COVER STORY



COVER STORY

Hot Starbucks to Go

It's a new American institution. Its stores are everywhere. Doubters say it can't get much bigger. But Howard Schultz is setting up his company for more growth—in coffee and beyond.

By Andy Serwer

I'm in Seattle, talking with the father of the richest man in the world, who is speaking eloquently about a remarkably successful younger man who lives right here in his hometown. Yes, the speaker is Bill Gates the elder, but no, he's not talking about his son the Microsoft guy. Gates is telling me about Howard Schultz, the man who built the Starbucks coffee company. Gates, before he retired, was lead partner of the biggest law firm in town, Preston Gates, and he just happened to be Schultz's attorney when Schultz was nothing more than an ambitious East Coast transplant with a jones for coffee. "A lawyer's eyes start to sparkle when he sees a person like Howard come in with a plan like Starbucks," recalls Gates. "Howard has an ability that isn't widespread. He is very directed and dogged, and a very decent person too. Howard Schultz is an incredible story."

That from a man who knows incredible stories.

Schultz, of course, has now created an American institution. Starbucks today is possibly the most dynamic new brand and retailer to be conceived over the past two decades. The company's stores—over 7,500 and counting—are everywhere from Omaha to Osaka to Oman. That's a blessing for the company's millions of latte-dependent customers but something of a challenge for Schultz and his team because it raises the saturation question. If Starbucks is already everywhere, how can it keep growing so fast?

"We are in the second inning of a nine-inning game," Howard Schultz says. "We are just beginning to tap into all sorts of new markets, new customers, and new products." Many of Schultz's ideas about how to achieve these are unconventional—like refusing to franchise—but that's the Starbucks way, and millions of us seem to love it. We stream into Starbucks to buy coffee for $1.75 that we used to pay 50 cents for. We drop into our local Starbucks to read on plush couches. We lug in our laptops and hold meetings, and we buy gifts and music there. We load money onto the company's stored-value cards. How unusual a set of customer experiences is that?

|Room to Grow? |

|Starbucks has grown bigger in the 11 years since its IPO than McDonald's did in its first 11 years as a public |

|company. But Starbucks has a long way to go before it gets as large as McDonald's is today. |

| |

|No. stores 11 years after IPO... |

|...and now |

|Revenue 11 years after IPO... |

|...and now |

|Stock price increase 11 years after IPO... |

|...and now |

| |

|Starbucks |

|IPO: |

|6/26/1992 |

|7,427 |

|(12/31/03) |

| |

|$4.1 billion |

|(2003) |

| |

|3,028% |

|(12/31/03) |

| |

| |

|McDonald's |

|IPO: |

|4/21/1965 |

|4,178 |

|(1976) |

|31,295 |

|(12/31/03) |

|$1.1 billion |

|(1976) |

|$16.5 billion |

|(4 qtrs. ending 9/30/03) |

|134% |

|(1976) |

|4,334% |

|(12/31/03) |

| |

Behind the counter and at headquarters, Starbucks is an unusual company too. It strives to mix capitalism with social responsibility. It gives all its employees who work more than 20 hours a week stock options and health-care benefits. It doesn't advertise on TV. And it funds breakneck expansion through its own cash flow, not by selling stock or debt.

Right now Starbucks is growing at an eye-popping rate. Its revenues continue to climb at above 20% a year. Same-store sales (that is, sales at stores open more than a year) rose at an 11% clip in November and December, the best showing in over a decade. Starbucks stock was up 56% last year—and 3,028% since its 1992 IPO—and is now hitting all-time highs. (The stock, as always, is priced sky-high on a P/E basis.) If you think Starbucks is everywhere now, don't be surprised to see even more stores in places like Winslow, Ariz., and Warsaw, Poland.

