Starbucks: No More 3rd Place (NASDAQ:SBUX)

Background

The 3rd Place concept that served as the guiding vision for developing Starbucks (NASDAQ:SBUX) café concept was an idea generated in the mind of Howard Schultz following his visit to Italy, as part of his employment with the company in the early 1980s. What was meant by 3rd Place was that it would be the preferred destination for customers, after home (1st Place) and work (2nd Place). This particular strategic vision is not trivial because it was the basis for the business model around which the company invested in store development and created the accompanying menu. But the vision almost died on the vine.

Starbucks’ business genesis was of selling beans in a single retail shop in Seattle, but it had “grown” to six-area coffee shops selling simple, brewed coffee and, following his visit to Italy and seeing its coffee culture, Schultz thought there was an opportunity to create an even bigger business.

However, Schultz was not able to convince the three Starbucks owners of the viability of developing what they believed to be an expensive undertaking. Failing at that, based on his belief in the Italian café concept, Schultz went off and started his own company – Il Giornale. The concept worked to the extent it fostered learning (though not much business success) and enabled another run at Starbucks owners. But this time, rather than trying to influence the owners to expand the business, Schultz sought to buy Starbucks and, in 1987, assisted by the lawyer, William H. Gates Sr. (yes, that guy’s dad), Schultz bought Starbucks for $3.8 million (and merged it with Il Giornale).



It is only slightly historical hyperbole to suggest that deal ranks right up there with the Louisiana Purchase and that of Seward’s Ice Box. (For those lacking unawareness of the icebox reference, here is an explanation).

With the Schultz purchase, the Starbucks café concept was born. To execute on the vision, Starbucks not only had to develop a more robust menu (apparently, three sizes of plain drip coffee with Italian names were insufficient to appeal to American consumers), it needed to find a way to position the concept. To begin with, the original logo needed change because it had challenges. It was an uninspiring brown with an obviously topless mermaid. While the brown logo might comport with the idea of coffee, the topless mermaid was a non-starter. After careful deliberation, the logo color was changed from brown to a green, a color change that was thought to represent growth, freshness, uniqueness and, of course, prosperity (after all, green is the color of money). Further, sensitive to public attitudes even at the onset, the “new” Starbucks added long flowing hair to cover the mermaid. While some minor changes were made to make the logo more or less “eye catching” over the years, it has remained green and chaste.

But a business is more than a logo or naming the coffee cup sizes Italian (I still struggle getting them right). The new café development required many strategic decisions. If it was truly going to be the 3rd Place as envisioned, not only would Starbucks need to find locations with the requisite parking and customer ease of access and egress, it would also need sufficient space for seating, recognizing a certain variability in development, as not all choice locations could accommodate the same seating capacity. Of great importance if you are building a 3rd Place is that the interior be appealing, with the proper ambience – the right furniture and color scheme – to be inviting enough to warrant a customer coming in to buy coffee and sit and read or chat with friends. (This, of course, was before the advent of the smartphone or the ubiquity of Wi-Fi).

The company went about outfitting the stores as is required of a place that sought to make people feel comfortable and welcome. Unlike other quick service (fast food) restaurants that sought to get people in and out as fast as possible (that is why they are called “fast food”) and freeing up tables, Starbucks did not try to “push” customers out. In fact, as we well know, Starbucks began adding features that made it a place to hang out, like music and Wi-Fi. Ultimately, this decision transformed Starbucks from a place to read and languish to one where work could be done and business conducted. (Who has not seen a job interview being conducted inside a Starbucks or heard the various and often too loud cellphone discussions?) Indeed, the Starbucks café concept flourished; growing from 17 stores in 1987 to 165 in 1992, when it completed its IPO, and now with over 30,000 locations globally.

Always trying to innovate and improve, in 2009, Starbucks did something that was illuminating; (gasp) it actually asked customers what they wanted. Whether an attempt to validate itself or an earnest effort to see how it might improve what it was offering customers, it was surprised with what it discovered. In fact, the findings began the company’s multi-year strategic transition from trying to build the relaxing 3rd Place to what we know as the hectic, frenzied, highly productive carryout and delivery stores (capable of being cleaned with a firehose) that is its focus of today; one clearly embraced by its customers.

