Chapter 1

Why aren’t there any
Starbucks stores in Italy?

Starbucks opened its first European store in 1998—in the UK.

Today, the only countries in Western European without a Starbucks are the small and mostly poorer markets of Albania, Bosnia, Croatia, Liechtenstein, Macedonia, Malta, Serbia, Slovenia.

And Italy.

Which is where Starbucks, as we know it today, began, back in 1983. As Businessweek put it: “If it weren’t for Italy, Starbucks might not exist.”

The first Starbucks outlet in Italy will open in 2018. Twenty years after Starbucks first crossed the Atlantic.

What took them so long?

This hardly seems like the first question that would come to anyone’s mind. Yet the answer is the key to understanding Starbucks’ success, some of its failures—and how it has permanently changed people’s coffee-drinking habits.

As Howard Schultz relates the story in his book Pour Your Heart Into It: How Starbucks Built a Company One Cup at a Time, he was in Milan on business. He was marketing director of Starbucks, at that time a Seattle-based coffee roaster and retailer of coffee beans. There, “I discovered the ritual and romance of coffee bars in Italy.”

 

Clue #1: Permanently Change People’s Habits

When you see a product like the computer, which has replaced typewriters, low-cost airlines that attract people who’ve never flown before (not to mention rich cheapskates), and innovations like the Tetra-Pak which replace plastic and glass bottles and containers—and has revolutionized the shipping industry—you know you could be onto the next “big thing.”

 

Inspired by what he saw, Schultz spent his spare time in Milan wandering through the streets and piazzas, observing customers, baristas, and sampling espressos at a handful of the 1,500-odd coffee bars in Milan back then.

It seemed they were on every street corner, and all were packed. . . . My mind started churning. . . .

As I watched, I had a revelation: Starbucks had missed the point—completely missed it. . . . What we had to do was unlock the romance and mystery of coffee, firsthand, in coffee bars.

Schultz returned to the United States with the vision of what would eventually become Starbucks as we know it today: a fusion of Italian espresso café culture with a McDonald’s-style operating model.

Vainly, he tried to persuade his employers to expand into espresso bars. Despite repeated rejection, Schultz was persistent. When Starbucks opened a new store in downtown Seattle, he was offered a small corner for an experimental coffee bar.

It was a success.

Nevertheless, Starbucks’ management decided to “stick to its knitting” and not embark on a brand extension. So Schultz quit to pursue his dream, starting Il Giornale in honor of the Milan espresso bars which inspired his epiphany.

From the beginning, Schultz was aiming high: Il Giornale stores all over the US, if not the world. When his former employer came up for sale Schultz had five Il Giornale stores: three in Seattle, plus one in Vancouver and another in Chicago.

Why Vancouver and Chicago, when it would have been easier, not to mention more economical, to open stores closer to home? Schultz wanted to prove to his investors (and himself) that his concept would travel, whetting their lips for the profits to be had in a nationwide chain.

In retrospect, Schultz’s 1987 purchase of Starbucks was a stroke of genius. After all, “Il Giornale” was not an Italian espresso bar, but an American one. Added to which, for too many Americans, “Il Giornale” was unpronounceable.

Changing the company’s name to Starbucks was an unexpected bonus to the obvious fit of having an in-house coffee roaster experienced in sourcing high-quality coffee beans from around the world.

Eleven years later with 1,412 stores in the US and Canada, Japan, Singapore, and the Philippines, Starbucks began expanding into Europe. The UK was the first stop, but Italy was one of the countries on the list.

Yet, today, as I write these words, there’s not a single Starbucks in Italy.

Why not?

We can find the answer some 9,000 miles away in Australia, almost on the other side of the globe.

In 2008, for the first time since it was founded, Starbucks shrank. It closed underperforming stores all over the world. The most, 661, were in the United States. But the worst-hit country was Australia, where 61 of Starbucks’ 84 stores disappeared.

What went wrong in Australia?

To start with, Starbucks was nothing new.

I’m Australian, and I had my first cappuccino as a university student in the late ’60s. It was in a coffee shop called Gus’s Café in Canberra, Australia’s capital

Started by a Viennese named Gus, he’d fought city hall for the right to place tables outside, on the sidewalk. We students cheered him on, if only to give the local government a bloody nose. It became one of our favorite hangouts.

 

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Gus’s Cafe

The history of Gus’s Café sounds rather like the experience of Howard Schultz some 16 years later:

Canberra’s thriving, cosmopolitan café society owes much to the perseverance and vision of one unique individual—Augustin “Gus” Petersilka (1913-1994). A Vienna native, Gus brought the concept of the continental-style café with him to the nation’s capital. His idea was simple, yet radical, for its time—the promotion and cultivation of a relaxed and convivial outdoor dining environment in the heart of the city.

