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BW 50: Strong Lattes, Sour Notes at Starbucks


For Starbucks Corp. (SBUX), the success of upstart folk rock band Antigone Rising couldn't be more delicious. The girl group's debut album, From the Ground Up, was promoted by Starbucks and for now is only on sale at the coffee shops. It's doing well: 35,000 CDs in its first three weeks. The New York City band has been deluged with requests to appear on late-night TV and music cable shows.

But Antigone Rising is one of the few sweet notes in the company's effort to blend coffee with music. Its new Hear Music media bars, which let customers burn CDs at Starbucks shops from a digital library of more than 150,000 songs, have been as disappointing as a tepid latte. And its broader goal of, as Starbucks Entertainment CEO Ken Lombard puts it, "transforming the way music is discovered and delivered" seems like marketing froth so far. This is Starbucks' most ambitious attempt yet to become known for something more than java, and a stumble could ding one of the world's best-known brand names.

That said, for all of its talk, Starbucks isn't necessarily looking to make big money in the music business. CIBC World Markets' (BCM) restaurant analyst John Glass estimates that Starbucks' annual revenues from the music bars could add up to $120 million at most, or just 3% of the company's $4.5 billion in U.S. retail sales. Glass figures Starbucks breaks even if customers create 1,600 CDs annually at each store. That would add between 4 cents and 7 cents to earnings per share. Even the success last year of Starbucks' multiplatinum Ray Charles album, Genius Loves Company, earned the company more buzz than anything else. Same goes for the Starbucks music channel it launched on XM (XMSR) satellite radio last year.

OFFICIALLY UPBEAT

Starbucks is investing cautiously enough that any impact would be minimal should this prove to be another ill-fated attempt to sell something else, anything else, with the Starbucks name on it. Indeed the company is in a position to take some risks: It enjoys a 10.6% operating margin, and its shares are up 34% from its 52-week low.

So what's really at stake here? Chairman Howard Schultz's deep conviction that Starbucks can be different from other retail chains: that it can offer people a place to do the things we spend much of our time on these days, such as connecting to the Internet and downloading music.

Despite evidence that the CD-burning service isn't doing well at the 45 test shops in Seattle and Austin, Tex., set up last fall, Starbucks is officially upbeat. It plans to roll out more media bars this year and expects eventually to have them in up to two-thirds of its 4,500 U.S. stores. "Our excitement is as high, if not higher, than when we initially launched our strategy," says Lombard.

The reality isn't so exciting. Hear Music insiders say the response at the stores in Austin -- a college and live-music town -- has been disappointing. Even in Starbucks' home city of Seattle, few customers were listening to the music during recent visits to four stores with media bars. During several hours at each of the four spots, only one CD was burned.

The Austin experiment could be a sign that Starbucks is misreading its customers. The city is full of tech-savvy music downloaders who carry iPods, not portable CD players. Digital music these days means MP3 file mixing and sharing, and that's not in the business model yet, says digital music analyst Josh Bernoff of Forrester Research Inc. (FORR)"Starbucks is not going to be a significant contributor to the music economy."

Besides the unproven premise that customers want to download music at a coffee shop, Starbucks' fees are high. It costs $2 to use the media bar, $8.99 for the first seven songs, and then 99 cents per song. Apple Computer Inc.'s (AAPL) iTunes Music Store charges just 99 cents a song, and Wal-Mart Stores Inc. (WMT), just 88 cents.

FAILED EXPANSIONS

Lombard does seem to sense that the media bars are using yesterday's technology. With more investment, the bars could become MP3 compatible and dispense with CD burning altogether, he says. Starbucks also could provide exclusive music to its WiFi customers. "We fully expect as digital delivery options change, so will we," he adds.

It isn't the first time an ambitious Starbucks expansion struggled. Its glossy magazine, called Joe, failed in 1999. In 2000, Starbucks killed an Internet lifestyle portal, taking a $20.6 million write-down from its investment in Living.com. Starbucks ice cream and bottled coffee sold outside Starbucks have done well, but Starbucks coffee liqueur got the company tossed from socially conscious mutual funds.

Investors have remained muted so far because Starbucks is showing financial restraint. The cost per unit, estimates CIBC, is $18,000 to $20,000 per store, making the bill for 3,000 stores about $57 million. That's a small sum compared with the $600 million in total capital-expansion spending that Starbucks has scheduled for fiscal 2005.

But more than dollars and cents are at stake for Starbucks. The media bars are all about creating the right atmosphere in stores, an ephemeral quality that executives believe only lasts if it is constantly improved or at least freshened up a bit. The strength of the Starbucks name does give it more room than some others to take risks without losing coffee customers. But music might not be Starbucks' cup of coffee.

By Stanley Holmes in Seattle


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