With Starbucks Closing 600 Shops, is the Coffee Business Still Lucrative?

Recently, Starbucks announced that it was closing 600 stores in the United States, and that it was scaling back plans to open new ones. Starbucks claimed that they wanted to get back to their "roots," and they brought back the original CEO, Howard Schultz, to try and rework his magic. So if Starbucks is having a hard time these days, why is it still a good idea to open a coffee business?

In the current economy, with the mortgage crisis and with gas prices way up, many retailers and restaurant chains are feeling a pinch. And for Starbucks to be closing stores instead of opening them is a real reversal. It seems that the coffee business is in trouble too. Or is it?

To think that Starbucks made its fortune by selling coffee is to completely misunderstand the business model that grew Starbucks into a multinational giant. While ostensibly Starbucks mainly sells coffee, in reality Starbucks - particularly under former CEO Howard Schultz - has long been known in the world of commercial real estate for its expertise at selecting prime locations, and for becoming a fixture in every upscale neighborhood and every upscale shopping mall.

In fact, the Starbucks business model in the 1990s was exactly the same business model that McDonalds used several decades ago. The real business of both of these giants was real estate. Selling coffee (and in the case of McDonalds, hamburgers) was simply the means by which prime commercial real estate was acquired.

It was the real estate, and not the coffee or hamburgers, that increased shareholder value for both companies, and made them wealthy. Throughout the 1990s, it was fairly well understood by the stock analysts that Starbucks' model caused them to increase in value only by opening new stores. But operating those stores was never the source of Starbucks' growth. Coffee revenue was simply fed back into Starbucks' real estate acquisitions, and this is what caused their stock value to explode.

In the last several years, Starbucks lost their magic in three ways; not all of them the fault of Starbucks. First, as the Starbucks model worked superbly well in the 1990s, many neighborhoods and malls became overrun with Starbucks. Adding a new Starbucks to a region full of Starbucks did not provide the same value-add in real estate as did the acquisitions of their original stores in Starbucks' first wave of expansion. That is, as this business model succeeds, it inherently hits a point of diminishing returns.

Second, after Starbucks grew, and since Howard Schultz left, Starbucks became less discriminating in choosing prime real estate. In some sense, this is an artifact of the first problem described above, but there is a second-order effect too. Once a small company becomes a giant, many of those who permeate the executive leadership ranks are new to the company. They came in without the inherent understanding of what Starbucks was originally about, and this caused Starbucks to lose its strategic direction.

In fact, interviews with commercial real estate brokers nationwide who work with the Starbucks chain have suggested that the company was so determined to meet its growth promises to Wall Street that it relaxed its standards for selecting new store locations. Starbucks underestimated the downside of putting stores too close to each other, which lead to a predictable decline in same-store sales.

And third, the flagging economy and soaring gas prices are responsible too, in a rather obvious way. But ironically, Starbucks' prior expansion overextended itself in many of the regions of the country that were hit hardest by the housing crisis; most notably Southern California and the Southeast. This resulted in a "double-whammy" for Starbucks. Also keep in mind that the growing demographic in these hot climates tends to be retirees - who are more hesitant than the Generation-Xers to drop $4-$5 for a latte.

Making judgmental mistakes in the acquisition of commercial real estate is new and out of character for Starbucks. For most of the last 15 years, the Starbucks' executive leadership was known for its rigor and expertise in choosing ideal commercial real estate. In evaluating locations, Starbucks looked past the generic demographic information most commonly used by Realtors, and started focusing on many new factors, like the education level in various neighborhoods. It also studied traffic flow on both sides of each street to make sure that customers could easily turn into the Starbucks' lots on their way to work..

"Starbucks rewrote the book on expansion and how to grow multiple store units, really in the world," said Craig Sweitzer, founder of Urban Works Real Estate in Portland, Ore., who has worked with Starbucks for 18 years. "No one had ever done that before, and now everyone copies them." But recently, the potential rewards of rapid growth have obviously caused Starbucks some problems.

In 2004, Starbucks announced to analysts that it had a plan to double its rate of expansion. Their stated goal was to grow to 15,000 stores in the US. (Currently, Starbucks has less than 7,000 US stores.) That very aggressive target is largely responsible for Starbucks' current situation. In fact, Starbucks has said that 70% of the 600 stores to be closed in 2008 had just opened in 2007 or 2008.

Nevada Commercial, who represents Starbucks in Las Vegas, said that the effects of these growth plans were most apparent at the end of each fiscal year, when Starbucks would scramble to open lots of stores to meet the goals it had promised Wall Street. In the rush to open more stores, Starbucks was much less careful in its selection of real estate than it has been historically, and it made lots of bad choices.

Commercial real estate brokers in Florida (another state chosen by Starbucks for rapid expansion) reported similar trends. In Florida, Starbucks had set a goal of having 1,000 stores by the end of 2010. To try to reach this goal, Starbucks doubled its average number of annual openings. But to do this required that the selection standards for new locations be lowered.

Another problem that hit Starbucks, even when very good real estate was purchased, was that many of the newer stores in "choice" locations were only "choice" because of an assumed potential population growth that never materialized. The mortgage and housing crisis derailed much of the planned development nationally, and it put Starbucks in the position of holding real estate bought on speculation to wait for growth in regions that never actually grew.

On top of this, many market analysts also wanted to see Starbucks decrease the growth of its "licensed stores" (smaller franchises in bookstores and supermarkets) which were siphoning traffic from more profitable Starbucks locations.

Starbucks acknowledges that despite the bad economic conditions that could easily be blamed for their current situation, as a company, they had moved away from their earlier very careful focus on selecting only prime real estate. When Howard Schultz returned as the CEO this January, his first move was to bring back Arthur Rubinfeld, who had led Starbucks' expansion from 1992 through 2002. Runinfeld helped to create many of the real estate techniques for which Starbucks is now known.

So if you are contemplating a coffee business, there is nothing in the Starbucks story that should sway you. Starbucks is much more in the real estate business than in the coffee business; coffee is simply their means to their real end. Starbucks proved what everyone already knew: that the careful selection of good locations for coffee shops leads to good revenues in coffee. But in the case of Starbucks, they've become so big that as they try to continue to expand, they are only competing with themselves. This is a classic dilemma of any big business.

We all have Starbucks to thank for having launched the "Seattle Coffee Craze," and for having grown the coffee market in the US into epic proportions. Because of Starbucks, there is now a very large set of discerning customers that are accustomed to dropping $4-$5 regularly for good coffee. Starbucks grew the coffee market for everyone.

If your business is actually coffee, and not real estate, the Starbucks story underscores that the coffee business is very lucrative indeed. But if your business is actually real estate, then if you are ever as successful as Starbucks, you will eventually hit the dilemma of growth encountered by any large corporation.

If you are in the coffee business, there is no reason at all to be disheartened by what is happening to Starbucks today. Starbucks is simply undergoing some needed adjustments that were caused by the pains of a massive growth that is almost unprecedented in any business. And coffee remains a great business - largely because of Starbucks.