However, turning this dream into reality didn’t come easily and Gus’s epic battle with local bureaucrats and council officials (including a petition to the Queen) is now legendary. Gus’s passion and determination resulted in the opening of Canberra’s first open-air, late night café in 1968.

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Gus was one of many European immigrants—from Italy, France, Germany, Greece, and Austria—who brought the continental coffee culture to Australia after the second world war.

The result is that today you can get a great cappuccino, espresso, or latte just about anywhere in the country. And I mean anywhere. The best cappuccino I’ve ever had was in some small country town I drove through on the way to somewhere else. I can’t recall the name of the town, which was about 200 miles northwest of Sydney with a population of a couple of thousand people—or the café.

The selection of this café was pure chance: a pleasant-looking place to take a break. The superb (compared to the usual good-to-excellent) cappuccino was a surprise bonus.

Long before Howard Schultz had his epiphany in Milan, Australia was, like Italy, “cappuccino country.”

When Starbucks opened up in Australia, it brought nothing new or different. And certainly not better.

But in the United States, the UK, Canada, and many other countries Starbucks flourished. For espresso, these countries were—

Virgin Territory

In 1976 I went to graduate school at UCLA. (I quickly dropped out, but that’s another story.) Back then, the best coffee you could get was the stuff that had been sitting on a hotplate for half an hour. Unless you made drip-coffee at home. If there was an espresso available anywhere in Los Angeles back then, I never heard of it.

Returning to Australia from LA, I stopped in London. The coffee there was even worse. (And let’s not talk about the service: “execrable” fails to describe how dismal it was.)

 

 

 

Neither the US nor the UK had an “espresso culture.”

Howard Schultz’s epiphany in Milan was (with the benefit of hindsight) very simple:

If Italians like sitting around in cafés sipping espressos, so will Americans.

His test with Il Giornale confirmed his insight. And Starbucks’ expansion around the world—generating hundreds if not thousands of competitors—proves it conclusively.

But not yet in Italy. Indeed, with the exception of New Zealand and Switzerland, Starbucks has limited penetration in espresso-culture countries, measured by the number of stores per million people:

Country	Number of Starbucks Stores	% of all Starbucks stores	Stores per million people
US	13,327	54.5%	41.1
Canada	1,437	5.9%	39.6
Singapore	125	0.5%	21.9
Hong Kong	154	0.6%	20.9
Taiwan	380	1.6%	16.2
UK	884	3.89%	13.6
Japan	1,1191	4.9%	9.4
Malaysia	220	0.9%	7.1
Thailand	264	1.1%	3.9
Philippines	283	1.2%	2.9
Saudi Arabia	79	0.33%	2.8
China	2,205	9.5%	1.7
India	83	0.3%	0.1
Espresso culture countries
Switzerland	63	0.3%	7.5
Netherlands	63	0.3%	7.5
Austria	18	0.1%	2.1
New Zealand	25	0.1%	2
Germany	161	0.7%	1.9
France	121	0.5%	1.9
Australia	23	0.1%	1
Italy	0	0%	0.0

As at 28 March 2016 (includes 365 Teavana store). Source: http://www.loxcel.com/sbux-faq.html

Virgin territories are far more profitable. Which explains why Starbucks has the most stores per capita in countries like the US, Canada, Hong Kong, Singapore, and Taiwan, where it changed people’s habits.

Even non-espresso markets like Malaysia, Thailand, and the Philippines, where per capita incomes range from 21% (Malaysia) to a mere 4.9% (Philippines) of the US, can be more profitable than Italy (per capita income: 75% of the US). As the table shows, Starbucks has a higher penetration rate in these three countries than it has in any continental European country, other than Switzerland and the Netherlands.

And, to come, are the markets with the most long-term potential of all: China and India. Already, Starbucks has more stores in China (2,204) than it has in the whole of continental Europe, plus Russia (1,629)! With the same penetration rate as the Philippines (2.9 stores per million people) Starbucks could have around 7,500 stores in China and India, over half the US number. And in the long run, both markets could be way bigger than the US.

Compare that to Italy’s potential: with the same penetration as France (1.7 per million), about 102 stores. Easy choice.

Schultz changed people’s habits, turning drip and instant coffee drinkers into espresso drinkers, by the millions—when Starbucks entered virgin territory.

While Starbucks is certainly the most spectacular recent example of this phenomenon, it is merely the latest entrant in what we can term—

The McDonald Brothers’ Fast-Food Revolution

The restaurant business before McDonald’s was like the car industry before Henry Ford’s Model-T. Cars were made in small production runs or even hand assembled, one at a time, by skilled craftsmen. They were expensive, often unreliable, and only the wealthy could afford them.

The Model-T was the world’s first mass-produced automobile. Introduced in 1908, it cost $950, less than half the price of the average auto. It sold 10,000 units in its first year.

