In 2016, Starbucks Pleased No One — Not Investors, Not Customers | Top 15 Annual Report

Howard Schultz, who announced his resignation as CEO last Thursday, capped a turbulent year for Starbucks. Behind the upheaval lies a harder truth: the industry's undisputed leader has hit its ceiling, and it needs to find its next engine of growth.

2016 was a turbulent year around the world, and in business the market leaders suffered more than their challengers.

The 15 companies QDaily tracks as drivers of lifestyle change had a rough year. Their shared trouble came down to a single word: ceiling.

Whether building new products (Apple's watch and car) or chasing new customers and channels (IKEA moving into e-commerce), these frontrunners were searching — urgently, and perhaps blindly — for "the next" engine of growth.

Breaking through that ceiling proved harder than anyone expected. The 2016 Top 15 year-end report is not all good news.

Things look pretty bad.

On the morning of December 1, U.S. time, Howard Schultz — the man who built Starbucks into a coffee empire — announced that he would formally step down as CEO on April 3, 2017. He praised his successor, current COO Kevin Johnson, and the whole senior team, and promised he wasn't leaving Starbucks for good. None of it calmed nerves. A brief panic swept the markets: Starbucks shares fell 3.35% in after-hours trading, erasing nearly $3 billion in market value.

This was not the first bad news of 2016. In each of the first three quarters, when earnings came in below analyst expectations, the markets answered with a thumbs-down. That dragged the stock down 13% over those three quarters; the fourth quarter clawed back just 1.41%. Investors had expected far more.

The one bright spot was profit. On the strength of the fourth quarter, fiscal 2016 became Starbucks' most profitable year in 24 years — but the company bought that result largely by raising prices. In July it added 30 cents to select drinks. Most customers barely noticed, yet the increase ran steeper than last year's 5-to-20-cent hike, and for a company Starbucks' size even a small bump means a meaningful lift to profit.

The chase for profit quickly drew blowback. In April, an overhaul of the Starbucks Rewards program touched off immediate anger. Liu Tianyuan, a Gold-level member who had lived in the United States for six years, "knew he was getting a worse deal." He usually ordered brewed coffee or a latte; the old rule — 12 visits for a free drink — was gone. Now he needed 18 straight purchases of a $3.65 tall latte. Social media erupted. The Twitter user @lakecountrydemocrat wrote: "This is not what consumers want (and Starbucks keeps claiming to care about customer feedback). Infuriating."

For a company that had always stressed caring for the vulnerable and cultivated the image of a beloved national brand, Starbucks chose, when profits were at stake, to stand on the opposite side from its customers. By the 2016 American Customer Satisfaction Index (ACSI), Starbucks scored 75 — its second-lowest mark in nearly a decade.

In 2016, Starbucks pleased neither its investors nor its customers.

In theory, this should not be Schultz's style. When Starbucks has to choose between the two, Schultz the professional manager has usually sided with investors. In the five-year plan he released at the end of 2014, he promised investors that revenue would reach $30 billion by 2019. Today it stands at $21.3 billion; at the current 11% year-on-year growth rate, the target looks out of reach.

Starbucks' bind today recalls Schultz's first departure, in 2000. By then he had run the company for 15 straight years. In a single year, 2,600 stores across 13 countries brought in $2 billion in revenue; measured from 1992, the chain's compound annual growth rate had reached 49%, vaulting it to the top of American coffee. But to keep growing, both Starbucks and Schultz would have to work much harder.

In his autobiography Onward, published years later, Schultz called himself "a warrior ready for the challenge." "We believe Starbucks' growth cycle is still in its early stages — we could have at least 20,000 stores overseas," he said at the time. Stepping back from daily operations, he turned to global expansion: a new challenge that could turn Starbucks into a major multinational, fuel another round of growth, and lock in its dominance.

By this year, Starbucks ran more than 25,000 stores worldwide — 13,000 in the United States, more than 2,300 in China, more than 1,400 in Canada...

Worth noting: as Starbucks pushed its global expansion, it folded in local knowledge, approaching customers with a friendly, adaptive touch. In last year's year-end review, we analyzed Starbucks' localization moves in four representative markets and the different stages of development each one stood at.

In the United States, a relatively mature market, Starbucks' strategy for several years has centered on lifting revenue per store — which is why it has consistently led on "same-store sales" in its earnings. It pushed food hard, hoping customers would spend more in-store, and it kept updating its app to deepen engagement. Last year it rolled out Mobile Order & Pay — order on your phone, pick up in store — worldwide. For Liu Tianyuan and many others, that change was a real convenience; he counts himself among the earliest adopters and quickly made it a habit.

