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Sunday, September 10, 2006 - Page updated at 12:00 AM

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Super Sizing Starbucks

Seattle Times business reporter

Once there was a food establishment obsessed with size.

For most of a decade, it opened more than four stores a day, spreading its menu to all parts of the land and into other countries, where its name became synonymous with U.S. culture.

Profits soared along with its stock price. Then McDonald's stalled.

The burger chain's market share and profits sputtered after 2000, sending its stock price into a tailspin.

Plenty of Starbucks investors fear their stock darling will endure a similar plunge as the Seattle company works toward its goal of opening 30,000 shops — the number McDonald's had when it hit the wall.

Early last month shareholders sent Starbucks stock down 9 percent in the hours after news of weaker-than-usual monthly sales.

Starbucks officials chafe at comparisons of their cafes to fast-food restaurants known more for their grease than panache. In his 1997 book about building Starbucks, Chairman Howard Schultz wrote that comparisons to McDonald's pain him.

Still, the world's largest coffee-shop chain might benefit from lessons McDonald's learned the hard way in its climb to the top of the international fast-food ladder.

When McDonald's crossed the 30,000-store mark in 2001, it was burdened with a dearth of innovation, market saturation and poor control over stores — the same maladies Starbucks investors fear.

As the ubiquitous burger chain expanded, its size helped make it a target of lawsuits, ridicule and envy that Starbucks has only begun to taste.

"Starbucks has been very adept at managing its growth, but for a long time McDonald's was as well," said John Owens, an analyst who covers both companies for the investment research firm Morningstar.

Right-sizing

McDonald's most obvious problem was overexpansion.

When profits plummeted in 2002 and the company posted its first-ever quarterly loss, executives threw the brakes on restaurant expansion. The Oak Brook, Ill.-based chain grew by only 21 stores the next year after opening at least one a day since 1972.

It also trimmed businesses bought during the days of blistering expansion — selling an Ohio-based pizza chain called Donatos, dumping stores in the Boston Market chain and gradually selling off ownership of Chipotle Mexican Grill.

"Their focus on rampant growth and extending into other concepts distracted them from the basics of running their restaurants," Owens said.

Scaling back helped boost McDonald's profits and more than double its stock since early 2003. The chain continues to grow modestly, and at the end of 2005 had fewer than 32,000 stores, including 1,120 Boston Market and Chipotle restaurants.

Overexpansion is a risk for Starbucks as well, Owens said, although he thinks its goal of 30,000 stores worldwide is doable.

Starbucks now has 12,142 stores, including 8,624 in the United States, and is opening more than five shops a day.

Ken Redding, Starbucks' vice president of business development, said the companies' differences make it impossible to use McDonald's as a gauge for Starbucks' growth.

"We're in a position to have far more outlets than they could ever have," he said. "By way of example, how many people are going to walk into McDonald's every day and buy a Big Mac and fries? Not many. But a lot more people walk into Starbucks four or five times a week and get a cup of coffee."

Signs of saturation at Starbucks would include lackluster same-store sales, a prospect so worrisome to investors that they dump shares at the faintest whiff of weakness. Sales at stores open at least 13 months indicate whether the company has underlying momentum or is relying on the addition of new stores to bolster profits.

This summer, Starbucks posted its weakest same-store sales in years. Although the 4 to 5 percent growth fell within management's guidance, it was disappointing to shareholders who have come to expect increases of 7 percent or better.

Starbucks officials often field questions — and jokes — about market saturation.

"Despite the common view, popularized by the likes of Jay Leno and David Letterman, that Starbucks stores are everywhere, there remain plenty of opportunities for growth," Starbucks Chief Financial Officer Michael Casey said at an investor conference this summer.

Starbucks continues to find profitable locations in Washington state, where it has one cafe for every 11,000 people, he said. That means the prospect of overbuilding is even more remote across the country, where it has one location for every 37,000 people.

Downtown Missoula and the North Olympic Peninsula are just now getting their first Starbucks stores outside of grocery stores. Detroit, a town of nearly 1 million people, has only a dozen stores, half of them at the airport.

Starbucks does not discuss how it chooses locations, but the formula includes customer traffic patterns and sales at existing stores.

Officials boast that first-year sales are better now than they were five years ago, partly because of new products like salads, sandwiches and seasonally changing Frappuccino drinks.

Keeping it fresh

A stale menu was partly to blame for McDonald's downfall.

After decades of launching a blockbuster new product every few years — the Filet-O-Fish in 1963, the Big Mac in 1968, the Quarter Pounder and Egg McMuffin in 1973, the Happy Meal in 1979 and Chicken McNuggets in 1983 — the chain's idea machine began to sputter.

Innovations such as pizza, pasta and fajitas bombed with customers, and McDonald's lost its trendsetting credentials to competitors such as Wendy's, which offered salads and baked potatoes for the increasingly health-conscious consumer.

"The more successful companies become, the temptation is to rely less and less on the consumer and more and more on one's invincibility," said Simon Williams, president and chief executive of Sterling Brands, a New York consulting firm whose clients have included Hershey's, Levi Strauss and Nike.