By 1920 the price had fallen to $280: as Ford refined his production techniques, he passed his lower costs to his customers. When the last Model-T came off the production line, 15 million had been sold and over half the cars in the United States were Model-Ts.

Ford’s innovations revolutionized the automobile business, and were quickly copied by other manufacturers. As a result, cars became a mass market consumer good rather than a niche product reserved for the wealthy few.

In 1948—40 years after the Model-T’s introduction—brothers Richard (“Dick”) and Maurice (“Mac”) McDonald set in motion a similar revolution in the restaurant business.

By offering a limited, self-service menu of burgers, fries, soft drinks, and shakes, they made eating out an affordable experience for just about everyone.

Today, we think nothing of taking the kids to McDonald’s or one of its many clones. But in 1948, for the majority of people a visit to a restaurant for the majority of people was a special occasion, mainly reserved for birthdays, anniversaries, and the like.

The major change that helped drive the growth of McDonald’s and similar chains was the post-war boom that slowly eroded people’s “Depression mentality.” From conversations I’ve had with American friends in their late 60s, even when their parents graduated from the poor to the middle class, they continued their Depression-inspired habits of rarely eating out.

It was the next generation who were happier to spend rather than skimp. And this happened at the time the McDonald brothers dramatically cut the price of eating out. Their hamburger cost just 15¢, half the price charged by most other vendors. They achieved this dramatic price reduction by—

• Limiting choice to just four items: burgers, fries, soft drinks, and shakes, compared to the standard restaurant menu which can run to a small book. Rather than holding inventory to make twenty or a hundred different dishes, they needed to stock only for four.
• As a result, they could apply Henry Ford’s assembly line concept to the preparation of food. Instead of cooking one meal at a time, they had special equipment made by a local craftsman that cooked two dozen burgers at once, while another machine prepared the same number of buns. Production was broken down into components: frying the patties, preparing the buns, assembling the burger, preparing the fries and drinks—with countermen to serve the customers. As a result, qualified cooks could be replaced with unskilled workers. And as a self-service restaurant, no waiters were needed.
• They also cut the startup cost. In the 1950s, a McDonald’s-style restaurant could be set up for around $75,000, including land and building, compared to $300,000 and up for other restaurants.
• Overall, they dramatically cut the cost of production, passing the savings to their customers: McDonald’s 15 cent hamburgers attracted buyers in droves.

Today, we take this for granted. But back then the whole world was virgin territory for their concept.

Other restaurateurs, mostly in California, quickly copied their low-cost production methods. Fast food chains like Taco Bell, Kentucky Fried Chicken, and Burger King all had their beginnings in the late 1940s and early ’50s—inspired by the McDonald brothers’ store.

But most of the copycats strayed from the brothers’ concept in one or more ways. Some expanded the menu, others charged higher prices, and few of them reached the McDonald brothers’ standard of efficiency and cleanliness.

Until Ray Kroc came along and turned the McDonald brothers’ fast-food revolution into a nationwide, and later global, phenomenon.

The McDonald’s Revolution, Part II

In 1954, Ray Kroc signed an exclusive nationwide franchise deal with the McDonald brothers, and opened his first store in April 1955 in Des Plaines, Illinois. He “cloned” the original store, maintaining (and eventually improving) the brothers’ highly efficient production methods, limited menu, and affordable prices.

Stretched for capital, he turned to franchising and—as we’ll see in Chapter 5—developed a highly profitable franchising method which was also very affordable to the franchisee. It also enabled him to maintain a tight control on the quality of franchisees’ operations resulting in high standard of consistency across different stores. A consistency we now take for granted that was unusual at the time.

Thus, he invented the franchising model that’s virtually universal today. When Kroc started out, franchisors made their money from selling franchises: few of them paid much attention to whether franchisees maintained standards, flourished—or went out of business. To Kroc, his franchisees were his business partners: they swam or sank together. Kroc’s profits came from the same source as his partners’: customers.

McDonald’s took off: by 1972 it was the world’s biggest restaurant chain by sales, a position it has held every year to this day.

To appreciate the magnitude of the “McDonald’s revolution,” imagine for a moment a world with no McDonald’s, no Burger King, no Pizza Hut, no Kentucky Fried Chicken, no Taco Bell, none of their many competitors, and no other fast food chain inspired by the McDonald’s model. Not even a Starbucks!

If you want a hamburger you head to a “Greasy Louie’s” and wait for it to be prepared—praying the cook isn’t having a bad day. Or, you could go to a hot-dog stand, or a diner like Denny’s. Or to plenty of other sit-down restaurants—which cost two, three, or many more times the price of a McDonald’s “Happy Meal.”

On top of that, disposable incomes in the 1940s and ’50s were a mere quarter what they are today. We could now afford an occasional Big Mac—except there weren’t any to be had.

