• New figures released by the company show that, instead of the bottoming out Starbucks predicted in October, the company's same-store sales have gotten worse. Though its overall revenues have grown, sales at U.S. stores open at least a year fell 9% in October and November from a year earlier.

What is the plan to fight back?

• Starbucks, a brand that encouraged consumers to trade up, is changing tack after discovering that its most faithful customers are saving money in part by making fewer visits to the chain. It recently launched a loyalty card and other promotions that offer customers cheaper drinks and allow it to target the chain's most-frequent visitors, who come to Starbucks an average 16 times a month.

In addition, there is apparently an aggressive cost cutting program underway. 

In the end, as we have noted, this is what happens to a high end luxury that is largely indistinguishable from its competitors.  For Starbucks to buck the trend, it needs a different strategy.  Social Responsibility is this company's ticket to profit maximization.  It has taken small steps in that direction (a nickle to the Global Fund for certain drinks and free coffee on election day) but clearly views the strategy in a tepid fashion.  The benefits of the strategy will take time to sink in.  The longer the delay, the longer the bad news will likely last.

As part of that, consumers needed to know that a purchase at Starbucks would make a difference.  Social Responsibility in short.  Free coffee on election way provided some evidence that this was a winning strategy.  We have held up Chipotle (a chain begun here in Denver) as an example of the successful use of this strategy.  The burritos at Chipotle are not cheap but consumers are likely aware of the organic nature of the ingredients and the commitment to free range meat and poultry.

With that in mind, we note that Starbucks seems to be moving in that direction.  A Friday purchase at a Starbucks in Dummont, Colorado, right of Interstate 70, revealed, on the sleave of the chai, that the purchase of certain drinks would result in the contribution of 5 cents to the Global Fund, a highly respected organization combating a number of diseases including AIDs.  A subsequent email (the same day and inserted below) repeated the offer.  So does the Internet, where the location of participating Starbucks can be found.

The approach is a good beginning but very limited.  The contribution only occurs upon the purchase of three drinks, Espresso Truffle, Gingersnapp Latte, and Peppermint Mocha Twist.  The program also, apparently, expires on January 2.  It would be far better for Starbucks to create a culture of Social Responsibility that applied to all purchases in the stores.  In other words, customers would know that every purchase made some type of positive contribution.  But hopefully Starbucks will see some type of improvement in sales as a result of this promotion.  Maybe then the company will realize that it needs to by a much broader, systematic approach to the Starbucks experience.

And, maybe, Starbucks will finally realize that it needs to provide free Internet.

• The company's fourth-quarter report didn't do much to bolster investors' confidence. Profit fell 97 percent, hurt by hefty charges for closing about 600 U.S. stores and 61 locations in Australia. Same-store sales, or sales at locations open at least a year, dropped 8 percent in the U.S. as fewer consumers came in and those that did bought less.

The gold card experiment in Denver has been abandoned, replaced by a card that costs $25 a year in return for a 10% discount on most purchases and free Internet.  Some analysts speculate that in a recession, sales of $4 lattes will continue to fall.  Share prices have already fallen dramatically, with the price cut in half since the beginning of the year.  

Starbucks has been trying to stem the fall by competing as a commodity.  Customers have been offered small emoluments in an effort to generate business.  Loyalty programs have been commenced.  Free flavors and an occasional free latte are the primary weapons used to address declining sales.  But from all accounts, it isn't working.

What can and should Starbucks do?  The company should compete not as a commodity but as an experience.  As part of that, stores should be better designed to encourage in house consumption.  Some of the newer, smaller Starbucks are downright uncomfortable, with chairs and tables jammed into small spaces.  This would also mean providing free Internet, a step taken by almost everyone (including, by the way, some grocery stores and McDonalds franchises) except, apparently, Starbucks.  In addition, however, the company should focus on social responsibility and advertise the social benefits of consuming Starbucks coffee.  The size and volume of the company means that it can devote far more resources to social responsibility than its competitors.  Among other things, the company should replace the tacky nick knacks now sold in all of the stores with goods that resemble the model employed by 10 Thousand Villages, selling goods produced by crafts people in third world nations.

