Starbucks wants to run China itself — why now, and what does it mean?

More control for Starbucks also means more risk.

Starbucks looks ready to change its playbook in China.

On July 27 — last night — Starbucks announced the largest acquisition in its history: a deal with its longtime joint-venture partners Uni-President Enterprises Corporation ("Uni-President") and President Chain Store Corporation ("President Chain Store") to pay $1.3 billion in cash for the remaining 50% of its East China joint venture, Shanghai Uni-President Starbucks Coffee Co., Ltd.

Once the deal closes, Starbucks will wholly own roughly 1,300 stores in Shanghai, Jiangsu and Zhejiang — the East China region. All 2,800 stores in mainland China, covering East, South and North China, will be company-operated.

That means Starbucks will own and run its China business itself, exactly as it does in the United States.

"Moving to full ownership and operation of our mainland China business is a deep expression of our commitment to this market, and reflects our confidence in our local management team," said Kevin Johnson, who took over from Howard Schultz as CEO of Starbucks Coffee Company late last year.

Bloomberg analyst Jennifer Bartashus said of the deal: "Given Starbucks' expectations for the China market, this acquisition isn't surprising — they want to maximize control over their stores there."

Johnson also repeated the target of going from 2,800 stores to 5,000 by 2021.

East China holds nearly half of Starbucks' stores in China. In August 2015, President Chain Store decided to put 60 million yuan into a logistics company in Taizhou to handle deliveries for Starbucks, built to feed the future expansion of Uni-President Starbucks across Jiangsu, Zhejiang and Shanghai. At the time President Chain Store also said publicly: "There is no uncertainty in the contract signed with Starbucks USA, and no issue with the term expiring — the territory Shanghai Starbucks is permitted to open in includes East China and part of Central China."

As David Palmer, an analyst at the investment bank RBC Capital Markets, sees it: "In investors' minds, Starbucks may increasingly become a China growth story. This is an opportunity to invest more deeply and capture a higher return, and Starbucks will keep a larger share of future revenue for itself."

More control for Starbucks also means more risk. Four things are true of its position in China at once: the market keeps growing, but first- and second-tier cities are saturated and third- and fourth-tier cities may not yet support very aggressive expansion; China's policy environment is unstable, which makes a local partner more useful for reading the situation; the run of commercial-property booms that Starbucks depends on no longer looks reliable, which could hold it back; and, finally, new rivals may siphon off the customers it already has.

Why is Starbucks changing strategy?

According to AB Mendez and John Lutz, senior research analysts at Frost Investment Advisors, Starbucks' biggest worry is slowing sales.

For several quarters now, Starbucks has failed to hand the capital markets a set of numbers it liked. Neither global same-store sales nor revenue met analyst forecasts — so much so that Starbucks announced it would stop putting guidance in its earnings reports.

A middling performance at home in the United States, and the market turmoil that followed Brexit, have both left Starbucks on the back foot.

But more products and more stores can ease those worries, and China is the growth market Starbucks is counting on. As Chinese consumers pick up the habit of drinking coffee — or drinking more of it — transactions at Starbucks in China rose 6%, lifting same-store sales in China by 7%. Of the more than 1,000 stores that opened across Asia-Pacific in the past year, most of the credit goes to China, where consumption is expanding fast.

That is why, from last year right up to this acquisition, Starbucks has kept talking about how many stores it plans to open in China. In the market it has defined as its largest single market in the world, and its most important, Starbucks wants control back.

Another set of numbers shows the reasoning even more plainly. We ran a rough calculation: according to Starbucks' just-released third-quarter results, China/Asia-Pacific brought in $840 million from 2,800 stores, about $300,000 a store; globally, Starbucks brought in $5.6615 billion from 21,000 stores, about $270,000 a store. China earns more per store than the global average.

East China's weight in the China business is beyond argument: it holds nearly half of all the stores in the country. Shanghai alone has more than 600, more than any other city in the world. It was also the first city outside the United States to get a Starbucks roasting plant.

Set up a joint venture first, then take control back when the time is right — that is the standard Starbucks routine for entering a foreign market. In 1995 it formed a joint venture with the Japanese company Sazaby League to enter Japan, taking a 39.5% stake. After spending long enough learning the local market, in September 2014 it paid $913.5 million for the remaining 60.5%. What Starbucks learned in roughly two decades of working with a Japanese partner were the local rules. In Japan it learned to put out Japanese-style New Year's lucky bags every January, stuffed with coffee vouchers and thermoses; it learned to team up with Suntory on canned coffee and get into the convenience stores that sit on every corner in Japan.

