By Megan Barnett
February 18, 2011

Starbucks announced earlier this week it’s wading into the single-serve market and its entrance into the business could revolutionize the coffee machine.

by Howard Penney, Hedgeye

I’m not privy to the thought process or grand strategy of Starbucks but I have been covering the company since the day it came public. So I wasn’t so surprised when the company announced earlier this week that it struck a deal with Courtesy Products to provide high-end hotels with single-serve cups of coffee, effectively dousing rumors that it would partner with single serve market leader Green Mountain Coffee (GMCR). The idea of Starbucks putting their coffee through Green Mountain’s Keurig machine does not make sense.

Why? A few weeks ago, I spent a weekend reading The New Rules of Retail, by Robin Lewis and Michael Dart, a tour de force that I believe offers a tremendous look-back and look-forward at the past, present, and future of retail, and of Starbucks in particular. I highly recommend it.

Without wanting to spoil the book, the key shifts in the consumer that Lewis and Dart outline pertaining to the new, third “wave” of retail are:

  • From needing “stuff” to wanting experiences
  • From conformity to customization
  • From plutocracy to democracy
  • From wanting new to demanding new and demanding now
  • From self to community

I see the first bullet as being most crucial here; the chains that offer an experience, and the anticipation of such, are thriving while those standing still in this regard are faltering. Starbucks offers an addictive product and its CEO Howard Schultz has succeeded, for many people, in creating a “third place” between work and home.

But it has learned some lessons the hard way. Simply by way of human nature, confidence can grow to outsized proportions and a company’s store base can grow in step with that. Lewis and Dart, in discussing Starbucks, reference a 2007 internal memo from Schultz to then-CEO Jim Donald that was highly self-critical, lamenting the concept’s move towards standardized, aroma-less, uniform stores that were seen as “sterile” and “cookie cutter”.

Moving back towards former practices and restoring the experience has yielded positive results for Starbucks. On new channels of growth, and Via in particular, Lewis and Dart have this to say: “If Via, its new instant coffee brand, is going to have sustained resonance in the supermarkets, it will be because people associate it with the Starbucks experience in the stores. If that experience remains strong and powerful, Schultz’s wholesale strategy for growth will succeed.”

Starbucks (SBUX) has certainly been taking up a lot of airtime of late, beginning with the dispute with Kraft (KFT), then with its most recent strong earnings release, and now with the speculation around the myriad possible avenues it may take towards growth in the single-serve market. I believe that the quote in the last paragraph is crucial to this whole story; customers have to associate the consumption of Starbucks’ products with the Starbucks in-store experience for it to truly gain traction and serve as a vehicle for earnings growth.

Lewis and Dart also outline control as a key attribute of successful retailers heading into the next phase, or third wave, of retail. Having maximum control, if not outright ownership, of their entire supply chains from creation through consumption, is a key characteristic of the winning brands.

The dissolution of the agreement with Kraft fits neatly into this framework. Both sides have been outspoken in their public and mutual admonishments. Starbucks, for its part, has alleged that Kraft failed to meet certain provisions of their arrangement, including keeping Starbucks involved in major marketing initiatives. Whether or not one agrees with this statement – I have no insight to how true or untrue it is – what is clear is that Starbucks is expressing a frustration at a lack of control over the distribution segment of its value chain. In extricating itself from the agreement with Kraft, Starbucks will likely take a charge that will ultimately prove to be an investment in that it will allow the company to assume more control of its distribution chain in perpetuity.

Given the healthy nature of Starbucks’ balance sheet, I think any incurred cost will be kept firmly in perspective; the company appreciates the importance of control.

The single-serve saga is just another act in this play and I do not believe the overall theme will change. Starbucks is a company that is forward-looking and our view is that its entrance into the business will revolutionize the coffee machine. Here is my prediction of what the new Starbucks machine will be like (if not at first, then version 2.0, 3.0 etc.). Notice that while some of these attributes seem fanciful, they all have founding in both Starbucks’ quest for control and the overall direction of retail, as described by Lewis and Dart and as confirmed by the trends within the space:

  • The design of the machine will evoke the design and feel of the Starbucks store and experience. I would think black and green, as well as the Siren logo, will feature. (experiences)
  • The name will also likely evoke the store. “My Barista”, “The Siren,” or other names along those lines are likely. (experiences)
  • The experience will be customizable, perhaps a touch screen or another user interface that allows the user to provide the machine with specific instructions as to the composition of the coffee they would like. (customization)
  • A “menu” (like a playlist in iTunes), where one can save a recipe or style of coffee for repetitive use and save it with a name like, “Jim – morning coffee.” (customization)
  • Connection to the Internet via home computer system to allow the sharing of “menus” and reception of coffee ideas from Starbucks and fellow machine-owners. This also allows a direct tap into social networking for the new machine. (community)

I’m sure this imagining of ours will be received by many with a high degree of skepticism. But if not Starbucks, who? If not now, when? This machine, or something like it, will happen. Starbucks has the ambition, financial muscle, and forward-thinking management team to make it happen. And I believe they will want to be in the driver’s seat, they didn’t seem overly content sharing control with Kraft.

I believe Starbucks will ignore the naysayers and enter the single serve market by revolutionizing it. As we have outlined in the prior “parts” of this post, beginning in January, “Starbucks will do to the single serve coffee maker what Apple (AAPL) did to the market for portable mp3 players”. In The New Rules of Retail, Lewis and Dart write the following on Apple, “Each purchase, be it an iPod, iPhone, iPad or otherwise, is then customized by each customer to reflect their individual tastes. This is one of the best examples of a co-creation of experiences with Apple as the platform.” Starbucks will create a co-creation of experiences between the office, the home, and the store in the same fashion.

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