The appropriateness of the approach can be seen in part from the successful decision to offer anyone who voted a free cup of coffee.  The Monday earnings conference indicated that this was a highly successful campaign.  While the success may have resulted from the distribution of a free product, it helped that Starbucks was identified with socially good behavior -- voting in the election.  Moreover, given the likely client base of Starbucks, the company essentially shared in the Obama victory.  The campaign shows that appealing to customers on the basis of social responsibility works.

Yet from all indications, Starbucks intends to fight the downturn with Italian sounding smoothies and loyalty programs.  The earnings conference mentioned social responsibility and increases in the purchases of free trade coffee.  But it was a mere mention and there was no significant sign of social responsibility in the stores themselves (at least the ones I visited).  The current strategy is short sighted and one that will seem even more short sighted when McDonalds (which is seeing large increases in same store sales) begins stepping up sales of specialty coffee.

Starbucks ought to be competing for customers not with loyalty cards but through social responsibility.  Social responsibility here is a profit maximization strategy.  It would encourage customers to continue to frequent the chain not because it necessarily makes the best latte but because it is the socially responsible thing to do.  We have raised Chipotle as a model.  At least one blog reports that only 6% of the company's stock is fair trade.  Another possible model?  Ten Thousand Villages and their emphasis on selling products designed to improve the livelihood of disadvantaged people in developing countries.  These are both places that make money but allow their customers to feel like the expenditures have a purpose beyond mass consumption.     

What might Starbucks do?  Perhaps some of the shelf space currently occupied by mostly ugly seasonal mugs and other often useless bobbles could be taken up by Free Trade products.  Emphasis on fair trade coffee is another place to put energy.  With the emphasis on music, what about musicians in developing countries?  There is no obvious answer here.  But it is an avenue that needs attention, at least as much as the new "gold card" promotion (being tried here in Denver).

Why? 

Needless to say they make a good product.  But that's not the whole story.  As we have discussed, they emphasize health (using organic ingredients), local produce (striving to buy 25% locally), and animal care (the meat is free range).  In other words, eating a burrito is more than eating a burrito.  Its promoting local farmers and helping to ensure adequate care of animals. 

Now we can add one more.  Anyone who goes to the same store on a regular basis notices that there is incredible stability in the employees who work there.  In my Chipotle (seventh and Colorado in Denver), I am recognized every time I go in.  It adds to the experience without any doubt.  One suspects that Chipotle must treat its workers reasonably well to engender the apparently low lever of worker turmoil.  A recent article in the Rocky Mountain News confirms this.  According to the paper,   

• Many of the store management employees who have stuck with Chipotle since the early days have benefited as well - Chipotle offers a two-month paid sabbatical after 10 years of service, and a company car for all restaurant managers who have been with Chipotle at least four years.
• There's also the potential for a stock option payoff. Chipotle distributed 774,150 shares among salaried employees ahead of its January 2006 IPO, with 456,150 going to nonexecutive employees like store managers, according to filings with the Securities and Exchange Commission. Under terms of the grant, recipients can't exercise their options until early 2009

The importance of social responsibility can be seen with particular clarity in the mutual fund area.  Socially responsible funds (SRIs) attract investors by promising to engage in socially responsible investing (with the phrase individually defined by each fund).  The usual notion is that investors agree to accept a reduced return but are promised an investment portfolio that meets certain socially responsible criteria.  And, in fact, as a group, the SRIs underpeform other mutual funds.  See Consumer Reports, Principles v. Performance, May 2008 ("And our analysis bore this out: In the past five years, SRI funds returned 11.1 percent annually, while all domestic equity funds returned 14.5 percent . . . . And only 15 percent of SRI funds with a five-year track record returned more than that."), and typically have a higher expense ratio.  While there are exceptions, therefore, investors as a group essentially pay for the costs of socially responsible investing.

