Starbucks (SBUX) Moving Outside Of Cafes And Into Grocery Aisles

It isn’t exactly big news when Starbucks Corporation (NASDAQ:SBUX) announces an expansion. The coffeehouse chain, with more than 13,000 U.S. stores, has become so ubiquitous that its stores are sometimes less than a block apart. The farthest an American in the Lower 48 can get from a Starbucks is in the middle of Grand Teton National Park in Wyoming, according to data compiled by an enterprising doctoral candidate from the University of Washington, and even then, a pumpkin spice latte is just 140 miles away.

With its storefront markets nearing the saturation point, the obvious question is: Where can a hungry giant find new sources of sustenance? The answer: at alternative sites, some of which are innovative – ski-through kiosks, and a Swiss passenger train – and some of which are decidedly mundane. A year ago, Starbucks opened a location inside a storage container in Tukwila, Wash., and in California’s Squaw Valley, customers craving a latte can use a convenient ski-thru location. The company is also expanding into Asia, where 700 of its 1,500 planned new stores will open this year, and Europe, where a Starbucks train carries passengers from the Geneva airport to St. Gallen, Switzerland. In keeping with the innovative approach, the company last year launched new pastry and juice lines and acquired specialty tea retailer Teavana.

But Starbucks’ main focus is on an old standby not known for trendiness or atmosphere: Grocery store shelves. There, Starbucks is trading wifi and folk music and all things mocha grande for fluorescent lights, shopping carts and… direct competition. In doing so, Starbucks has introduced two new variables into its model: It has ceded control of merchandising to second and even third parties, and has opened itself to competition from other brands that are now only an inches away.

Back in 2011, CEO Howard Schultz proclaimed a long-term goal when he told German magazine Der Spiegel, “We’re going to build a major multibillion-dollar business in the grocery industry”. The company has always sold bagged coffee in its cafes, but taking the brand to grocery aisles was a new step, offering the potential to reach an untapped market of customers who might not be willing to pay $4 for an aggressively fru-fru cup of coffee at a retail location.

On Jan. 15, the company introduced a new line of Seattle’s Best instant coffee and latte mixes into its product lineup.

This wouldn’t have been possible had Starbucks still been in a partnership with Kraft Foods Group Inc. (NASDAQ:KRFT). Since 1998, Kraft had agreed to distribute Starbucks brands, which had included Seattle’s Best coffee which they acquired in 2004.

In 2010, when the business was generating nearly $400 million in annual sales, Starbucks attempted to buy its way out of the agreement. Kraft rejected the attempt, but a few months later Starbucks terminated the agreement altogether.

In November an arbitrator ruled that Starbucks owed Kraft $2.8 billion for the breach.

On a conference call, CEO Howard Schultz called the breakup with Kraft over Seattle’s Best “without question, the right decision for Starbucks, our brand, and our shareholders.”

Starbucks’ chief financial officer, Troy Alstead, said in November at the Morgan Stanley Global Consumer Conference that the company’s executives have “strategically set our sights on all of that consumption of our core products of coffee and tea… and the coffeehouse experience outside of the store.” He added that the grocery market represents “a huge amount of global consumption and [it’s] where we’ve always been underrepresented and under-shared.” Alstead also announced that Starbucks had gained a 30 percent share of the U.S. at-home coffee market, thanks to their single-serving coffee-maker products.

In fact, Starbucks coffee has been in grocery stores since 1998, when the company signed a deal with Kraft to distribute their Seattle’s Best brand, but it has never been a big part of the company’s U.S. revenues. Even in 2007, grocery store sales accounted for just three percent of Starbucks’ total revenues, and 23 percent of its “specialty” segment, which also includes foodservice. In fiscal year 2013, the same sales were worth nearly three quarters of the same segment.

The increases come amid intense competition and record decreases in coffee prices. In January, the price of Arabica dipped to $1.19 per pound, down from a record-high of $1.90 in 2011. Cafe prices rarely hinge on these numbers because a latte depends on more than beans.

But the lower prices helped the company compete with low-cost brands in the grocery aisle. Though all packaged coffee prices dropped, customers who once reached for the J.M. Smucker Company (NYSE:SJM)’s Dunkin’ Donuts and Folgers Brand coffee could now afford Starbucks for a similar price. This meant a jump for profits in the grocery sector.

Operating margins for bagged coffee jumped 4.5 percentage points in the fourth quarter of 2013 “primarily due to lower coffee costs and sales leverage,” according to Starbucks’ October earnings report. This report puts the United States in the “Americas” category – where operating income jumped 17.1 percent last year, thanks in part to the grocery sales.

These inroads pale in comparison with the latest iteration of the original Starbucks storefront expansion model, in Asia, where operating revenues jumped 27.2 percent in the same period. There, Starbucks is pursuing the same strategies that worked so well at home in the 1990s.

“China is set to be their second-biggest market pretty quickly,” observed Will Slabaugh of Stephens Inc. research analysts.

But because Asia, like North America, will eventually reach storefront saturation, the company has further incentive to develop off-site markets. Added to that, reception has been lukewarm to the company’s expansion into Europe, where Starbucks closed 72 “underperforming” stores last year. “Europe has always been the one region that’s gotten the least amount of traction,” Wedbush Securities analyst Nick Setyan said.

As the company’s marketing strategy evolves, taking the coffeehouse experience home – where, ironically most people were drinking coffee before Starbucks took the coffeehouse concept mainstream, may provide the best prospects for long-term gains. If so, Starbucks will basically be making an old tradition new again.