To achieve that kind of omnipresence, Schultz is building his company for bigness—hiring a new management team, constructing huge coffee-roasting plants, and helping coffee growers improve their crops to meet Starbucks' exacting standards and insatiable demand. Last year the company bought Seattle Coffee Co., a chain of lower-priced coffee shops, and it plans to expand the business to $1 billion in annual revenue. Starbucks will open dozens of stores in France starting this month. And in the U.S. it plans on opening more stores with drive-thru windows this year. Altogether, the company says, it will open 1,300 new stores worldwide in 2004.

"I consider Howard Schultz to be a kind of genius," says former Senator Bill Bradley, now an Allen & Co. banker, who joined the Starbucks board last June. As a New York Knick, Bradley was a boyhood idol of Schultz's. (Today Schultz is the lead owner of the NBA Seattle SuperSonics.) "Howard is consumed with his vision of Starbucks," Bradley says. "That means showing the good that a corporation can do for its workers, shareholders, and customers."

Today Schultz, 50, is a genial, self-effacing type, over six feet tall, lanky, and trim, with shiny white teeth. His expression when speaking with people is generally either empathic or collaborative. His accent doesn't reflect his Brooklyn roots, and his vocabulary is like a college professor's, filled with words like "empowerment" and "visual cues."

"He's happiest in his stores" is something you hear over and over about Schultz. And why not? Starbucks is a pretty darn nice place to hang out. During my recent visit with Schultz in Seattle, he really wanted to show me the store at 23rd and Jackson, located in a low-income, minority neighborhood. And so we drove over in his Porsche Cayenne SUV. (He's not that understated.) We park, walk in, and order coffee. "After we put this store in, all these other national companies came in," he says, pointing to a Hollywood Video store and a Walgreens across the way. Employees and customers greet Schultz, though some are more interested in chatting about the Sonics than about the Christmas Blend.

"Starbucks has become what I call the third place," says Schultz, seated and sipping one of his five or so daily cups of company product (usually black). "The first place is home. The second place is work. We are the place in between. It's a place to feel comfort. A place to feel safe. A place to feel like you belong." Schultz says he's trying to create something that never really existed in the U.S.: cafe life, for centuries a hallmark of Continental society. Schultz points to the British pub, too, as a close cousin of his third place, and notes that a Barnes & Noble has some of the same characteristics. Whether or not you buy his concept, it is unassailable that the number of people visiting Starbucks—25 million people each week—is impressive.

Non-Gold

Not all that Starbucks touches turns to gold. Here are some ventures that didn't.

Joe magazine In 1999, Starbucks and Time Inc. rolled out a coffeehouse magazine with the tagline "Life is Interesting, Discuss." It lasted three issues.

Internet On June 30, 1999, Howard Schultz announced that his company was embarking on an Internet venture to sell things like kitchen products. The stock fell 28% by the end of the following day.

Restaurants Starting in 1998, the company opened five Starbucks Cafes. "They are all gone now," says Schultz. Food in Starbucks stores still needs work.

Drinks Not many Starbucks drinks flop, but Mazagran, a carbonated coffee beverage developed with PepsiCo, never made it.

Four years ago Schultz stepped aside as CEO to become the Starbucks chairman and chief strategist, much like his counterpart across town at Microsoft. He gave the CEO job to Orin Smith, a decade his senior, who had joined the company in 1990. Why did Schultz do it? "Because Orin deserved the job," Schultz says simply. The move freed Schultz from routine tasks like budget meetings and let Smith focus on critical matters such as driving same-store sales. At first, Smith says, only yuppies went to Starbucks. But now, with no special marketing at all, "we are bringing in a much wider demographic than we thought possible—older people, younger people, people of different ethnic backgrounds." It just seems as though the word is out. "Starbucks understands that Americans want to trade up," says Jeff Brotman, co-founder of Costco and an old friend of Schultz's. "They are aspirational, and Starbucks is a part of that very powerful force in our society. That's why I am so convinced Starbucks has even more legs than we ever expected."

