Into the Black
Howard Schultz has transformed Seattle's Starbucks from a local coffee manufacturer into a profitable $90-million national retailer, with a simple, if somewhat radical, growth strategy: every dollar you invest in your employees shows up -- and then some -- on the bottom line* * *
On the far side of the glass behind Howard Schultz, multicolored boxes of coffee move like rush-hour traffic on a miniature freeway, winding their way on a conveyor belt that runs through the center of the building. The air is gently infused with the warm, fresh-brewed scent of today's blend. From where he sits, Schultz can see the tasting room, a kitchen cum laboratory complete with Bunsen burners that's located just outside his office. High-gloss snapshots of the coffee-brewing process decorate the walls, along with the current prices per pound of each of the 30 blends Starbucks Coffee Co. sells. "My dad was a blue-collar worker," Schultz says, recalling his upbringing in one of New York City's tougher neighborhoods. "He didn't have health insurance or benefits, and I saw firsthand the debilitating effect that had on him and on our family. I decided if I was ever in the position to make a contribution to others in that way, I would."
Schultz got the chance and seems to have made the most of it. As CEO and president of Seattle's Starbucks since 1987, he has overseen phenomenal growth -- a compounded annual rate of 80% over the past three years -- resulting, to hear him tell it, from one central strategy. "Our only sustainable competitive advantage," explains Schultz, "is the quality of our work force. We're building a national retail company by creating pride in -- and a stake in -- the outcome of our labor."
The centerpiece of Schultz's vision is a generous and comprehensive employee-benefits package encompassing health care, stock options, training programs, career counseling, and product discounts for all workers, full-time and part-time. "No one can afford to not provide these kinds of benefits," says Schultz. "The desire to scrimp on these essentials helps reinforce the sense of mediocrity that seeps into many companies. Without them, people don't feel financially or spiritually tied to their jobs." Emily Ericsen, head of Starbucks's human resources, puts it another way: "We are in the people-development business almost as much as the coffee business."
Though the connection between such an aggressive employee-benefits package and the bottom line is often difficult to show conclusively, the circumstantial evidence in Starbucks's case is compelling. The company is clearly on its way to becoming the dominant specialty coffee retailer and brand in North America. Since Starbucks went public, in June, the stock price has climbed 82%. Employee attrition, which typically hovers in the triple digits for food retailers, is less than 50%. The company is posting higher profit margins every year, beating even Schultz's own ambitious targets, and Starbucks's health-care costs, despite the extensive coverage, are well within the national average.
Looking at Schultz's success so far, Corey Rosen, director of the National Center for Employee Ownership, in Oakland, Calif., notes that Starbucks is swimming against the tide. "They've clearly taken a different approach. Many retailers want a lot of turnover so they don't have to pay a lot of benefits. Starbucks doesn't want turnover; it wants loyalty." As for the stock options, Rosen adds, "it's extremely unusual to offer those. I don't know of any retailers offering them. And I don't know anyone who offers them to part-timers."
For his part, Schultz says he needs no further proof that employee benefits are the key to competitiveness and growth. He's convinced his employees are working harder and smarter because they have a stake in the outcome. "We can't achieve our strategic objectives without a work force of people who are immersed in the same commitment as management," he says.
Dressed in soft green slacks and a tieless starched shirt, fresh from selling the company stock to investors across Europe and the United States, Schultz bounds along the carpeted floor from one end of his office to the window overlooking the roasting-plant floor. Shifting from loafered foot to foot as if he had downed several gallons of his own Kona Blend, he begins ticking off the company's milestones.
In 1971 Starbucks opened its first store in historic Pike Place, Seattle's landmark fish market overlooking Puget Sound. In 1982, when Schultz came aboard as head of marketing and retailing, Starbucks had 85 workers and sold whole beans. Schultz had been working in New York marketing coffee makers to a number of retailers, including Starbucks. That introduced him to the three founding partners, Jerry Baldwin, Zev Siegl, and Gordon Bowker, who eventually recruited him to bring marketing savvy to the loosely run company.