As a result, a fund that promises to engage in socially responsible investing but reneges on the promise is doing more than merely violating a policy.  This issue came up in connection with the SEC's recent action against Pax World Management.  In Pax World Management, Investment Company Act No. 38344 (admin proc July 30, 2008), the Commission issued a cease and desist order (and imposed a civil penalty of $500,000) against a fund that violated its socially responsible criteria.  As the Commission found:

• At all relevant times, investment adviser Pax World represented to investors and to the boards of the mutual funds it advised (the "Pax World Funds" or the "Funds") that it complied with various "socially responsible investing" ("SRI") restrictions, including, among other things, that it would not purchase for the Funds securities issued by companies that derived revenue from the manufacture of weapons, alcohol, tobacco or gambling products. Pax World acted contrary to these representations and violated the Funds' SRI restrictions from 2001 through 2005 when it purchased for the Pax World Growth and High Yield Funds ten securities that these Funds' SRI restrictions prohibited them from buying, including securities of companies that: (1) derived revenue from the manufacture of alcohol and/or gambling products; (2) derived more than 5% of their revenue from contracts with the U.S. Department of Defense; and (3) failed to satisfy the Funds' environmental or labor standards. During this period, Pax World also failed to consistently follow its own SRI-related policies and procedures with respect to these two funds that required that all securities be screened by Pax World's Social Research Department prior to purchase to ensure compliance with the SRI disclosures. In addition, during this period, Pax World did not consistently adhere to other SRI-related policies and procedures, including continuously monitoring fund holdings. As a result of conduct during the period from 2001 through 2005, the Pax World Funds held at least one prohibited security at all times from 2001 through early 2006.
  

We have taken the position often here that Starbucks needs to use its huge corporate presence to promote socially responsible causes as a means of differentiating its product, whether economic, in the case of employees and coffee producers, environmental, whether in the coffee growing process or in the process of coffee consumption, or health, whether by using organic or locally grown products. This is what the burrito maker, Chipotle, does. But if Starbucks insists on treating its product like a commodity, it must have in place a strong commodity strategy. By closing stores, purchase of the commodity becomes a bit more difficult and threatens to lose customers to an outlet that is more convenient and not necessarily a Starbucks.

Starbucks has become a commodity.  80% of the orders are consumed off premises.  In other words, most people coming into Starbucks are not coming in for the experience.  The company seems to recognize the consequences of this approach, deciding to expand more rapidly overseas where the statistics are the reverse.  80% of orders are consumed on premises.  In foreign countries, where homes and apartments are smaller and open spaces at a premium, Starbucks likely provides a meeting place that causes people to collect there and, concomitantly, buy and consume Starbucks products.  This is not true in the United States.

As we have noted, Starbucks is increasingly an outlier in the US because it does not offer free Internet access (Peaberry's in Denver does, Caribou Coffee does, so does almost every independent coffee shop I've entered).  This discourages those ubiquitous laptop users from planting themselves in the shop and buying product throughout the day.  Do a small survey.  Go into a variety of coffee shops (including Starbucks) and count the number of open laptops.  Over any protracted period of time, Starbucks will lose. 

How is the company responding?  Starbucks has started a loyalty program, allowing for the purchase of cards that provide modest benefits (free flavors, two hours of Internet usage).  In other words, as a commodity, they are trying to retain customer loyalty by offering small discounts.  This is a strategy that can be easily matched by competitors and does nothing to reward repeat customers or encourage coffee drinkers to stay on the premises.

It is the opinion of this Blog that to maximize profits, Starbucks needs to differentiate itself from competitors, not offer small economic emoluments that can be easily matched.  The answer is at Chipotle, the burrito company started here in Denver.  Chipotle is not cheap, with an ordinary burrito easily costing about $6 -$7 dollars.  Yet the company has robust growth in part because of the experience associated with eating in the establishment.  It is hard not to know that the burrito is made with free range chicken and organic ingredients, socially responsible and healthy.  Indeed, the company has just announced that it will begin to buy produce from local producers.  See Denver Post, June 19, 2008 ("This summer, Chipotle is purchasing 25 percent of at least one produce item for each of its stores from small and midsize farms within about 200 miles."). 

Chipotle has no loyalty program, no free guacamole.  But it does have increased earnings.  Rather than foregoing payments for flavors or soy milk, would Starbucks be better off using the funds to engage in more socially responsible activity and let customers know that the purchase of each latte results in a social good?  Ought Starbucks to place greater emphasis on employees (the company apparently already provides health benefits and options to part time employees) and let its customers know that each latte goes to the payment of a living wage?  This Blog thinks that it should and that the behavior will help earnings more than free soy milk. 

