Starbucks Corporation's High-End Strategy Could Help It Win Back Coffee Snobs

By Markets Fool.com

Starbucks recently opened its first high-end Reserve Roastery and Tasting Room in Seattle, nine blocks away from its first store in Pike Place Market. The Reserve Roastery is a massive, 15,000 square foot "coffee lab" for small-batch roasting of its premium line Reserve coffee.

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Starbucks intends to eventually start offering Reserve coffee -- which was previously sold at select locations for $13-$50 per eight-ounce bag -- to 1,500 global locations. It also plans to open more than 100 Tasting Rooms across the U.S. over the next five years, starting in Chicago, Los Angeles, New York, San Francisco, and Washington D.C.

Why start in America?
To understand why Starbucks is launching this premium initiative across America, we should understand the challenges it currently faces. In fiscal year 2014, Starbucks' Americas region accounted for 72.7% of its revenue and 86.9% of its operating income.

In the fourth quarter, Starbucks' comparable sales in the Americas rose 5% year over year -- a solid figure compared to McDonald's 3.3% decline and Dunkin' Brands' Dunkin' Donuts growth of 2% in U.S. comparables in their most recent quarters.

But 5% growth represents a notable slowdown from previous years -- in 4Q 2013, Starbucks' comparable sales in the Americas climbed 8%, and in 4Q 2012, they rose 7%. That slowdown raised concerns that Starbucks, like McDonald's, was running out of room to grow across the Americas.

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Yet the notion that Starbucks' American growth is slowing down because of market saturation is misguided. In the U.S. and Canada, Starbucks has unmatched regional reach, yet it struggles in certain states. According to research firm Flowing Data, Starbucks dominates the U.S. west coast, but coffee drinkers on the east coast overwhelmingly prefer Dunkin' Donuts. Tim Hortons dominates Canada and large portions of the northeast U.S. This means that Starbucks could still have room to keep growing across the Americas, and selling higher quality coffee could be a good start.

Quality matters
Starbucks often ranks poorly among coffee aficionados. Online magazine The Bold Italic once rated Starbucks' Medium Roast House Blend as the worstof six packaged coffees in a blind taste test. Last year, a Consumer Reports blind tastetest claimed that Wal-Mart's Great Value coffee tasted the same as Starbucks coffee. Others have nicknamed the coffee chain "Charbucks," claiming that Starbucks coffee tastes harsh and overroasted.

Those complaints wouldn't matter much to a low-end fast food chain like McDonald's, but they matter to Starbucks, which built its reputation on sellingpremium coffee for over $4 a cup. To maintain that high-end image in the U.S., Starbucks temporarily closed all its U.S.stores to retrain employees in 2008, acquired San Francisco-based Bay Bread (La Boulange) in 2012 to improve its baked goods, and started selling wine and beer atselect locations earlier this year.

But none of those initiatives helped Starbucks shake its image as a chain competing against Dunkin' Donuts and McDonalds' McCafe. However, launching "coffee museums" showcasing their best beans and sending them to select locations will create an additional premium price tier within its stores. This could help Starbucks shed its strip mall image and boost U.S. comparables growth over the next few years.

Growth potential abroad
Starbucks also plans to open its first Reserve Roastery and Tasting Room in Asia in 2016 as part of a multi-city expansion. Starbucks previously opened its first Reserve store (not a tasting room) in Tokyo, Japan in 2011, and has since expanded the premium brand to select locations in China.

Starbucks' Asia Pacific region only accounted for 7.4% of the company's revenue and 12.1% of its operating income last quarter. But it's also Starbucks' fastest growing and most profitable region, with 7% year-over-year comparables growth and an operating margin of 33.5%.

In newly affluent markets like China, where Starbucks has opened nearly 1,400 stores, a cup of Starbucks coffee is widely considered a status symbol by the rising middle class. Adding a higher price tier of coffee to this market could widen regional margins further while offsetting rising coffee costs. Moreover, it could reinforce Starbucks' reputation as a premium brand before its novelty wears off.

Why Starbucks investors should care
As a long-term Starbucks investor, I admire the company's plan to reinforce its position as a premium brand with massive coffee museums and better small-batch brews.

This focus on quality, which is what investors have come to expect from CEO Howard Schultz, is an assuring departure from the "Starbucks as a brand" approach of his predecessor, Jim Donald, who spent more time selling CDs and energy drinks instead of improving its coffee. If Schultz's Reserve expansion goes as planned over the next few years, it could attract fresh customers and boost comparable sales growth across the Americas and Asia.

The article Starbucks Corporation's High-End Strategy Could Help It Win Back Coffee Snobs originally appeared on Fool.com.

Leo Sun owns shares of Starbucks. The Motley Fool recommends McDonald's and 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.