About that illumination…

Learning As They Go

Since the Schultz team took control, Starbucks focused on innovation and creating new drinks, because it was what it thought the consumer wanted. It also meant a complicated menu. Nonetheless, because the truism remains that structure follows strategy, R&D and planning were the primary focus of growth drivers for the business, as the company continually researched and applied various metrics to determine customer attitudes about new beverages. Implicitly, this meant that operational management was subservient to product innovation. The thinking at Starbucks HQ was – “We give the store operators what they need, now they just need to sell it without too much fuss.” But ignoring the importance of the customer interface at the site of actual revenue generation was a mistake and caused the company to fail to recognize that if it builds it, customers may not always come.

As such, there is an unexpected (or at least unrecognized and certainly unplanned) cost associated with complex, innovative product offerings. One such outcome was that serving a wide range of complex beverages that were made upon demand meant the need for continual training in new beverage making, which meant increased customer wait times. This increased labor demand in the stores was notable because, even in operationally well-controlled fast food shops, fully 33-39% of the cost of restaurant operations is labor. Relatedly, over time the consumer demand for labor-intensive drinks in Starbucks stores declined, even in the face of greater product and technical innovation and improvement. Beyond conflicting with the store labor schedule, this confused those in higher-level positions, particularly in R&D, who continued to focus on developing innovative drinks and wondered why they were not selling as well (for them it was “obviously” an operational problem). Now, here is where it got even more interesting.

According to Starbucks’ own research (numbers adjusted for inflation – aka Starbucks’ frequent annual price increases), a “highly satisfied customer” spent roughly $5.30 on average per visit and visited an average of 7.2 times per month, translating into an average spending of $38.16 per month and $457.92 per year. By contrast, “unsatisfied customers” spent $4.62 per visit and visited an average of 3.9 times per month, translating into a monthly average of $18.02 and $216.22 on a yearly basis. So, one highly satisfied customer is worth more than two unsatisfied customers and this becomes real money when extrapolated on a system-wide basis of 8,791 U.S. stores, of which about 6,300 are company owned. But it got even more interesting when the remainder of the research was analyzed. Why? Because this is what called into question the financial commitment of the 3rd Place café concept.

In what had to be a shock to its system, Starbucks discovered that 75% (fully three-quarters) of its customers placed a high value on fast, friendly, convenient service, while only 15% (fifteen percent!) considered new, innovative beverages to be highly important. This stark realization meant that the costly 3rd Place strategy was misguided and the incumbent costs of R&D developing novel, innovative drinks for an ever-increasing menu were not a driver of revenue. In fact, it was contrary to what the customer actually wanted – to get their drink, perhaps from a smiling employee or perhaps not, and get out the door fast! Likely, it was because the 2nd Place (aka work) was calling and not the 1st Place (aka home), because the vast majority of Starbucks’ sales occur before 2pm.

Further, despite its lack of recognition that unbridled store development actually did cannibalize sales (long a blind spot for the company, which clearly believed the basic “laws” of retail economics did not apply, until it discovered it during the recession of 2008-2009, when it closed 600 stores and ceased development of a few hundred more), what has made Starbucks successful over the years is its ability to recognize the changes in the competitive environment and adapt by mimicking the success of others, aided in its early years by hiring a number of veterans of the fast food wars.

It was their research findings that led to a flurry of changes resulting in efficiencies and cost savings, as Starbucks refocused on product quality, reduced its menu, re-focused on customer service, cut service times by 18%, and sought to reignite a pleasant store atmosphere, albeit with a new interior design that promoted faster service rather than cushy seating and relaxing ambience. It also started creating more drive-thru units, which did alter site selection and development criteria. However, if imitation is the sincerest form of flattery, it was a great idea borrowed from the experience of McDonald’s (MCD), which gets about 68% of store revenues through its drive-thru windows, and during the COVID-19 pandemic, unsurprisingly that number has risen to about 90%, with the remaining orders for delivery. In truth, even before the pandemic, Starbucks said that a full 80% of its sales were ready-to-go purchases (highlighting the obvious benefit of the move away from the 3rd Place concept). And, regarding the pandemic, as the CEO of one restaurant chain said: “Until something really changes with the coronavirus, people would rather go to the drive-thru, get it and go. People feel a lot safer doing that at this point.”