Starbucks has put in place a loyalty card and this week began offering holders two hours of free Internet use (so writes Your Money, Loyalty Program Offers Freebies (but Read the Small Print).  It is a useful step but one that only illustrates the weaknesses in the company's approach.  Only those aware of the benefit will take advantage of it; it will be useful only to those with relatively short term Internet needs.  To attract and retain customers, Starbucks needs, among other things, to offer  free Internet, no strings attached. 

Starbucks has become a commodity so customers will go elsewhere if the commodity is as good and either cheaper or more convenient.  The question for Starbucks is how to create increased customer loyalty that is impermeable to these factors.  It means transforming Starbucks from a commodity to an experience.

Support for this comes from the WSJ article.  The Journal studied consumer reaction to ethically produced goods.  It defined these goods as follows:

• For our purposes, "ethically produced" goods are those manufactured under three conditions. First, the company is considered to have progressive stakeholder relations, such as a commitment to diversity in hiring and consumer safety. Second, it must follow progressive environmental practices, such as using eco-friendly technology. Finally, it must be seen to demonstrate respect for human rights -- no child labor or forced labor in overseas factories, for instance.

The study looked at a number of problems, in particular coffee, and sought to determine whether consumers would pay more for ethically produced products.  The results, with respect to coffee?

• After reading about the company and its coffee, the people told us the price they were willing to pay on an 11-point scale, from $5 to $15. The results? The mean price for the ethical group ($9.71 per pound) was significantly higher than that of the control group ($8.31) or the unethical group ($5.89).

Of course, not all consumers felt this way.  Moreover, the degree of the differential varied depending upon the attitudes of the consumers with respect to their expectations about the ethical behavior of companies.  As the article noted:  "People with high expectations doled out bigger rewards and punishments than those with low expectations."

In other words, ethical behavior can pay.  Starbucks can learn from this lesson.  To the extent it puts more emphasis on social responsibility and less on its unique blend of coffee (which does not taste all that unique), it will do a better job creating customer loyalty and inducing them to pay a price higher than that charged by competitors. 

This is further proof of the commoditization of the Starbucks product.  Despite all of the efforts at improving quality, the company puts out a commodity that can be obtained in other coffee stores and restaurants, often at a lower price.  The company has not done a particularly good job of emphasizing why the purchase of a latte from Starbucks is better than in other locals.  While the effort to market a special blend of coffee (no doubt expensive but likely to be ineffective) or improve the skills of the baristas may result in a modest improvement in quality, it is unlikely to attract in (or keep) the hordes of coffee drinkers that the company needs to maintain its earnings. 

Some effort has been made to expand the menu, with sports drinks (in partnership with Pepsi) and smoothies, an apparent stab at the health conscious market, and "a more-indulgent sweet, icy beverage developed with an Italian company."  But while none of these products has yet reached the stores, they look to be little more than additional commodities, something that may bring in those seeking the convenient but not resulting in strong consumer loyalty. 

Social responsibility is the answer.  To the extent coffee drinkers think they are improving the world through the purchase of a Starbucks latte, they will be less likely to abandon the company when similar products start to flow at places like McDonalds.  Our poster child for this approach is Chipotle, where eating a burrito is more than a culinary experience.  From the looks of it, it will take some additional bad quarters for the company to realize that it needs to take a different approach against the competition, something that will include social responsibility and, by the way, free Internet.

• In order to ensure that Fidelity is an ethically managed company that respects the spirit of international law and is a responsible member of society, shareholders request that the Board institute oversight procedures to screen out investments in companies that, in the judgment of the Board, substantially contribute to genocide, patterns of extraordinary and egregious violations of human rights, or crimes against humanity.

Management opposed the proposal, mostly because it interfered with the investment choices of the funds.  "The Fidelity Funds Board of Trustees recognizes and respects that investors, including those investing in this Fund, have other investment opportunities open to them should they wish to avoid investments in certain companies or countries. Shareholders of the Fund, however, have chosen to invest in this Fund based on its specific stated investment policies. If adopted, this proposal would limit investments by the Fund that would be lawful under the laws of the United States. For this reason, the Board of Trustees recommends that you vote "AGAINST" this proposal."

The proposals were rejected but not after displaying considerable support.  As the WSJ reported:

• In results revealed at an emotionally-charged meeting this morning in Boston, 25% of the shares in Fidelity's $12.3 billion Mid-Cap Stock Fund voted for the proposal. The tally was 21% in Fidelity's $12.5 billion International Discovery fund, 22% in the $8.5 billion Overseas Fund, and 23% in the $4.4 billion Canada Fund.