But users like Liu were a minority. By the end of the fiscal year, Mobile Order & Pay accounted for just 6% of all U.S. transactions — nearly two years into the rollout, it had barely made a splash. The food business, once carrying high hopes, also fell short. Stores began stocking the bagels talk-show host Oprah Winfrey loves, launched $8 lunch combos, and in some locations offered brunch. Starbucks even drummed up some buzz by partnering with a nonprofit to donate each day's unsold food, and it invested in the Italian bakery chain Princi — yet customers largely refused to follow the brand beyond coffee. As a result, Starbucks' U.S. same-store sales growth slipped across fiscal 2016 compared with the year before.

The fallback was what it has always been: open more stores — on a massive scale, worldwide.

Even in the United States. After opening 171, 132, and 194 new U.S. locations in the first three quarters, Starbucks opened 307 in the fourth quarter alone — nearly as many as the first two quarters combined. Given the modest fourth-quarter recovery in the stock, opening stores still seemed to work.

In the emerging markets of Asia and the Pacific outside the United States, expansion remained the main mission. After visiting Shanghai in person, meeting Party Secretary Han Zheng, and appointing Belinda Wong as China CEO, Schultz laid out an even bigger plan for China: more than 500 new stores a year over the next five years, reaching 5,000 stores by 2021.

But the market Starbucks faces today is far more complex than the era when expansion alone drove fast growth. In mature markets, the payoff from new stores keeps shrinking. In emerging markets, geopolitics and local economic conditions have become variables the company must actively weigh. Europe has already sounded an alarm. In that market — where Starbucks holds comparatively little sway — it still opens roughly 70 stores a quarter, yet same-store sales there swing between 1% and -1%, threatening to become its second collapse after Australia.

Meanwhile, the competition has intensified.

On January 7, 2008, The Wall Street Journal ran a front-page story on McDonald's move into coffee; the line, developed in its Australian market, began poaching Starbucks' core customers. Then came Burger King's purchase of the Canadian coffee chain Tim Hortons, and the old-line operator Peet's snapping up the specialty roasters Stumptown and Intelligentsia. The pressure came from every direction.

The most striking challenger may be Dunkin' Donuts, the donut-focused brand with 7,000 U.S. stores, a 16.1% market share, and a strong voice in New England. It has been closing the gap fast. This summer it copied last year's cold brew — Starbucks' most successful new product — and it recently announced a "premium tea" line, aimed both at the much-hyped U.S. tea market and at Teavana, the Starbucks tea brand that entered the space first but never caught on.

It wasn't only products — Starbucks' lead in digital looked set to erode too. The digital effort Schultz had learned from Dell founder Michael Dell, branded the "greener look," once earned Starbucks the title of "most tech-forward restaurant company." After Starbucks launched mobile ordering in 2015, Dunkin' Donuts followed a year later with the same feature — still not very effective, but closing the gap.

"Dunkin' Donuts has always had a habit of imitating Starbucks," said John Gordon, an analyst at Atlantic Management Consulting. Once Starbucks works hard to find a genuinely viable innovation, Dunkin' can copy it quickly. The barrier to entry here was never high to begin with.

This is a pattern across every industry: competitors watch the market leader and adjust accordingly. What has changed for Starbucks is that rivals now catch up faster and more capably, so the edge it builds erodes much sooner.

At the same time, Starbucks has run into a sharper problem: its own creative energy has begun to flag — or it has badly misjudged what customers want.

Next to last year's cold brew, which rivals have been scrambling to copy ever since, the long-prepared, heavily promoted Teavana tea line landed with a thud. Li Ping, who lives in Evanston, Illinois, says she has been "scared off by the seasonal new products," though she did try Teavana once over the summer.

She has no objection to drinking tea at Starbucks, but found it "a little strange. I'd rather have an iced shaken lemonade." The line, which in theory should have had more room in China, fell flat there too. Because of its retreat at home — Starbucks closed four Teavana Tea Bar locations in the United States early in the year — Teavana took the cautious route of entering China through existing store formats, which may be why a line suited to middle-class tastes has struggled to break through in China as well.

In October, Starbucks launched its first alcoholic drink in North America: the Espresso Cloud IPA. Li Ping, a beer fan, spotted the ad and snapped a photo on her phone — but never tried it. "I haven't had it yet... I think it's a bit odd, because it's on the evening menu. But who drinks at Starbucks in the evening? You don't need the caffeine at night, and if you want a buzz you go to a bar." That sense of dissonance — drinking at Starbucks — may date back to when the company first promoted its Starbucks Evenings liquor service. Yet Starbucks keeps pouring more into the category.

For the Chinese market, Starbucks also pursued a baffling digital strategy. Last November it opened a flagship store on Tmall. Aside from selling gift cards — which couldn't be linked to a Starbucks Rewards card — the store offered a crude e-commerce experience: buy a digital voucher on Tmall, then scan a QR code in store to redeem a drink.