Williams thinks McDonald's relied too heavily on its success with children and alienated almost everyone else.

"The message for Starbucks is that times change, aesthetics change, needs change," he said. "Ultimately, people get bored, and those of us who are Starbucks addicts will need a change of scenery."

Starbucks has met customers' fickle tastes with its own string of product successes.

In 1971, the original Starbucks at Pike Place Market sold only coffee beans. Howard Schultz introduced Starbucks customers to lattes in 1984.

In 1995 came the popular Frappuccino blended beverage and Starbucks ice cream; the next year brought bottled Frappuccinos; in 1999, Starbucks bought a Portland-based tea company called Tazo; in 2002 it launched the DoubleShot coffee drink in a can.

In recent years, Starbucks has begun selling more noncoffee products, including CDs by artists such as Joni Mitchell and Pearl Jam. It plans to offer selected books, beginning this fall with Mitch Albom's new novel, "For One More Day." And it stepped out of retailing altogether this spring by pitching the movie "Akeelah and the Bee" with in-store promotions.

"We're always going to push the envelope and try new things to extend the coffeehouse culture in what we consider unexpected ways," said spokeswoman Christy Salcido.

While investors want Starbucks to keep things fresh, skeptics worry the company might lose its way.

Some concepts have crashed, including a magazine called Joe and a full-service restaurant concept called Cafe Starbucks in the past decade. The company lost $59 million to bad investments in Internet ventures during fiscal 2000, but it does not disclose numbers for most of its noncoffee projects.

Starbucks has a mixed record with entertainment choices. It had a hit with the 2004 Ray Charles CD "Genius Loves Company," which it helped finance and market. But customers spurned CD-burning machines, which were pulled from 35 of their 45 test locations in Seattle and Austin, Texas, earlier this year.

Franchisees vs. partners

McDonald's woes were compounded by tangles with franchisees.

Some refused to carry certain menu items, update their decor or feature in-store promotions.

Richard Adams, a franchise consultant who publicly battled McDonald's in the 1990s, said much of the problem stemmed from franchisees going broke by the hundreds because of overexpansion.

"If the stores were not upgraded, it was because the company's actions had put so much financial strain on franchisees. How can you absorb losses from the cannibalization that took place in the mid- to late 1990s and then turn around and update your decor frequently?" said Adams, who once worked as a regional franchising director for McDonald's, then was a franchisee for 12 years.

Management eventually lost control of a chain that was meant to offer the same customer experience around the world, wasting hundreds of millions of dollars in advertising because of poor execution.

Starbucks, which spends little on advertising, also does not have franchises.

"Starbucks broke all the rules about how you're supposed to grow in the restaurant business," said Sharon Zackfia, a Starbucks analyst at William Blair & Co., which makes a market in the stock.

It proved that fast, profitable growth was possible without franchises, she said.

Nearly two-thirds of its U.S. stores are run by the company. The rest, along with most of its international locations, are controlled by partnerships with large corporate partners that are officially called "licensees."

Dealing with large corporate licensees is easier than having hundreds or thousands of franchisees, explained Redding, Starbucks' vice president of business development.

"Even if they're going through hard times, the big retailers we usually do business with have strong cash flows," he said. "They're well-capitalized, so they're well-positioned to do things that are right for the business."

In the United States, Starbucks partners with other companies mostly when the stores are on their turf — for example, in airports and in Safeway, Albertsons and Barnes & Noble locations.

In other countries, it partners with large companies with similar clientele. A Hong Kong-based restaurant and bakery chain called Maxim's Catering is its licensee for Hong Kong and part of China. In Spain and France, the licensee is a Madrid-based restaurant and retail company called Grupo Vips.

Staying popular

Even if Starbucks manages to avoid McDonald's pitfalls, it will have to deal with the baggage that accompanies icon status.

McDonald's has faced it for years. Its foreign stores are bombed because of anti-American sentiments, and it has been sued for allegedly making people fat.

In the 2004 documentary "Super Size Me," the filmmaker becomes sick from eating nothing but McDonald's food for a month.

"As you get bigger, you become a bigger target," said Janna Sampson, director of portfolio management at OakBrook Investments in Lisle, Ill., and co-manager of a mutual fund that owns McDonald's stock.

"Getting them to change is a way of getting a whole industry to change, because if the big guy does it, everybody else falls in line," she said.

Starbucks' increasing prominence has made it such an example.

The chain was a target during WTO protests in 1999, when some stores in Seattle were vandalized.

It has been fire-bombed in Greece, boycotted in Malaysia and shunned in Austria. Activists have called on the company to eliminate trans fat and bovine growth hormone from its products. Some communities greet the coffee chain the same way they would greet a McDonald's or Wal-Mart.

"Do we really need another big-name multinational corporation in this town?" a resident of Powell River, B.C., asked in the town's newspaper this spring.

Melissa Allison: 206-464-3312 or mallison@seattletimes.com

Copyright © 2006 The Seattle Times Company

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