Named for the coffee-guzzling second mate in Herman Melville's Moby Dick, Starbucks at the time seemed content to roast and sell beans without a lot of fuss or impressive profit margins. Then, on a trip to Italy, Schultz was awed by the amount of espresso to be readily had at the more than a thousand coffee bars in Milan alone. "Coffee bars are the mainstay of every Italian neighborhood," he says. "That's what I wanted to bring back to Seattle."
But after halfheartedly trying to persuade the founders to open an espresso bar, Schultz left to do the same himself in 1984. Three years later he was back at Starbucks with a buyout offer of $250,000 and a plan to roll out retail shops far beyond Seattle.
That he did with a vengeance. When Schultz first returned to Starbucks, it had just 11 stores and fewer than 100 employees. Today the company boasts 100 stores in the Northwest and 56 more outside the region. Some 2,000 retail workers are ringing up $700,000 a week in sales, more than half of that in high-profit liquid refreshment. By adding brewed coffee to the product mix in addition to beans, Schultz fattened gross margins by nearly 5%.
From the beginning of his stewardship, Schultz saw a symbiotic link between Starbucks's growth curve and his ambitious benefits plan, gambling that revenues would outrun spending for Starbucks's expansion. At first, the company's losses almost doubled, to $1.2 million from fiscal 1989 to 1990, as overhead and operating expenses ballooned to $18.4 million on $19.2 million in sales. But in 1991 sales shot up 84%, dramatically outpacing expenses, and the company broke into the black.* * *
Although the company already had an adequate benefits package in place and had been covering part-timers since 1971, Schultz began to beef up offerings substantially. He added a heavy emphasis on preventive health care, for example, by providing a special deductible-exempt $300 allowance for annual physicals. There's similar encouragement for regular dental visits, with a ceiling of $2,000 in expenses and no deductible. He also kicked in vision care, and the company picks up the total tab for disability and life insurance as well.
All that, however, didn't make it easy to persuade the insurance companies to sign Starbucks up. Kibble & Prentice, Starbucks's insurance broker in Seattle, faced the daunting task. The biggest problem was explaining why Starbucks insisted on covering part-timers. A handful of retailers provide benefits to people who work 30 hours a week but not to those who work only 20. At Starbucks at least two-thirds of the workers are clocking fewer than 40 hours.
"It was a philosophical battle," admits Dan Guy, a vice-president at Kibble. "But we made the insurers understand what the company's commitment was." Schultz outlines his reasoning succinctly: "More than half of our retail sales force is part-time workers. That tells me that the majority of our customers are coming into contact with part-timers. How we treat our people is directly related to how we treat our customers and to the quality of our product. It's inarguable that our part-timers are key to the company's success.
"Designing the plan was rough. Our insurance premiums went up slightly when we decided to provide everyone with full coverage. But that was offset by the lower training costs associated with a lower attrition rate. We normally spend 25 hours of classroom training time on every new employee. The longer an employee stays with us, the more we save."
Starbucks's high-octane growth is now supporting its employees' benefits without skipping a beat. Despite the range of benefits, they represent just one-quarter of the company's labor costs and are holding steady at that level. Insurance makes up half the benefits expenses. At the end of the month, employees end up footing just a quarter of the total benefits costs, or $31, on average.
The success of Schultz's strategy has depended, in part, on the relative youth of most Starbucks employees. Schultz himself is only 39, and half his management team is under 50. In general, the company appeals to young people who have a more healthful lifestyle, and that can justify lower insurance rates. Orin Smith, Starbucks's chief financial officer, is banking on that fact. "In this business, I don't think we can expect a big increase in the age of our employees," he says. "I'd be very surprised if we had 40-year-olds behind the counter 10 years from now."
Starbucks's average monthly coverage costs $125 per employee, compared with a more typical $200, according to human resources' Ericsen. "Our claims are lower, and that's reflected in the lower rates," she says.
The company is hitting a claims ratio of 75%, meaning that for every dollar paid in, the insurer is spending 75¢ on claims. Medical claims were low enough, in relation to Starbucks's premiums, that the company even received a $12,700 refund in 1991. An estimated refund of $30,000 was expected in 1992.
