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Is Starbucks Running Out of Steam?

The coffee wars scorch on. Retail wunderkind Starbucks Corp. has come up with a few new tricks in recent months in its attempts to widen the lead it has built over other java sellers at a time when Dunkin' Donuts has its sights set on becoming a national player and upscale upstarts try to erode the chain's marketshare.

In the past decade, consumers and real estate developers alike congregated to the Seattle-based chain, making it the leader in the U.S. specialty coffee market and a preferred anchor tenant for shopping centers less than 15,000 square feet. As a result, the company today operates 9,814 U.S. stores (6,281 are company-owned, 3,533 are run through licensing agreements) and has become a global phenomenon.

But Starbucks may be vulnerable in a tougher consumer climate. Are people going to spend $4 for coffee now that the housing bubble has popped and gas and food prices are rising? Does that open the door for Dunkin' Donuts--as a lower cost alternative--to gain ground?

Lower-than-expected sales growth during the company's fiscal third quarter may be one indication that Starbucks' momentum is slowing. (Starbucks did not return calls seeking comment.) During that period, the company reported same-store sales growth of 4 percent and a 20 percent increase in net revenue to $2.4 billion. That was good--but the growth missed analysts' expectations of 6 percent growth, reflecting flat traffic for the second consecutive quarter, according to Marc Greenberg, retail analyst with Deutsche Bank. Greenberg worries the waning traffic and increased pressure from competitors will hurt Starbucks' aggressive expansion plans.

"Starbucks is growing up, and coping with maturity is rarely an easy process," Greenberg wrote in a research note on August 1.

For now, it's still opening stores at a rapid pace. During the third quarter, the firm opened 668 stores, as part of its expansion target of 2,400 new stores by the end of fiscal year 2007 (1,700 of those are planned for the domestic market). For next year, it is forecast to open another 1,700 locations in the U.S.

Owners and operators of smaller strip centers that rely on Starbucks as an anchor are watching closely. The retailers' brand recognition and traffic-driving potential make centers with Starbucks very popular investment targets. Such centers trade at cap rates in the 5 percent to 6 percent range, below the national average of 6.65 percent for all strip centers, according to Anthony Villasenor, principal of retail investment with La Jolla, Calif.-based real estate services firm Lee & Associates

"Starbucks-anchored properties might trade at a lower cap rate than the credit Starbucks deserves, but investors know it, they use it and they think it will be around forever," says Adam Lutz, principal with Farmington, Mich.-based Lutz Real Estate Investments.

Meanwhile, a center of equivalent size and profile anchored by a Dunkin' Donuts or another coffee chain would trade at 25 basis points to 35 basis points higher than one with Starbucks, says Chad Firsel, executive vice president of the investment services practice with Chicago-based brokerage NAI Hiffman.

The power of the Starbucks brand name is so strong that RetailWorks, a Southfield, Mich.-based strip center developer and manager that operates as a joint venture of REDICO, Lutz Real Estate Investments and iCap Realty Advisors, often determines the location of entire projects based on where Starbucks wants to build new stores. Where a Starbucks goes, other national tenants, including banks and wireless service providers, soon follow, Villasenor says.

"Starbucks brings in a higher-end clientele, which is more desirable for co-tenancy," says Villasenor. "Nobody is even close to them in terms of market dominance."

Still, Canton, Mass.-based Dunkin' Donuts has risen as an unlikely challenger. The firm is an institution in the Northeast going on 60 years. In the past decade it accelerated its growth largely due to the popularity of the chain's coffee. Beverages now account for between 60 percent and 70 percent of the company's annual revenues, according to a Fast Company report.

In its fiscal year 2006 ending August 2006--the last year for which information is available--Dunkin Donuts posted sales revenues of $4.6 billion overall. In contrast, Starbuck's global retail revenue was $6.6 billion. (Dunkin's parent company, Dunkin' Brands, Inc., is privately-owned by a consortium of Bain Capital Partners, the Carlyle Group and Thomas H. Lee Partners and thus does not release quarterly or monthly sales figures.)

Still, investors don't see Dunkin' Donuts the same way they do Starbucks, Villasenor notes, in large part because the chain operates through franchises, with lease terms and store performance that vary depending on the market.

"To their credit they are being more particular about the sites they go after and the interior of their stores are being upgraded, but Dunkin' has traditionally mixed brands and Starbucks has consistently offered one product, one interior and one theme. That has been well received by the public," says John Palmer, president and CEO of RetailWorks.

Last year Dunkin' launched a new store prototype, complete with an expanded menu and it recently announced an espresso station and a self-service coffee finishing station. On August 13, the company also announced a licensing agreement with Procter & Gamble, which will allow it to sell packaged coffee products through various grocery, mass merchandise and drug store chains.

This August, Dunkin' also announced that it had signed the largest store development agreement in its history with the Heartland Coffee Company of Pittsburgh, which will open 105 new Dunkin' Donuts restaurants throughout Allegheny County, Pa. over the next several years. Overall, the chain plans to triple the number of its domestic stores from 5,300 to 15,000 by 2020 and, in the process, develop a full national footprint.

That could become a problem for Starbucks down the road, especially if its high-end prices leave a bad taste with its less affluent consumers, says Morningstar retail analyst John Owens. In July, the chain raised the price of its coffee by $0.09, its second price increase in 10 months.

"I don't believe there is a huge amount of overlap between Starbucks customers and Dunkin' customers right now, but they both have ambitious growth plans and they both desire to capture customers from each other, so the competition could certainly intensify in the future," Owens says.

In any case, intent to maintain its dominance, the retailer is trying to combat market pressures. Two weeks ago, it signed a new licensing agreement with supermarket operator A&P to operate Starbucks coffeehouses within its Northeast grocery stores, opening up a new avenue for growth right in Dunkin' Donuts' backyard. Starbucks already has long-standing licensing agreements with several chain retailers, including Barnes & Noble, Borders and Albertsons, in addition to operating Starbucks units within hotels, airports and other high-traffic venues. The A&P stores are included in the 700 new licensed store units the company plans to open in fiscal 2008.

Last week, the retailer also announced a music partnership with Apple iTunes, which will give its customers wireless access to song downloads from the Wi-Fi iTunes Music Store. In addition to allowing customers to preview and buy iTunes products without a connection fee or hot-spot login, the service will highlight the songs playing in the Starbucks itself, with the opportunity to buy and download those songs to an iPod. The service, believed to increase the amount of time and coffee dollars customers spend at the store, will go into effect in October at 600 company-operated locations in New York and Seattle.

For the moment, Starbucks' market dominant position is safe. For one thing, a coffee chain is the kind of retail establishment that tends to get more customer visits with the opening of more stores, says Eric Hillenbrand, vice president of the retail division with Indianapolis-based brokerage firm Colliers Turley Martin Tucker. People get used to their coffee.

The proof? Starbucks is still opening stores within its home market of Seattle.

"Maybe they'll have to be more creative out on the West Coast, where they have snapped up the majority of good locations, but I wouldn't say they are anywhere near saturation," Owens says.

--Elaine Misonzhnik

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