When Howard Schultz stepped into the first Starbucks store he was impressed..
“This is the kind of environment and product and young company I would like to be part of. Over the course of a year I kept banging the door to say to the founders,”If you expand the company I think I can help you”
Howard left Xerox and joined the tiny Starbucks company in 1982. Upon a trip to Italy to source coffee he realised that Starbucks should get into the business of selling coffee in cups, not just coffee beans by the pound …
“What struck me [in Italy on my first tour of coffee stores] was the sense of community. I would go to the store at the same time every day and I would start seeing the same people. I realised when I was in Italy that Starbucks was in the coffee business, perhaps the wrong part of the business. There was no service of any cup of coffee at any Starbucks. It was just pounds of coffee for home use”.
The Italian coffee houses weren’t just selling coffee, they were selling an experience..
“A lot of people said it was a crazy idea to roll out coffee stores, but we believed early on that what we had seen in Italy was replicable in America, through an American lens, it was thinking let’s create a store not only just a store for coffee but produces this sense of community between home and work. Early on we realised the brand we were going to build was going to be experiential”
After parting with the original owners and buying the Starbucks business in 1987, Howard realised that to grow, he needed to invest and that losses were inevitable..
“We weren’t profitable [in the first few years after I bought the company] but in order to grow the company and raise the money, we said kind of metaphorically, we want to build a one hundred story skyscraper, we’re going to have to invest to build the foundation. We started investing heavily. Like any other start up – investing in people, processes, IT and infrastructure – the company lost money almost from the day I bought it. Investors understood early on, we were going to lose money in order to build a much bigger company“
This is no different to many businesses today, in spite of most market participants’ demands for short term profitability. As Charlie Munger says “Almost all good businesses engage in ‘pain today, gain tomorrow activities“.
Starbucks continues to invest for growth; In a recent podcast I listened to, Investment Master Thomas Russo, highlighted why he likes businesses that show ‘A willingness to suffer‘. He touched on Starbucks’ foray into China…
“Companies that can make the trade off [to invest in growth] are much more powerful in their position to secure permanent and enduring franchises. The companies that choose to not swing for the long term fence leave themselves exposed. A company that faces this question of how to invest for the long term is Starbucks. I met the chairman of Starbucks recently and he was being grilled by a young analyst as to why he wasn’t showing profits in China. He expressed the trade-off so well when asked “when will you give us profits from China?” His answer was “How big do you want us to be?” And they asked again, back and forth. And finally the CEO said “It’s quite simple, We are profitable at the store level and we could easily be profitable at the country level. But we think China offers a vast opportunity and if we invest enough upfront, we will own the dominant brand in the category we create“.
If you’re the first-mover, in a category that is created by your brand, you have the first-mover advantage for eternity. And if Starbucks were permitted to invest for that type of profitable future they would have to be permitted to show losses at the start as they build warehouses, manufacturing, distributions and advertise aggressively. All with the idea of building an enduring franchise and in doing so generating reported losses for quite a considerable amount of time. They are willing to do it and as a result they won’t end up as one of thirty coffee companies sharing a market, but they have the chance of becoming quite powerful.
That’s the mindset you look for as a long term investor – brand, capacity to invest behind the brand and then the willingness to suffer from the investment until scale is reached. Then you have the benefit of that strong brand, created over that build up period, affording you pricing flexibility and price elasticity relative to consumer incomes because of the strength of the brand.”
Starbucks did things differently, they still do …
“Even today Starbucks is not a traditional marketing company. It sounds really old fashioned but we built the company one customer of a time, one cup at a time”
And like Jeff Bezos more recent experience in building Amazon Web Services, Starbucks was lucky enough to have a long runway without competition..
“I think the large companies [like Nestle] never believed you could build a national company and brand around selling coffee in a cup. I think they were naive, maybe arrogant and they gave us a lot of runway.“
In 1996, Howard convinced the board to expand internationally and open the first store in Japan. Consultants hired by the board recommended against investing in Japan, believing it would be a disaster .. it wasn’t.
“The board said we should probably hire an outside resource, a consultant – a word that really gives me hives. If we have to hire a consultant it means we don’t really know our business.”
Interestingly, the Seventh ‘Commandment of Business Failure‘ in Donald Keogh’s book is ‘Put all Your Faith in Experts and Outside Consultants‘. It should come as no surprise that both Buffett and Munger are on the same page ..
‘“We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.” Warren Buffett
“I have never seen a management consultant’s report in my long life that didn’t end with the following paragraph: “What this situation really needs is more management consulting.” Never once. I always turn to the last page. Of course Berkshire doesn’t hire them, so I only do this on sort of a voyeuristic basis. Sometimes I’m at a non-profit where some idiot hires one.” Charlie Munger
Howard stepped down as CEO in 2000 …
“I felt like I was repeating myself, I no longer felt engaged in the fun, creative part of the business where I get the most joy. I was not having fun. I decided I needed a break. I did step away. I was Chairman and as Chairman I should of been paying more attention to the company.”
Eight years later, in 2008, Schultz returned after Starbucks had lost its way and the share price hit a record low..
“Two things hurt the company, the country was heading into a cataclysmic financial crisis. I would describe those years as the years of hubris. Starbucks was growing at a pace at which growth and success began to cover up a lot of mistakes. Too many stores cannibalising other stores, financial controls and discipline not being leveraged. The big mistakes was Wall Street and the share price became an albatross on the company’s neck. Growth became the strategy and growth is not a strategy. Growth meant too many stores, growing in areas that should not have had a Starbucks and the experience, which had defined the essence of the company was being compromised by efficiency. The management team started measuring yield, sales per hour and doing things that were so dilutive to the essence of the foundation of the company. I began going into the stores and not recognising what we had built.”
Warren Buffett expanded upon just such an issue in his 2005 letter to shareholders..
“If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.
“When our long-term competitive position improves as a result of these almost unnoticeable
actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted.”
Howard decided to return as CEO because he loved the business …
“I came back for two reasons, what it means to love something and the responsibilitythat goes with it”
Like great investors, great business people love what they do. Donald Keogh, with more than sixty years’ business experience observed “I have never met a successful person who did not express love for what he did and care about it passionately.”
Howard closed 900 stores and retrained every employee on how to make quality coffee. Every store manager, ten thousand in total, were brought together in an auditorium and told they each needed to take every customer interaction personally and to act as if it was their own store. Failure to correct the situation would mean they were not going to be able to feed their families. Within a year, the downward spiral that almost engulfed Starbucks, was a memory.
Howard referred to his employees as partners and introduced free college tuition, health care, and stock options. Like him, many people in the company were not born with a silver spoon and he wanted to offer them a work environment not available to someone in his fathers’ day. Soon customers began to realise workers had ownership and the intimacy built between baristas and customer began to build. Starbucks enjoyed much lower staff turnover than the rest of the industry. He had created a win-win culture.
So what did Howard learn from the mistakes?
“The question was what did we learn? We were so hungry and so driven when we started the company. But when we were that successful people got sloppy and lazy. This is so vitally important.. Success in any business, no matter what it is, is not an entitlement, it has to be earned. And we stopped earning it and that is why we got in trouble”
“Building a company is a lonely place sometimes, your imprinted, especially as a man, of not demonstrating vulnerability. I think one of the most undervalued characteristics of leadership is vulnerability and asking for help. I’ve done that a number of times. When you’re vulnerable and ask for help people come towards you, I have tried to do that every step of the way and be honest and truthful about what I know and don’t know and most importantly what I believe.“