Starbucks copied the model when it entered China in 1999. It gave the rights for Hong Kong and Guangdong to Hong Kong's Maxim's Group; the rights for the northern region centered on Beijing and Tianjin to Beijing Mei Da Coffee Co., Ltd.; and the rights for Taiwan and the Jiangsu-Zhejiang-Shanghai region to Taiwan's Uni-President Group. At the start, Uni-President Group held 50%, President Chain Store 45% and Starbucks just 5%. Putting in 5% at the outset is what Starbucks does in the great majority of its overseas investments. Letting local companies carry most of the operations and most of the capital lets Starbucks dodge a lot of risk while keeping headquarters tied to the foreign business. As it comes to understand the market, and as policy allows, it takes back control of the stores step by step.

In 2005, once mainland China began allowing wholly foreign-owned companies, Starbucks started converting its licensing and partnership arrangements on the mainland into company ownership. In 2006 it bought a 90% stake back from Mei Da Coffee, making all of North China wholly owned, and raised its stake in Maxim's Starbucks to 51%.

Back in 2003 Starbucks had already bought a combined 45% of Shanghai Starbucks from Uni-President Enterprises and President Chain Store — but that cost only 176 million yuan. The remaining 50% now costs $1.3 billion.

The deal still needs approval from the relevant regulators and is expected to close early next year.

What does it mean for Uni-President?

Uni-President is letting go of Shanghai Starbucks just as its momentum peaks, which looks like odd timing.

Uni-President and Starbucks go back a long way. Uni-President brought Starbucks to Taiwan in 1997 and to mainland China in 2002. Within East China, Shanghai stood out. In Taiwan, Starbucks lost money for three straight years; in Shanghai, where it arrived in May 2000, the business turned profitable in one year and nine months. In 2001, its first full fiscal year, Shanghai Starbucks took in more than 60 million yuan; by 2002 the figure was more than 100 million yuan.

Uni-President Group was then at its height in Taiwan, with food manufacturing, distribution, finance and related businesses. In the late 1990s, group president Kao Ching-yuan ranked fifth among Taiwan's most respected entrepreneurs and was called "the entrepreneur who changed life in Taiwan."

Starbucks picked Uni-President mainly for President Chain Store, the group's retail arm. When the joint venture was announced in 1998, Hsu Chung-jen, then President Chain Store's general manager, pointed to the company's record in chain retail as the reason he was confident it could repeat that success in coffee.

But Uni-President's plain decline on the mainland may be one of the main reasons Starbucks is dropping it.

According to Uni-President Enterprises' 2016 annual report, Uni-President China Holdings Ltd. ("Uni-President China"), which runs the mainland business, posted revenue of 20.986 billion yuan, down 5.1% from a year earlier — its third straight annual drop. Its 2016 profit fell 27.22% to 607 million yuan.

Since last year Uni-President has also been shedding businesses. Last May it sold a 47.83% stake in Jinmailang Beverage for 1.291 billion yuan. In November 2016 the group sold its entire stake in Foshan Sanshui Jianlibao Trading to the Jianlibao Group for 950 million yuan. All of these, though, were businesses that had been dragging results down.

In this deal, Uni-President Enterprises and President Chain Store will pay about $175 million for the remaining 50% of Uni-President Starbucks Taiwan, taking full control of Starbucks in Taiwan.

Put Shanghai Uni-President Starbucks next to Taiwan Uni-President Starbucks and the gap is easy to see.

Shanghai Uni-President Starbucks has been expanding at speed. It opened its first Shanghai store in 2000, and in its 2016 report it forecast that the count would pass 1,500 in 2017. Profit has grown with the store count, from 631 million yuan last year to 921 million yuan this year.

But that expansion will no longer have much to do with Uni-President.

At the press conference, Uni-President chairman Lo Chih-hsien would not say directly whether the sale was because Starbucks wanted its fast-growing mainland market back, stressing only that the company would pull its resources together and dig deeper into Taiwan. "Considering how the world coffee market will grow, we are thinking about how to be more focused and more consistent in our organization and our resources."

Taiwan Uni-President Starbucks, by contrast, saw profit fall from 184 million yuan last year to 79 million yuan. President Chain Store general manager Chen Jui-tang said in March that growth in Taiwan had slowed as the business fell in line with the loyalty program Starbucks USA was rolling out — and even so, Taiwan's profit remains far below Shanghai's.