Nobody expects that to continue for too long. First, Starbucks is growing so fast it is paying in more than its insurers are paying out. When the growth slows, so will the rebates. Plus, common sense says that the premiums Starbucks pays will be heading upward as the stores continue to grow in number and as the company expands eastward. It appears that health costs are higher in the eastern part of the United States than in the West, says Guy. Also, the store workers are aging, having children, the sorts of things that naturally increase costs.
Already, Ericsen is considering offering workers a cafeteria-style benefits program that lets them select different degrees of coverage. Under such a plan, monthly benefits costs could rise to $200 to $240. Those are costs, she says, the company is willing to absorb. "To have the best employees, you first have to attract them," says Ericsen. "Benefits are our competitive advantage in that regard."* * *
Starbucks wants to continue attracting and keeping an effective, loyal work force -- to be "the employer of choice" as Schultz puts it -- because the company continues to expand aggressively into a gourmet-coffee market ripe for the picking. Over half of all adults drink two cups of coffee every day. According to FIND/SVP, a New York City market researcher, the coffee-bean-and-beverage market was $6.5 billion in 1991. Of that, one-third of the sales were specialty coffees, a category growing at nearly 10% annually. Those brews, made with rich brown arabica beans rather than the pale robusta found on supermarket shelves, are Starbucks's stock in trade.
Despite such vast opportunity -- and 300 or so daily calls from willing investors -- Schultz shuns franchising, which he believes would compromise quality. "We're unwilling to take the route others have taken, like franchising," he says. "The only way we're going to be successful is if we have the people who are attracted to the company and who are willing to sustain the growth as owners."
Schultz understands that the first point of contact with customers is his workers, and he's determined to have them recite in their sleep how to make a mocha latte, and to know the difference between espresso macchiato and espresso ristretto. Each is given 25 hours of training before taking up work behind the counter. Management trainees attend 8 to 12 weeks of classes with titles like Coffee Knowledge 101. "The training is designed to embrace the company culture," says Schultz. "There's a deep sensitivity to the customer and the coffee."
Smith, the company pragmatist, adds: "The biggest defense against pilferage is a strong culture." Indeed, Starbucks's inventory shrinkage is less than half of 1%.
At Starbucks's newest store in Los Angeles, manager Mark Smith, 28, points to the company's strong culture as a large part of the reason he left another Seattle institution, Eddie Bauer, two years ago. He also felt the coffee maker offered him more opportunity, and that seems to be the case. After recently completing an 8-week management-training course, Smith steered his store through a major expansion that included hiring 20 people. From that experience, he says, he can attest to the fact that Starbucks's benefits "make a big difference in attracting quality workers."
The approach is working. For the past 12 months, the company had sales of $90 million, not counting stores that opened within the period. Two new stores just opened in Denver, following the opening of 31 locations in Chicago. One in Washington, D.C., is among the 75 debuts slated for this year, with another 90 targeted for 1994.
Schultz leaves little to chance when it comes to opening a new outlet. Stores are located in new cities with surgical precision. By tracking the addresses of mail-order customers in such a way as to find the highest concentration in a city, Starbucks ensures that its new stores have a ready audience. In San Francisco, where there are some well-entrenched rivals, Starbucks's first store is the fastest-growing Schultz has ever opened. For good reason: one-third of the store's customers were already familiar with the company through its mail-order service. Best of all, despite losing customers to newly opened stores, mail-order revenues nearly doubled last year.
Through it all, Schultz runs a tight ship. Although the company spends, by his estimate, $1,000 to train each new worker, his overhead is dropping as a percentage of sales, even as the number of stores climbs. The figure fell from 12.3% in 1989 to a scant 8% in 1992.* * *
In addition to the reduced attrition and shrinkage, Schultz points to yet another benefit of maintaining a superior and involved work force: ideas. Executives from Seattle fan out to a dozen cities each quarter to conduct open forums and to gather ideas, which run the gamut from addressing environmental concerns to marketing. For example, in July the company doubled the customer discount to 10¢ for reusing paper cups, with the hunch it will eventually prompt customers to use their own containers.