Smith also says the company is now selling drinks all through the day and night—some stores are open 24 hours—thanks to new specialty drinks like teas and Frappuccinos, and during all seasons of the year too (think holiday peppermint mochas). "Our new automatic espresso machines are making our service faster than ever, and our merchandising has never been stronger," Smith says. The focus on same-store sales doesn't mean Starbucks is ignoring expansion. "We are able to open stores in places we never thought possible," Smith explains, citing Starbucks outlets run as a joint venture with Magic Johnson in inner-city neighborhoods and ones in smallish towns like Temple, Texas.

One trick Starbucks hasn't pulled out of the bag recently—at least not in the past three years—is to raise prices, though it probably could without customers' batting an eye. Why do customers pay $3.50 for a latte? The short answer is that they think it's worth it. But what are they getting? Some of the finest coffee available commercially. Custom preparation. (How many retailers could put up with "I'll have a grande low-fat triple-shot half-caf white-chocolate mocha, extra hot, easy on the whipped cream. And I'm in a rush.") Then there's the Starbucks ambiance. The music. The comfy velvety chairs. The smells. The hissing steam. "We aren't in the coffee business, serving people. We are in the people business, serving coffee," Schultz says.

Howard Schultz grew up on some of Brooklyn's meaner streets. He was raised in a cramped apartment in the Bayview public housing project in Canarsie, where he shared a tiny bedroom with his brother and sister. If you go there today, especially at night, you get a feeling for just how grim and scary the place is. The grounds of the project are deserted and dirty, and huge jets roar in low on their way to J.F.K. Airport. Inside, the halls are dark and narrow. You hear sounds coming through the walls, and nasty cooking smells fill your nostrils. It's not that different from the way it was when Howard was growing up—not terrifying, but tough in a West Side Story kind of way. Jewish families like Howard's living side by side with Italians, Irish, and African Americans. Kids playing ball, fighting, and flirting. You figured out where to fit in and tried to stay out of harm's way.

Howard was kind of shy around girls, but he was a natural leader and a consummate playground rat. Stickball, basketball, slapball, skully, football, baseball, punchball—he'd play them all, day and night. Howard would be the captain and pick the teams. He'd bring in all the kids, make them feel included, make them a part of the team. He'd draw up the plays and make everyone compete like hell. Later in the day he'd take them on a subway ride all the way to Yankee Stadium in the Bronx to see Mickey Mantle. He'd buy bleacher tickets and then sneak them down to the expensive seats. And for a time the kids would feel as if they had escaped the projects, and that they were part of something bigger than Bayview. "It shaped my character," says Schultz. "But I always wanted to escape. I always wanted to improve my standing."

Schultz frequently tells a story about coming home one day as a boy to find his father, Fred—who worked a variety of blue-collar jobs to keep his family going—laid up on the couch with a broken ankle. His father couldn't work. He lost his job, and he had no medical benefits. The family's tight finances became even tighter. "I will never forget that episode," says Schultz. "I never want that to happen to our employees." That's why thousands of part-time Starbucks workers have full medical benefits.

Howard's ticket out of Brooklyn was football. "He wasn't a great athlete," says Canarsie's current football coach, Michael Camardese, who played on the junior varsity when Howard was quarterback. "But he was very hard-working and smart. The team was pretty bad back then, and Howard was constantly being chased out of the pocket." Howard landed a scholarship to play football for the Wildcats of Northern Michigan University, and he became the first member of his family to go to college. Northern Michigan, in the town of Marquette on Lake Superior on the state's Upper Peninsula, has to be one of the coldest campuses in America, but at least Howard was out of Carnarsie.

His football career was a washout, so Howard focused on his studies. After graduation he took a position as a Xerox salesman in New York, then a plum job for a young man with student loans to repay. Soon after, Schultz moved over to Hammarplast, an importer of Swedish kitchenware. Schultz noticed that one of his customers, a little coffee company in Seattle, had a brisk order pattern for some of his coffeemakers. Schultz went out to investigate. And that's how Howard Schultz walked into the Starbucks Coffee, Tea, and Spice store in Seattle's Pike Place Market. Immediately, he knew he wanted to work at the company the rest of his life.