Investors who want to invest in socially conscious funds can select funds that promise to invest accordingly as a matter of investment strategy.  Most investors, however, are more concerned with maximizing returns and not worried about investments in firearms or gambling or cigarettes.  But in competing for funds, it is possible to combine both and achieve a competitive advantage.  

Proposals like the ones considered by Fidelity theoretically can impair return.  But in fact, it is likely that the number of investments foregone as a result of the policy would be modest and that the funds could still produce a favorable return.  For investors selecting a fund, therefore, would it influence their decision to know that the investment companies had in place a system of ethics that sometimes, in narrow circumstances, resulted in the avoidance of investments that  "substantially contribute" to immoral behavior such as "genocide, patterns of extraordinary and egregious violations of human rights, or crimes against humanity?"

Perhaps.  Said another way, social responsibility can be good for the bottom line.

While Starbucks had attempted to address the threat with customer loyalty cards and better espresso machines, it has shied away from the most likely solution:  Increased emphasis on social responsibility.  Customer loyalty would be stronger from a program designed to demonstrate that the purchase of Starbucks coffee was socially responsible, good for the environment and so on.  Starbucks does some of this, as its web site indicates, but it is not a big part of the Starbucks experience.  We have often held up Chipotle, the burrito maker, as a model.

Today we note that coffee and social responsibility has not been lost on another major player, WalMart.  WalMart has announced that it will sell its own line of organic,Rainforest Alliance and fair trade certified coffees.  In other words,  WalMart thinks it can profit from selling socially responsible coffee.  Starbucks may eventually discover that if and when it promotes socially responsible coffee, the field is already crowded with competitors and that the advantages have been seized by others.    

The latest from Starbucks is that it plans to introduce new coffee blends, some kind of improved espresso equipment, and a loyalty program for regular customers.  Starbucks is struggling and things will only get worse when the baristas open for business at the 14,000 McDonalds in the United States.

Starbucks is trying to win customer loyalty and no doubt these efforts will have some marginal impact.  But it is not the right way for the company to win a stronger customer base.  As we have discussed, the dilemma is how to transform Starbucks from a commodity to an experience.  People will pay for an experience.  For a commodity, they'll go where it is cheapest or most convenient.  At least sometimes that means McDonalds.

Starbucks should be trying to win over customers through an intelligent mix of social activism, an activism that might be related to healthier ingredients.  This is largely the approach used successfully by Chipotle.  Customers would be willing to pay extra or look for a Starbucks if they knew their latte was doing some good, whether helping coffee growers or contributing to a living wage for employees (both of which Starbucks does but does little to publicize).  This type of loyalty will take time.

In the meantime, the best loyalty program in the short term?  Free Internet.  With it, Starbucks might have had my latte in Washington. 

As a result, on December 31, 2007, President Bush signed the Sudan Accountability and Divestment Act (the “Act”) into law. The Act aims to pressure the Sudan Government to end the ongoing violence in the Darfur region by encouraging divestment of assets in companies that conduct business in the Sudan. Section 3 of the Act authorizes state and local governments to adopt measures to divest assets from companies doing business in Sudan, despite any other provision of law. Similarly, section 4 provides a safe harbor for investment companies and its employees, officers, directors, and investment advisers by eliminating civil, criminal and administrative actions based solely upon a company’s divestment of certain securities tied to Sudan. In addition, section 4 instructs the SEC to prescribe regulations within 120 days of enactment that require an investment company to disclose its divestments.

The SEC recently issued the proposed rules. See SEC Release No. 34-57306 (accepted comments through March 17, 2008). Specifically, the Commission proposed amendments to form N-CSR and N-SAR that would require a registered investment company to disclose any divestment of securities made under the Sudan Accountability and Divestment Act.

The Act appears to be an attempt by the government to encourage socially responsible investing. Many investment companies have socially active criteria that a company must possess before it decides to invest. Apublic website provides examples of investment companies who have either divested or refused to invest in companies with ties to Sudan. The website calls for investment firms to “Divest for Darfur” and encourages people to contact investment firms and tell them to “stop investing in genocide.”

For primary materials go to theDU Corporate Governance web site.