With rare exceptions, most of us would eat at home—just as our parents and grandparents did.

The McDonald brothers proved this. Their new store was in the working class area of San Bernardino, California: before long a major part of their business came from families eating out for the first time.

Ray Kroc and the McDonald brothers changed the way people eat—and revolutionized the restaurant business in the process. “Fast food,” as we know it today, simply did not exist on any scale before McDonald’s restaurants—and their countless copycats—began appearing across the United States.

Whole Foods and “The Law of Attraction”

Whole Foods was not the world’s first organic, environmentally friendly health food store—yet, it was the one that changed people’s habits.

Founder John Mackey’s genius—as we’ll see in more detail in Chapter 4—was to create a unique customer experience in the supermarket space. We go to other supermarkets to restock the refrigerator; a Whole Foods store is actually a pleasure to visit, a place to have lunch or just hang out as well as load up your trolley with goodies.

Other health food stores existed to serve the niche market of people who were already sold on the idea of eating “whole foods.”

Mackey reached out to “non-foodies” by applying the “law of attraction.” Though an evangelist on the subject of eating well (Mackey himself is a vegetarian) by offering a close to full range of foods, including many that a strict health food addict would reject, Whole Foods’ “soft sell” approach creates many loyal customers who come for the range, product quality, and ambience—but start to change their diets nonetheless, even if minimally to begin with, thanks to the ease of selecting more healthful foods.

As a result, Whole Foods’ success has forced other supermarkets from Safeway and Kroger (and even Walmart) to the corner health food store to alter their product lines.

Which Comes First: the Chicken or the Egg?

Total sales of food products in the US have been rising at around 2% per year. But Whole Foods’ organic foods niche between 1996 and 2011 expanded at 18% a year. Is this because Whole Foods and its competitors persuaded people to adopt healthier diets? Or did changing consumer demands drive their growth?

The answer is rarely a simple one.

Steve Jobs built Apple by producing products like the iPod, iPhone, and iPad that nobody knew they wanted until Jobs and his team created them. At the same time, that latent demand had to be there or those product launches would have failed.

The only way to be certain that latent demand exists is to dip your toe in the market. Howard Schultz tested his concept with a small espresso counter in a corner of a Starbucks store when Starbucks was just a coffee roaster. Its success enabled him to gather enough investors to launch Il Giornale.

McDonald’s originated when Dick and Mac McDonald decided to close their previous business, a “car hop” they started in 1937. It had become a hangout for teenagers, giving it an unsavory reputation with the adult and family market.

Analyzing their business they discovered that 80% of their sales were hamburgers, which spurred them to refurbish their store as a hamburger-only restaurant. Sales and profits were lower to begin with: only after a year did they recover to previous levels—and then accelerate to new heights.

By the time of Ray Kroc’s visit, the McDonald brothers had thoroughly tested, refined, and proven their concept.

Had that latent consumer demand for Schultz’s and the McDonald brothers’ tests failed to exist, we would never have heard of either of them.

Only in the case of Walmart does the answer appear clear-cut: few people in this world will turn down the offer of a lower price.

If this is such an obvious business proposition, why didn’t stores like Walmart, Kmart and Target emerge years, if not decades earlier?

To be profitable, a discount store must compensate for lower margins with much higher volume. That necessitates a large retail space and a similarly large inventory which, in turn, requires capital.

Such a high volume of sales can only be supported by a large customer base, which is easily found in big cities.

But low prices can only be offered profitably if a tight lid is kept on costs, which initially ruled out such high-rent city-center locations.

By the 1950s, the combination of the post-World War II boom and the flight to the suburbs set the scene for a dramatic change in America’s retail industry.

The automobile, an essential part of suburban living, meant that large pools of customers were no longer limited to locations served by the fixed mass transit lines of buses and subways. Low-cost out-of-town locations now offered the perfect environment for large discount stores—and entrepreneurs were quick to respond.

Early movers included Ann & Hope (Rhode Island, 1953) and FedMart (San Diego, 1954). Their success inspired a number of clones including Kmart, Target, and Walmart (all started in 1962 within months of each other: March 1, May 1, and July 2 respectively).

In the next chapter we’ll see why Walmart, a late-entry “upstart,” overtook the first movers in the big-box space, including the better-capitalized Kmart and Target, and changed American shoppers’ habits. Walmart lowered the price structure of the American retail industry, saving not just its own customers but all retail shoppers untold billions of dollars.

Applying the “five clues” to identify the next growth company has a surprising side-effect: identifying the “ingredients” essential for a small business to become a big one becomes a “recipe” for starting a successful business of your own.

Which means: rather than investing in the “Next Starbucks,” you could decide to create it yourself!

 

Continue to Chapter 2: “Most everything I’ve done I copied from somebody else” — Sam Walton

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