Why? Here he was, a successful New York City executive who had already made it out of the projects. And as for Starbucks, it wasn't much of anything at the time. The company had been founded in 1971 by a couple of local coffee aficionados, Gerald Baldwin, Gordon Bowker, and Zev Siegl, who were disciples of Peet's Coffee in Berkeley. When Howard came calling, the company had just four stores. And it sold only beans, not drinks. "I walked into the market and into the store. There was something incredibly special," Schultz says. "The aroma. The authenticity. But it also felt like a rough diamond. It was something I felt I could polish into a jewel."

Schultz desperately wanted in, but the owners weren't easily convinced. Why would they want a slick East Coast salesman? Schultz's family was unsure too. In his book, Pour Your Heart Into It, Schultz describes what was going through his mind: "Taking a job at Starbucks would mean giving up that $75,000-a-year job, the prestige, the car, and the co-op, and for what? ... My mother was especially concerned."

In 1982, Schultz got his wish and joined Starbucks as director of retail operations and marketing. He began by selling coffee to restaurants and coffeehouses in Seattle, which back then was far from the bastion of urban hipness that it has become. Only a decade earlier, someone had erected the infamous Will the Last Person to Leave Seattle Please Turn Off the Lights billboard, after huge Boeing layoffs. The city was still in a funk, and it would be years before Kurt Cobain's screaming genius and Nora Ephron's cinematic confection Sleepless in Seattle helped revive it. Schultz toiled away in Seattle's damp chill, reporting to a couple of owners who weren't really interested in making Starbucks big—which is exactly what Schultz wanted to do.

Just a year after joining Starbucks, Schultz was traveling to Milan and walked into an espresso bar. Right away he knew he could bring the concept to the U.S. "There was nothing like this in America," he says. "It was an extension of people's front porch. It was an emotional experience. I believed intuitively we could do it. I felt it in my bones."

But Starbucks' owners wouldn't really give it a try. So Schultz left the company in 1985 to start a small chain of espresso bars called Il Giornale in Seattle and Vancouver. Two years later Starbucks' owners wanted to sell the company. Schultz raised $3.8 million from local investors to buy them out, negotiating the deal with Bill Gates the elder. (Gates bought some stock at that point, which hardly seems fair considering the success of his son's venture.) Finally, Schultz was in charge of his dream.

Out at Starbucks' roasting plant 15 miles southeast of downtown Seattle, in the shadow of Mount Rainier, there's a blown-up black-and-white photograph of the company's operations back in the early 1980s. What you see is a small-time operation, a handful of employees watching over coffee roasters amid piles of burlap sacks of beans. It's an amazingly far cry in an impossibly short period of time. Today Starbucks is a sleek, fast-growing beast with more than $4 billion in annual sales. It made $268 million in profits last year. Starbucks' profit margins are lower than those of McDonald's and others in the fast-food or restaurant businesses, partly because it has higher salaries and benefit costs since it doesn't franchise. To Schultz that is simply the price you pay for doing business his way, and it is nonnegotiable. Declining to franchise is a hugely important part of the Starbucks formula. "I look at franchising as a way of accessing capital, and I will never make the tradeoff between cheap money and losing control over our stores," says Schultz.

Starbucks has over $300 million of cash on its balance sheet and next to zero long-term debt—even with all those new-store openings. It is so conservatively run that the company could be accused of being overcapitalized. Its return on equity is only around 12% or 13%, and the stock pays no dividend. "We are keeping our powder dry," says CFO Michael Casey. "This position gives us flexibility if we were to make an acquisition."

The company is growing so fast that it has just completed its third and fourth state-of-the-art roasting facilities, in Nevada and Amsterdam. Even if the company's growth slows by half, to 12% or so, Starbucks could be doing $7 billion in sales in five years. Which is why Schultz has added a whole new team of executives, from companies like Wal-Mart, Dell, and PepsiCo. "I wanted to bring in people who had experience working at $10 billion companies," he says.

