Is Starbucks Pushing Prices Too High?

The upscale coffee chain may have reached the ceiling on what its increasingly budget-conscious customers will pay for a latte

by Burt Helm and Jenna Goudreau

Editor's Note: This is an update to a story originally published on July 31. This update incorporates third-quarter results announced Aug. 1.

Ali Zouaouid enjoys watching the Starbucks on 49th Street and Seventh Avenue in Manhattan get busy. He runs the coffee and pastry cart on the street nearby. When the lines inside Starbucks get long, customers flock to his cart instead, where a small cup of coffee is only 75¢. At 9:45 a.m. on July 31, as four headset-clad baristas scramble to take orders, about 20 people are in two lines that snake around the inside of the Starbucks store. That morning, Zouaouid also got an extra helping hand: Starbucks had just raised prices by an average of 9¢ a cup. "It's very good business," he says, grinning widely.

Certainly most of the customers stayed inside to wait for their Starbucks drink. But as Starbucks (SBUX) prepares to announce its third-quarter earnings on Aug. 1, the company is struggling to continually boost the amount each customer pays at the cash register while it tries to add new customers. Some on Wall Street wonder whether, after 15 years of blockbuster growth, Starbucks will finally be unable to show an increase in the number of transactions at the cash register—the prime indicator of customer numbers. "That's the big unknown, the big question," says John Glass, analyst with CIBC World Markets. More troubling, now there may be signs that Starbucks, famously the purveyor of the $4 latte, won't be able to raise prices much higher.

Margin Squeeze Pulls Down Stock

After the bell on Aug. 1, Starbucks announced its third-quarter results. Earnings were in line with analyst estimates, with revenues rising 20%, to $2.4 billion, and net income increasing 9% to $158.3. Investors cheered the news, bidding up Starbucks' stock by 3% to more than $28 a share in after-hours trading.

Still, the stock has dropped by 20% over the past 12 months and many concerns remain. Operating margins declined to 10.4% from 10.9%, because of increased expenses such as building costs and renovations. And same-store sales growth remains a tough challenge. Sales at stores open more than a year increased by 4% for the period. But 3% of that came from an increase in the value per customer transaction, including price hikes. "Less than 1%" of the same-store increase came from the number of transactions in store, said Michael Casey, the company's chief financial officer, in a conference call with analysts. "'[Foot traffic] continues to be impacted by a number of factors," he said. "There is an increased competitive environment, there is increased pressure on consumers from macroeconomic factors." Casey also said that while he thought there was a possibility that the latest price increase "could have a modest negative impact on transaction growth," he said the company didn't expect it to have a significant impact on next quarter's same-store sales.

To improve same-store sales growth, Starbucks has said it will slow new-store growth to avoid cannibalizing customers from existing stores. Instead of increasing the number of new stores added each year, Starbucks will build 1,700 each year for the foreseeable future.

Starbucks has raised prices seven times since 1997. Each time, there has been little effect on demand, according to analysts, and they say they expect the July 31 price increase to be the same. However, with increased competition and new growth coming from less-affluent customers, that could change in the near future.

Fast-Food Java Joints

First, there's vastly increased competition in the coffee market. McDonald's (MCD) recently entered the fray with its own "Premium" coffee, which it sells for $1.39 for a small size, compared with Starbucks' $1.75. A juggernaut with 13,794 stores that spends roughly $782 million in advertising in the U.S., McDonald's has been aggressively marketing its coffee to win breakfast-time customers, even giving it away in some regional promotions. And it's been winning plaudits for quality. Consumer Reports conducted head-to-head comparisons with the coffee from Starbucks, Dunkin' Donuts, McDonald's, and Burger King (BKC)—and McDonald's won the top prize.