Schultz says: "Over the past several years, we've really focused on our infrastructure. In a series of open forums, we heard our people asking for what I call a new paradigm," an incentive not only to stay with the company but also to have a stake in its success. As the centerpiece of that new paradigm, Schultz and Orin Smith came up with Bean Stock -- Starbucks's stock options, structured to achieve both employee and corporate goals.
"Our goal here was to design a plan that would combat the attrition that is the greatest threat to a retail operation," says Schultz. "We've set up a vesting period of five years; it starts one year after the option is granted, then vests the employee at 20% every year. In addition, every employee receives a new stock-option award every year, and a new vesting period begins. The percentage of the grant is tied to the profitability of the company. It took us two years to design this."
To put the plan in place, Smith had to get an exemption from the Securities and Exchange Commission, the federal regulatory agency charged with monitoring corporate governance. Any company with more than 500 shareholders has to start reporting its financial performance publicly. That's costly and reveals information to competitors. Because Smith argued that employees would be receiving options, not shares, the rule was waived.
Before Starbucks went public, the original plan had been to let workers cash in their options based on a private valuation of the company by investment bankers. An employee stock ownership plan wasn't possible as long as Starbucks was private, and stock wasn't as much of an incentive as options were. Under ESOPs, workers have to buy the shares, but with options, there's a lengthy period until they can be exercised, one hopes at a very low price.
Though Starbucks is now public, Schultz says the basic offering can be duplicated by most any company, public or private. "For our plan to work in another company, there has to be some type of liquidity or cash-in potential," he says. "Now we're public, but a smaller private company would have to design an alternative structure, maybe backed by buy-sell agreements when employees retire or leave the company. But these aren't the kinds of obstacles that should get in the way of anyone who is considering setting up an option plan."
The first year that Bean Stock was offered, the company overshot its profit goal by 20%, and the board responded by nudging up the percentage of salaries for stock options to 12% from 10%. Schultz was so enthusiastic, he went so far as to give the first wave of workers who were offered options the same 30% discount on the price as the top company officers received. But the venture capitalists and shareholders on the board weren't going to let their stake be diluted without a challenge. "Increasing the shareholders substantially dilutes our interest," says Craig Foley, a director and a managing partner of Chancellor Capital Management Inc., in New York City, and the largest shareholder before the public offering. "We take that very seriously."
For months Orin Smith and his team crunched numbers to come up with a convincing argument for continuing the plan. He analyzed corporate studies, including some from Corey Rosen's group, the National Center for Employee Ownership, comparing productivity in companies where workers owned a stake with productivity in those where employees didn't. Most significant, Smith looked at what would be vested in four to five years and discovered that less than 3% of the entire company would be affected, based on the number of people and sales of the stores. "We could determine the number of shares offered per year, and applied turnover scenarios through year five," says Smith.
The most convincing case was built on how few people were leaving and how much easier it was to add topflight talent to the company. After a brief discussion, the board voted to keep the plan.
As Foley puts it: "We realize that if we can reinforce the culture and reduce the turnover in part-time employees, all shareholders will be better off. The grants are tied to overachieving. If you just come to work and do your job, that isn't as attractive as if you beat the numbers."* * *
At Bean Stock's unveiling, Schultz recounted to his employees his memories of growing up in the Brooklyn projects, where his father "went from truck driver to cabbie to factory worker and never made more than $20,000 a year." When he died, said Schultz, the children took care of their mother. "I would have felt troubled if five years from now the wealth and success of Starbucks would affect only a few."
The way Schultz describes it, the stock options and the complete benefits package act as a glue that binds workers to the company, forging loyalty and, above all, encouraging attentive service to the customer. "It's reduced attrition," says Schultz. "And we've literally changed the level of communication. You can't imagine how excited our workers were when we started unveiling our new benefits package and explaining Bean Stock. All kinds of people started coming up with ways to save money and improve productivity. Now they're invested in our future. The future of Starbucks lies in increasing shareholder value -- and increasing employee value will increase shareholder value."* * *
Additional reporting provided by Jill Andresky Fraser.