One such hire is Jim Donald, a press-the-flesh type who is head of Starbucks' core North America business and some say heir apparent to Orin Smith as CEO. Donald was a manager at Safeway and Albertson's, and spent five years at Wal-Mart running its food operations—"I was the last guy Sam [Walton] hired" before he died, Donald says. As Starbucks grows, its margins are bound to shrink, and Schultz says he values Donald's "ability to operate in a low-margin environment."

Even as it grows, Starbucks isn't likely to lose its touchy-feely quality, which comes directly from Schultz and gives the company a cultlike zeal. Starbucks employees sometimes sound almost Maoist, as in, "Well, I read in Howard's book ..." Schultz says, "The most important thing I ever did was give our partners [employees] bean stock," meaning Starbucks stock options. "That's what sets us apart and gives a higher-quality employee, an employee that cares more."

Schultz cares too. At 5 a.m. on July 7, 1997, Schultz and his family were asleep at his house in East Hampton, N.Y., when the phone rang. Three Starbucks employees had been murdered in a botched robbery in Washington, D.C. "I was stunned. Catatonic," says Schultz. He chartered a plane and arrived in D.C. before nine that morning. He took charge of the scene and stayed for a week, visiting the store, working with the police, meeting with the victims' families, attending the funerals. Ultimately Schultz decided that all future profits from the store would go to organizations working for victims' rights and violence prevention. Schultz dedicated his book to the three employees. "You cannot do better in a crisis than he did in that instance," says Washington Post CEO Don Graham. "He went way beyond the normal bounds."

As Starbucks stretches and grows, it is making itself felt in all manner of businesses besides coffee. It has a dreamy line of coffee ice cream, and a ready-to-drink coffee beverage business it runs with PepsiCo. Now it is moving further afield to tap into the brand equity it has built.

As crazy as it sounds, music has become one of Starbucks' zingiest brand extensions. Music at Starbucks began when a store manager named Timothy Jones made tapes for his store, which proved so popular that the company licensed compilations for sale. "I had to get talked into this one," says Schultz. "But then I began to understand that our customers looked to Starbucks as a kind of editor. It was like, 'We trust you. Help us choose.' " In 1999, Schultz bought Hear Music of Cambridge, Mass., run by Don MacKinnon, who was putting together albums of cool music, both old and new, that wasn't getting played on the radio. Since then Hear has released about 100 albums and sold about five million CDs, including the Artist Choice series, in which performers like the Rolling Stones and Ray Charles pick their favorite tracks by other artists.

In financial services, Starbucks has recently teamed up with Bank One to offer the Starbucks Card Duetto Visa, so named because it's a two-in-one product that is both a stored-value card and a traditional credit card. Customers get points at Starbucks for using the Visa. "We could have partnered with any number of retailers, but Starbucks really is on the cutting edge of this," says Bank One CEO Jamie Dimon at the rollout of the Duetto at a Starbucks in downtown Manhattan.

There are limits to how far Starbucks can go here. The company tried its hand in publishing, teaming up with Time Inc. (publisher of FORTUNE) to roll out a magazine called Joe, which flopped. Schultz still keeps a rack of Joe issues in his office "as a reminder." Another embarrassing foray came in 1999, when Schultz declared Starbucks an Internet company and the stock fell 15% in one day. "I got caught up in it," Schultz admits.

Today, 22 years after joining Starbucks and molding it in his image, Howard Schultz is a very rich man. He controls more than 18 million shares of Starbucks worth some $600 million. Schultz was also an early investor in eBay and owns tens of millions of dollars of that stock as well. His net worth is said to be in excess of $1 billion. Guarded about his personal life, Schultz lives with his wife, Sheri, and their teenage son and daughter in a 6,300-square-foot, three-bedroom home—with Rothkos and Kiefers on the walls—in a gated community overlooking Lake Washington. At night you can hear his son shooting baskets at their backyard hoop.