Still, full control of Starbucks Taiwan may put Uni-President in a better position to improve its results there. In a Taiwan coffee market worth roughly 15.6 billion yuan, Uni-President Starbucks holds about a 10% share. And while coffee consumption in Taiwan has risen from 55 cups a person a year to 120, mature markets such as Japan and South Korea drink more than three times as much — so the Taiwan coffee market still has room to grow.

Tea failed because Starbucks ignored the power of space

Starbucks once treated the $40-billion tea market as a gold mine, paying $620 million in cash for the upscale tea company Teavana and then raising its own estimate of the market to $100 billion. Howard Schultz, CEO at the time, said the acquisition "will allow us to disrupt and lead this category the way we did with espresso 30 years ago."

In 2012 Schultz said every $1 invested in Teavana would return $3.

The China team sounded just as optimistic: "China's tea market has huge potential, which is why Teavana is Starbucks' strategic priority in tea. Over the next five years we will carry out our development plan effectively, and we expect the tea business to grow to $3 billion."

Starbucks turned out to have hitched tea culture to its own profits by mistake. One error was ignoring its own strength: the "third place."

When Starbucks bought it, Teavana's chief selling point was its wide sales network — but more than 500 of those outlets were Teavana stores selling canned tea leaves inside department stores. After the acquisition, Starbucks opened five street-front Teavana tea bars.

The usual explanation for Teavana's failure is that tea culture never took root in the United States. In fact it was Teavana's success at scaling up tea retail that attracted Starbucks in the first place. The real cause of the decline was that foot traffic in American department stores has fallen sharply in recent years, pushing same-store sales at Teavana stores down until the business was losing money.

Unfortunately, the habit of not opening standalone stores came to China too. To promote its two tea drinks — Shaken Peach Green Tea and Shaken Pomelo Honey Black Tea — Starbucks simply put them on the menu boards of its existing stores, which left Teavana's experience and brand presence close to zero. And what persuades people in China most of all is the Starbucks experience, the "third place."

With no space of its own, the two Teavana drinks were compared head-on with other tea brands, and they were not especially competitive on taste or price. Other customers complained they tasted thin — "more than half of it is ice."

Last January, Starbucks closed four of its tea bars and turned them into coffee stores, keeping only the one in Seattle, where it is headquartered. Teavana's drinks were moved into Starbucks stores, and the decision to close 379 Teavana stores affected 3,300 employees.

The new competitors: who is poaching Starbucks' customers?

The China that Starbucks faces now is far more complicated than the one where opening stores was enough to grow fast. It is not the only coffee brand adding stores here. Its rivals include European and American chains like Costa, and, now that the Korean coffee wave has passed, homegrown specialty cafés racing to turn themselves into chains and claim territory across the country.

Seesaw, which raised 45 million yuan in a Series A from Hony Capital this June, has opened 10 cafés in Shanghai and Shenzhen over the past few years and plans to move into Beijing, Hangzhou and elsewhere. Mellower Coffee has gone from one store to more than 20 since 2016. Zhiguan, founded by the Taiwanese advertising man Cheng Sung-mao, says it will use an O2O e-commerce platform to open 1,000 franchised stores nationwide, hoping to take the lower-tier markets before the market takes off.

Next to these specialty cafés, Starbucks has been losing its old appeal to first-tier-city consumers as the brand that taught them coffee.

One answer has been to launch new products often, and to shorten the lag between markets. The nitro cold brew, for instance, went on sale in China and the United States at almost the same time. The industry generally expects Starbucks to start developing products specifically for China.

A wider product line is also a way to raise revenue per store.

In early July, at Starbucks' 25th anniversary on Nasdaq, CFO Scott Maw said the company's immediate priority is to raise food's share of total revenue. Breakfast has done well, but lunch is the bigger part of future growth in food.

Starbucks China has been pushing lunch harder since last year. Gross margin on coffee is around 80% against only 50% on food, but Starbucks sells food using staff and space it already pays for, so food sales actually lift store profit. They also offset the cost of the low table turnover that comes with selling coffee alone.

Starbucks should also watch the rise of China's new generation of tea-drink chains. They look like a different category of competitor, but they threaten Starbucks on consumers' budgets and, depending on where they open, on foot traffic.

More importantly, this wave of tea chains is shaping a new consumer culture. Teavana and formats like it never got far in China, and the energy of street brands, the speed at which they change, and their grip on young consumers are precisely where Starbucks is weak.

Cover image from: Upslash