Post-3rd Place Store Development

To say COVID-19 has changed the way we shop and eat would be a vast understatement. Just one year ago, “curbside pickup” and “social distancing” were rarely, if ever, used in conversation. In 2020, they are essential considerations and businesses have to adapt or face the consequences.

So it is that Starbucks announced it is expanding its footprint by concentrating on drive-thru locations in the outer edges of urban and suburban areas, as well as urban walk-in stores focused on takeout and order pick-up. While a strategic decision that has its roots in a 2019 executive decision, Starbucks saw the pandemic as the opportunity to move more quickly on its new development strategy (apparently subscribing to the idea of never letting a crisis go to waste).

Subsequently, Starbucks has accelerated the 2019 timetable and has announced it is closing 400 stores in the U.S. so it can focus on “innovative store formats,” which prioritize to-go menu options. Over the next 18 months, Starbucks will offset the closures by adding 300 locations (down from its original goal of 600) with features like double-lane drive-thrus, walk-up windows and curbside pickup.

Starbucks says the moves are being driven by changing consumer behaviors that have shifted because of the COVID-19 pandemic. “As we navigate through the COVID-19 crisis, we are accelerating our store transformation plans to address the realities of the current situation, while still providing a safe, familiar and convenient experience for our customers,” according to Starbucks CEO Kevin Johnson.

The company also said its U.S. store portfolio transformation includes the expansion of “new Starbucks pickup stores in dense markets including New York City, Chicago, Seattle and San Francisco, and convenience-led enhancements such as curbside, drive-thru and walk up windows in suburban areas.” These will all be locations where customers order and pay exclusively through the Starbucks app. Curbside pickup is an experience accelerated due to the COVID crisis, but it also addresses customers’ increasing need for convenience in on-the-go occasions that are, in fact, more than occasional.

According to some reports, one thing Starbucks needs to do is focus on service times in the drive-thru locations because (according to its own complaint line) the wait for some customers is too long. Creating double-drive thrus and adding staff will help improve service times at the new Starbucks locations, as it has at McDonald’s. Interestingly, during the pandemic, McDonald’s said it has simplified its menu and improved focus on service times, which has led to a near half-minute reduction in each order (a significant efficiency gain). While it might be argued that delivering made to order drinks is more time intensive, that is not the point. That Starbucks has acknowledged some customers are reporting frustration with the delays suggests there is improvement to be made, and based on its action following the past consumer research, we should expect Starbucks to figure out how to reduce wait times.

Regarding the development of smaller stores to include drive-thru locations combined with carryout, curbside delivery and a simpler menu, this will reduce utility costs, labor costs, and food costs. Since it has been in the store development process for a few years, even with the new concepts, Starbucks will benefit from its learning curve in store development; that is, the cost of performing an activity that can decline over time as the learning and experience of company employees builds. The learning curve applies whenever the cost of accomplishing a business activity is reduced as a function of the cumulative times that function is engaged. For Starbucks, the point behind the learning curve is that it generates efficiencies (cost reductions) that serve as a cost advantage. Starbucks has clearly learned from its rival and fast-food icon McDonald’s, which, having developed thousands of locations on a national and international scale, knows what type of site it needs to control the overall costs of development and generate sales that enable greater profitability.

In an “OBTW” claim, Starbucks says this new store development will save $50 million in system-wide utility costs over the next decade. Though that does not amount to a rounding error on its expenses, it is consistent with Starbucks’ effort to appear environmentally friendly and socially conscious.