Basketball is Schultz's other hometown pursuit. Three years ago he and a group of other local businessmen bought the Sonics for some $200 million. Sit with Schultz in the front row at center court, and you see the truly competitive and, well, passionate, side of him. Call him a slightly more mellow version of Mark Cuban. Slightly. "Fuck! That was a bad shot," he says. (Like so many others, what Schultz has discovered about the NBA is that success in business does not necessarily translate into wins on the hardwood.)

So it's a good, rich life, and a long way from Canarsie. The big question for Schultz is whether Starbucks can keep it up. There are those on Wall Street who say that Starbucks' game is almost over. With all those thousands of stores—more than 1,400 in California, another 1,000 in Asia, and 168 in Manhattan—there must be no more room to grow. And yet there are reasons to think that Starbucks has years, perhaps even decades, to go before it taps out its growth. Eventually, Schultz suggests, his company will have in the neighborhood of 25,000 stores. (McDonald's, by the way, has more than 30,000 stores.) Starbucks could expand even faster than it does, but it governs its growth to make sure it can maintain quality—which is why it sees no need for national TV advertising, which Schultz believes would diminish the brand.

That's also one reason Starbucks is resisting the siren call of Bentonville, at least for now. "The guys from Wal-Mart wanted to talk business with us, and they told me to come down to Bentonville to talk," says North American chief Jim Donald. "I told 'em, 'It's a busy time right now, maybe in a little bit.' They called back and asked me again, and I said no. Finally I told them, 'If you guys want to talk so bad, come on up here to Seattle.' And they did!" But no agreement was reached, so naturally Wal-Mart is quietly trying out its own coffee bar concept, called Kicks Coffee Cafe, at a single Wal-Mart in Plano, Texas (see box).

Spurn distribution through Wal-Mart? Now there's a company that goes its own way. But again, Howard Schultz's business has always been different, and perhaps for that reason frequently underestimated. Ten years ago a financial commentator called Starbucks "the short of the decade." It wasn't in the 1990s, and a third of the way into the next decade, it still isn't. Instead, Starbucks seems to be moving neatly from a startup to a blue chip, as Schultz's concept of a "third place" catches on. It's as American as Caramel Macchiato.

Bigfoot Dips Toe in Coffee

Wal-Mart experiments with an espresso bar of its own.

By Kate Bonamici

It is certainly a case of strange bedfellows. Wal-Mart has teamed up with Hollywood image maker Benny Medina (the man behind the early careers of Will Smith, P. Diddy, and Jennifer Lopez) to experiment with a Starbucks-style coffee shop in a Texas outpost of the megastore.

It seems the big-box retailer is looking to give shoppers a low-key, upscale place to relax. Medina's Kicks Coffee Cafe, in a Plano, Texas, Wal-Mart, has low lighting and wooden chairs that make it a dead ringer for its heavyweight competitor. Wal-Mart says it has a purely landlord-tenant relationship with the shop, though the corporation had been considering a cafe concept when the Kicks proposal came in.

One unique Kicks development is an in-store delivery service, although there are kinks to work out. As of early December, a single Kicks employee wandered the giant Wal-Mart taking orders. If you were lucky enough to find him, you could order a cup of coffee—and stay put until it was delivered. But a test cup of house coffee in the actual cafe was, according to one customer, "a lot better than Starbucks."

Kicks is also taking a cue from its landlord and offering fancy coffee drinks at slightly lower prices than the competition's—about 25% below what a nearby Starbucks is charging. It remains to be seen whether the formula is a success. A Wal-Mart spokeswoman said the superchain has no plans to expand the partnership with Kicks: "We've got the one, and we'll watch that. We tend to test things quietly at Wal-Mart and see if things meet the fancy of our customers." Tests may be quiet, but major developments at Wal-Mart rarely are. If Kicks is a hit, Starbucks will be paying attention.

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