Even here, customers couldn't pay straight from their Rewards balance as they could in the United States, and WeChat Pay and Alipay — already everywhere — were nowhere to be found. Since Starbucks has always tested new ideas in the United States first before bringing them to China, this is not entirely surprising. But mobile payment has become a way of life for young Chinese consumers, and China's mobile-payment market is in fact more pervasive than America's. In that context, the strategy may be hiding real risks.

Over the year, Starbucks also weathered a string of smaller controversies. Some predated 2016, but the way they converged into a single turbulent year is striking.

Controversies Starbucks Faced in 2016

February

The British health group Action on Sugar accused Starbucks of exceeding safe sugar levels, claiming 7 of the 10 most sugar-laden hot drinks on its watch list were Starbucks products — including an autumn hot spiced fruit tea with 25 teaspoons of sugar.

March

Backed by the union Working Washington, Starbucks employees spoke out at the annual shareholders' meeting, accusing the company of steadily cutting staff levels, raising workloads, and stretching the pay-raise cycle from every six months to once a year.

March

Two customers in California sued, alleging Starbucks shorted its lattes by at least 25% of the coffee, leaving drinks below the menu's stated amounts.

May / June

Customers in Illinois and California filed separate suits alleging that too much ice left drinks underfilled. Two months later, Starbucks won the California case.

November

Starbucks released a green "unity cup," only to be accused by customers of mixing coffee with political indoctrination.

November

A second price increase for the year came to light. The official reason — rising operating and raw-material costs — failed to convince customers.

In his resignation remarks, Schultz said: "I still want to throw myself fully into Starbucks' affairs, and I have no plans to enter public life... at least that's how I see it now." With Trump just elected, talk of a turn toward politics swirled — but the more urgent task may be getting Starbucks back onto a fast-growth track.

He said he would lead a small team to build out the company's premium line. At its center is the Starbucks Reserve Roastery and Tasting Room, which debuted at the Seattle headquarters in late 2014; this year, Starbucks announced new locations planned for New York, Shanghai, and Tokyo.

"This line will be like Air Jordan for Nike, like the Purple Label line at Ralph Lauren," Schultz said. Premiumization has indeed been Starbucks' theme over the past six months. In August it launched St. Helena coffee beans at $10 an ounce — the hook being that they came from the remote island where Napoleon was exiled — at a price close to a Yemeni coffee bean once released by the specialty roaster Blue Bottle. But the Starbucks Reserve Roastery and Tasting Room is meant to be about more than going upmarket.

Schultz is a careful professional manager, and his departure was no impulse. A preview came back in August, when he sent an open letter to all employees. Beginning with "Dear partners," the long message announced a round of personnel changes effective September 1 — including putting former North America head Cliff Burrows in charge of the Roastery and other premium-tier stores — and made clear that Schultz himself would directly lead the design and customer-experience teams for the high-end stores.

From that reshuffle to the resignation, the picture may go beyond a single product line. The Wall Street Journal called the premium-store strategy Starbucks' biggest strategic pivot since "expanding overseas." Schultz described it as "a metaphor for the future of coffee innovation, store design, and the customer experience" — and he was willing to lead it himself.

Against the U.S. system's 6% average annual same-store sales growth, the Starbucks Reserve Roastery and Tasting Room runs at three times that — 24%, a handsome number. At the same time, Starbucks needs to widen the gap with rivals by raising its own bar.

Stretch the timeline back further and Starbucks' latest transformation looks like a return to its roots. In Everything but the Coffee, written in 2009 by Temple University history professor Bryant Simon, he notes that in the 1990s Starbucks in the United States still carried the air of a small luxury — like a MINI Cooper or a Kate Spade handbag. But by 2008, citing a survey, he wrote that "to many people, Starbucks had become indistinguishable from McDonald's." Today, Liu Tianyuan thinks Starbucks and Dunkin' Donuts look an awful lot alike.

In the markets, some investors remain skeptical of the premium-store strategy. First, they doubt whether anyone will raise their Starbucks spend from $3 to $12. Second, as The Wall Street Journal cited analysts as saying, "If the economy slumps badly, investors will worry that spending $100 million a year to build glamorous stores that serve only a handful of people simply isn't a good business."

Compared with his mindset before stepping down in 2000, Schultz, three days ago, offered a similar line: "Resigning frees me to do what I do best." But it doesn't look like an easy decision.

If a real comparison must be drawn, it may be closer to what Schultz wrote when he returned as CEO: "By early March 2008, my being back at Starbucks was no longer news. People outside the company — shareholders, analysts, journalists — were watching us change, turning their attention to other things, and waiting to see whether we could turn it around. Many doubted we could."

But this time, what Starbucks has to break through is its own ceiling. Will the premium line become its next engine of growth?

Everything will be much harder.

Graphics by Wu Lingwei

Cover image from Starbucks Newsroom