coffee was perhaps once best known for being scaldingly hot. Now it offers premium coffee, not only cheaper than Starbucks' but of a quality that won first place in a survey in March by Consumer Reports here.

As a result, Starbucks finds itself caught in a new, unweclome, "third place", pressed from below by the fast-food chains from whom its very ubiquity has made it almost indistinguishable in the public mind, and from above by a new generation of expensive and exclusive coffee houses – to the modern industry what Starbucks was 20 years ago.

Such an identity crisis would be bad enough on its own. But Starbucks has compounded the problem by, in Mr Schultz' words, "cannibalising" itself – opening so many stores, so close together, that they attract business not from new customers but each other. And even the quality may be sagging. In a recent independent taste test of the main coffee chains in the UK, Starbucks came bottom.

For such structural difficulties, the chief executive admits, there is no instant fix. The giddy growth of yesteryear will never return, even when the US economy picks up. A solution, almost certainly, will require a return to first principles. As Mr Schultz told analysts this week, discussing that first-in-15-years quarterly loss: " We are not going to go down the fast-food lane and do things that are ... not in the long-term interest of the brand and the experience."

It would be unwise to count Mr Schultz and Starbucks out, whatever the current travails. The loss reflected exceptional costs relating to the closure of 600 stores, and the next quarter will be back in the black. Wall Street is cheered by the company's readiness to face up to its difficulties. Some foreign markets are still faring well, and Starbucks is still looking expand in areas such as Eastern Europe. New products, among them a milder "regular" coffee called Pike Place Roast, have also been introduced at its 11,000 American stores. But it will be a while, if ever, before the Starbucks siren regains her former magic.

How a coffee empire was built

1971: Gordon Bowker, Jerry Baldwin and Ziv Siegl open their first store, selling coffee beans and coffee-making equipment, in Seattle's Pike Place Market. It is named Starbucks after the first mate in Herman Melville's Moby Dick.

1982: Howard Shultz joins the company as the director of retail operations and marketing. It begins providing coffee to restaurants and espresso bars in addition to its own five stores. Shultz, having seen coffee bars in Italy, convinces the founders to try the same idea in Seattle.

1984: The trial was successful and Starbucks as we know it is launched. Separately, Shultz creates the company Il Giornale, selling products made from Starbucks coffee beans.

1987: Il Giornale acquires Starbucks assets and it morphs into Starbucks Corporation, opening stores in Chicago and Vancouver. It loses money throughout the 1980s as it expands. By 1989 it has 55 stores.

1991: The privately owned company offers stock options to employees and in 1992, starts trading on Nasdaq. It also sets up shops in Barnes and Noble bookstores and Nordstrom department stores and in 1994 started providing coffee to ITT/Sheraton hotels (now Starwood).

Mid-nineties: Starbucks branches out with various deals that include making coffee ice cream with Dreyer's Grand Ice Cream, a partnership with PepsiCo to sell bottled Frappuccino drinks and a licensing deal with Kraft Foods to sell its brand in supermarkets. It also expands overseas, in Asia and then the UK, where it buys the Seattle Coffee Company chain. It launches a music business through its acquisition Hear Music and also buys Tazo, an Oregon-based tea company.

2000: Mr Shultz becomes chairman and chief global strategist, ceding the post of chief executive.

2004: It jumps on the Wi-Fi bandwagon, offering high-speed wireless internet access in many restaurants. Through Hear Music, it releases Ray Charles's Genius Loves Company CD with Concord Records, which goes on to win eight Grammy Awards. A new record label is created between Starbucks and Concord Music Group to distribute recordings. Paul McCartney becomes the first artist, in 2007, to sign.

2007: After falling sales, Jim Donald, the chief executive, quits. Shultz returns to that role and announces that the group will slow US growth and accelerate international expansion. Starbucks now has 15,756.

2008: Starbucks cuts jobs and close stores worldwide.

Louise Dransfield

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