Big mistake at Starbucks?

I’ve blogged on Starbucks before, but just seen their results for y/e Sep08, with sales up $9.4>10.4bn but profits down $1.1>0.5bn. A pity, but what are they doing about it?

To see the 6-year path that brought them to this point , see their 07 Annual Report. Store numbers and revenues multiplied by ~2.5 – operating profits and earnings more than tripled ! How do you do that? – by squeezing more margin out, so operating margins up from 9.5>11.2% [but hit 12.3% in 05] .. and how do you do that by pushing prices or squeezing costs.

To understand how they came to be so successful, it’s worth a look at Preserving the Starbucks Counter Culture by Gretchen Weber in Workforce Management Feb’05 [great article!]. Which closely matches the reasoning in many business school case studies. In summary, it’s this:

Background

The fast food industry may not so admired for success in retaining people – staff satisfaction ratings of 50-60% are common, and staff turnover can hit 300% per year, people need to be productive fast. Starbucks turned this industry norm on its head, devoting considerable effort to staff satisfaction and retention in the belief that this was essential to retaining customers and winning their spending. From the start, generous benefits and stock options  even for new employees – called as ‘partners’ – pushed satisfaction levels to over 80%. Starbucks hit 2nd place amongst large US companies in the Fortune 2005 ranking of best places to work. Result – turnover rates way below industry averages at 70%-80% per year. And it’s not just direct staff benefits – the company spends more on employee training and development than on marketing.

It’s when these advantages impact on customers, though, that the real benefits show up. Staff get to know their customers, so visits to the company’s stores become a regular part of their lives. Some simple numbers show just what all this is worth. The company captured $10.4bn in revenue in 2008, so if the most loyal customer used a store only 10 times a month rather than the 18 times it often hits, then revenue would only have been $5.7bn. But then, with lower customer usage, many of the stores that have been opened over the years would never have been viable. So instead of the 15,000 outlets operating at the end of 2007, it would have been operating many fewer, and revenue would have been way less than that $5bn.

Think too about the impact on hiring and training itself. With 170,000 employees, 80% turnover means hiring and training over 130,000 new people each year. If turnover were a more typical 200% each year, that hiring rate would rise to 340,000 per year. And that’s on top of the need to find some 30,000 extra people each year to staff their newly opened stores, often in new geographic markets. A further advantage arising from strong staff retention, then, is that it ‘breeds’ people with experience, who become available to support the opening of further stores.

Response to ’08 profit problems

So how has Starbucks responded to the difficulties this year? – here’s extracts from their results announcement, as above … revenues increased 10 percent to $10.4 billion, vs $9.4 billion for 07.  … the U.S. posted comparable store sales of negative 5 percent.   Operating income decreased to $504 million, vs $1.1 billion for fiscal 2007. Margin contracted to 4.9 percent from 11.2 percent … primarily due to lower revenues. Excluding restructuring charges [and other exceptionals], margin was 8.1 percent.

The response:

• ”  A re-architected cost structure to allow for long-term operating margin expansion
• A healthier store portfolio achieved through closure of underperforming stores
• A stronger value and rewards platform – consistent with Starbucks premium brand   “

I argued in a previous post that they had been foolish [in spite of McKinsey’s endorsement!] to over-expand their store network [investors might ponder how their fortunes might have differed had that error not been made], so I can hardly argue that rationalising over 600 ‘underperforming’ stores is anything but unavoidable. And ‘a stronger value and rewards program’ is presumably code for cutting prices, however it’s wrapped up for public consumption – again unavoidable. The killer is on the staffing issue – “… in the 4th quarter, general and administrative expenses … improved to 3.8 percent, from 5.1 percent for 2007. The favorability was primarily due to lower payroll-related expenses.” [emphasis added]

Now read again the Gretchen article above, and ask what this will likely do to the very special staff culture in the stores, and what that might then do to customers’ experience, and what that might then do to sales in FY 2009? I don’t have time to do the numbers in detail, but those savings would be worth about +$130m in operating profits for a full year. You can do a heck of a lot of training and staff development with that kind of money, even with Starbucks’ staff numbers.

The question for investors [and the pesky analysts who keep pushing companies to do these kinds of stupid things!] is – would you rather have $130m less profit this year, and stand a good chance of having better profits next year, or keep the $130m now, and risk having no profits at all next year?

To track the gossip on Starbucks and watch how staff and customers seem to be responding to all this, by the way, starbucksgossip.typepad.com is great fun and very informative.