Starbucks China

A Starbucks in Xian. Image source: reibai, via Flickr.

Like any global business, Starbucks Corporation (NASDAQ:SBUX) faces a number of country-specific quandaries, yet few rise to cipher-level difficulty. Here's an example of this next magnitude of complexity: How do you change the coffee-drinking habits of the Chinese, who have the potential to eventually become the largest group of coffee consumers in the world?

This question surely tantalizes Starbucks CEO Howard Schultz, who's had many years to ponder it. Starbucks famously entered the Chinese market well before the first waves of Western corporations mining for retail gold descended, opening its first mainland store in Beijing in 1999. The company has over 1,700 locations in China today. As an example of the potential of this market, current stores make up but a slim fraction of Starbucks' 22,500-plus locations worldwide. The country, along with Japan, is an anchor of the China / Asia Pacific segment, the company's second-largest and fastest-growing business segment. 

But Starbucks has achieved this success without a certain anchor of sales that it enjoys in the U.S. and many other countries. Chinese consumers aren't, for the most part, morning coffee drinkers. The legions of customers pouring into Starbucks locations in the a.m. hours for a caffeine fix are responsible for 46% of U.S. sales. But this phenomenon doesn't yet exist in the People's Republic. Schultz aptly characterized the situation at the Sanford Bernstein Strategic Decisions Investor Conference this spring: "[A]s strong as our businesses [is] in China  -- and we will have thousands of stores when all is said and done -- we have not yet cracked the code on the morning daypart, which is beginning to come." 

A conundrum created by Starbucks itself
It's tantalizing to consider what a strong morning daypart in China could mean for Starbucks over the long term. But evidence suggests that the company isn't likely to crack the code in an eyeblink.

This has partly to do with the way Starbucks built its market share. The coffee purveyor was one of the first to recognize and exploit the Chinese consumer's inclination for high-end goods. Starbucks has marketed its products as a prestige expenditure, and a visit to Starbucks has ample cachet for the country's rising middle class.

It's arguable that a higher price point versus Starbucks coffee sold in other parts of the world contributes to the brand's allure. The company has been criticized in the past for charging too much for its coffee in Chinese cities, although management has maintained that its prices in China are fair and reflect its costs of doing business in the country.

Whatever the reason, Starbucks coffee is more closely associated with social ritual and occasion than it is with the idea of a powerful wake-up jolt. And it might be too expensive to ever become a daily morning habit. As a recent article in the U.K.'s Guardian pointed out, a medium latte in a Starbucks in Xintiandi, a district of Shanghai, costs 30 RMB, or about $4.83, a full dollar more than the equivalent cup at many U.S. locations. Despite the buying power of China's middle class, for most Chinese, a cup of Starbucks is priced as a treat, not as a commodity.

As a result, Starbucks now finds itself having to partially unwind its own mass customer education and persuade consumers to stop in for coffee on the way to work. Yet even if the company introduces discounts and gives incentives for cheaper offerings -- say, "tall" cups (i.e., 12-ounce) of drip roasts -- here again is another obstacle, as it turns out that Chinese consumers are quite fond of cheap, quick, instant coffee. 

Dominated by Nescafe's popular "3 in 1," a product that combines instant coffee with creamer and sugar, ready-to-drink coffee is widely prized in China as a convenient home beverage. In the manner of making tea, one just needs to add hot water from a kettle to a cup filled with 3 in 1 mix. Surprising as it may be, Nescafe currently owns the market for the morning cup of Joe in China. 

A promising brand in a consumption economy
Looking out years ahead from today, Starbucks should be one of the corporations most efficiently poised to reap rewards from the Communist Party's desire to move the Chinese economy from a manufacturing output model to a consumption economy. In this model, personal spending is one of the primary engines of growth -- not unlike our own economy.

But slowing economic expansion, even when defined as a nominal GDP growth rate of 7%, has a psychological impact on consumers. Uncertainty about the overall economy as manufacturing shrinks has caused wage earners to rein in personal consumption, and luxury goods or perceived prestige brands may encounter demand imbalances in the future.

This hardly hurts Starbucks in the near term, as it has for years relied not just on same-store sales increases, but also on a blistering pace of new store openings to increase absolute sales. But it pushes further out the hope of solving the morning daypart riddle.

Just how important can this a.m. window, fueled by masses of caffeinated office workers, really be? During the Bernstein investment conference, Schultz described an experiment in which Starbucks had created a closet of a store -- only 500 square feet, in downtown Manhattan. The "14 Wall Street" location, just 30 yards away from a core Starbucks property, was fully expected to cannibalize 10% to 15% of its larger sibling's sales.

To management's surprise, after a few weeks, both stores were flourishing without any cannibalization at all. Schultz drew the conclusion that at certain times of day in certain locations -- for example, the morning daypart in a dense financial district of a major global city -- there's a greater demand than anyone, including Starbucks, has realized for its products. This has obvious implications for the hundreds of metropolises spread throughout the Asia-Pacific region, and specifically in management's eyes, China. But first to crack that elusive code.

 

Asit Sharma has no position in any stocks mentioned. The Motley Fool recommends Starbucks. The Motley Fool owns shares of Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.