Adding to its desire to improve speed of service in its locations, Starbucks continually seeks improvements through mobile payments, and with the ubiquity of the smartphone and its various apps, as the use of currency as a form of payment has fallen out of favor during the pandemic, it is reasonable to believe that the efficiency of the cashless transaction, particularly with curbside, drive-thru and walk up windows, will increasingly become customers’ preferred method to pay.

Surprisingly, despite the 3rd Place café being born of an Italian concept and unlike the coffee houses of Europe, Starbucks was not very adventurous in serving food. Still, over time customers expressed an interest in more food choices to go with their coffee. But, despite the potential revenue generation from food, Howard Schultz was fearful that the smell of cooking food would detract from the pervasive smell of coffee. So, Starbucks senior management resisted adding anything more than a limited number of cold items, a marketing argument its competitors often used against it. However, eventually Starbucks decided to add food items that were reheated (requiring investing in new equipment) but not cooked in the stores. Ultimately, this has proven to be a wise decision, as food sales now represent about 20% of Starbucks’ revenue. Nonetheless, given the time consumed by reheating the items, there is a reasonable question of its impact on both sales and service times for convenience-led enhancements such as curbside, drive-thru and walk up windows.

A Few Final Words

As a multi-billion-dollar business with more locations in the U.S. than McDonald’s, Starbucks has the financial flexibility to alter its strategic and organizational decisions. This enables the company to adapt more readily to the competitive environment, as it did when it realized customers were less focused on novel, innovative drinks and more on speed of service. Consequently, it was decided that the cozy store interiors Starbucks was spending large sums of money on to create the 3rd Place were no longer necessary. That was not what attracted current customers. It is this learning that led to various and important decisions resulting in cost savings for store development and design.

In fact and without question, far from failing to always make the right decisions, what has made Starbucks successful over time has been the ability to react to drivers of change in the competitive environment, mimic industry leaders, and create a more optimal strategy for growth, against which it has executed well.

Execution is always an issue in fast food businesses, particularly when considering employee retention. A not-so-fun fact: Only 32 percent of workers feel engaged at their jobs. So, not only does a happy staff make a business run more smoothly, but it also greatly reduces the risk of employees quitting. This is no small issue in the fast food environment, with its average turnover cost of $2,004 for an hourly team member and a turnover rate of 150-400%. That means the cost of labor is a critically important factor to control.

Starbucks altered that dynamic by offering employees working 20 hours a week full benefits, including insurance and college tuition reimbursement, and a higher wage that has improved employee engagement and reduced its turnover rate to 65%. While there is room for improvement, Starbucks’ turnover is among the lowest in the fast food industry. And, beyond the cost of replacement, the other insidious aspect of turnover is that it robs businesses of institutional knowledge, when people quit, and that translates into an impact on customer service times.

From a strategy perspective, Starbucks’ success was not because of an ability to predict the future accurately. Rather, it can be directly attributed to its ability to adapt its strategies to the dynamic context of the competitive landscape as a means to address the uncertainty that is always present. And it did so by doing the hard work necessary to identify the range and limits of uncertainty and determine what was possible. As the move toward more locations focused on efficient takeaway products has shown, it is willing to invest in and execute on its chosen strategies; adapting as the situation changes. For example, there is very little mentioned now of the development of the high-end Roasteries.

I may not spend a lot of time and money at Starbucks, I may not be a fan of its over-roasted coffee, and I do not have its app or a Starbucks card. But that notwithstanding, I recognize and applaud its adaptive strategy, which is critical because as the great military strategist Carl von Clausewitz noted, strategy rarely survives first contact with the enemy (competition).

In business, a highly competitive environment will de-value any business strategy that is inflexible to change when the context demands. Timing being as important in business as in baseball and recognizing not all strategic change is fast, moving away from the concept of Starbucks as the 3rd Place and into more drive-thru and carryout locations, with its lower development costs and quicker forms of service, is an effective and adaptive strategy that may provide the impetus for improving business in the time of the coronavirus.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


Originally published on Seeking Alpha

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