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Starbucks, China, and Overdevelopment

As you may have read recently in The Wall Street Journal, Starbucks is planning to open 1,000 new stores in China.

Starbucks
AP
Starbucks

In many ways, it's a heartwarming tale: Starbucks is a true American—and now international— business success story. After going public a little less than two decades ago, Starbucks now has a market capitalization of over $20 billion. And the success of Starbucks has been more than merely financial: Not only have they managed to reinvent coffeehouse culture, but they've maintained many of the core progressive values the company grew up around. (The best-known example of this is probably Starbucks commitment to providing health insurance to its employees—even those who work only part-time—a topic Starbucks Chairman Howard Schultz recently spoke of with justifiable pride in an interview with the New York Times.)

Superimpose this inspiring narrative of financial and cultural success onto the hot Chinese emerging markets growth storyline and the results are sure to be something to anticipate with great expectations. Well, perhaps not.

Before analyzing the Asian storyline, it is useful to understand a bit of the domestic back story concerning Starbucks' retail growth.

In the summer of 2008, as the US economy ground into recession, Starbucks announced it would be closing 600 stores in the United States. The over-development of Starbucks retail locations was so great that, as the Seattle Times pointed out, "Most customers whose Starbucks stores close will be a short walk from a caffeine fix, the company said, because many of the unprofitable stores were being cannibalized by nearby Starbucks locations"

At the time, I was working at an investment bank on the corner of Lexington Avenue and 57th Street. When I would go to the Starbucks on the southwest corner of the intersection for my morning coffee, the view from the front window was—as you may have guessed—a building with yet another Starbucks, just across 57th street, on the northwest corner of the intersection.

(In the interest of full disclosure: Starbuck's coffee continues to fuel my daily scribblings.)

Some business writers had begun to question whether all the retail locations that Starbucks had opened had begun to dilute the brand. Others saw a connection to the housing bubble, as this New York Times article from July of 2008 points out:

"Another problem [for Starbucks], according to analysts and brokers, was that many of the newer stores were in areas of potential but unrealized population growth. The housing crisis derailed much of that planned development, in many cases putting the company in the position of waiting for new traffic patterns that never materialized."

On the more extreme end of the spectrum, some on the celebrity left, for example, had {LINK} already begun referring to Starbucks as a cancer—metastasizing across the United States and abroad—a retail chain with one link of its capitalist DNA mutating out of control.

The satiric newspaper, The Onion, perhaps best managed to capture the spirit of the cultural zeitgeist: In the summer of 2008, an Onion headline jocosely announced: "New Starbucks Opens in Rest Room of Existing Starbucks"

And, with that framework of overexpansion in mind, we turn east, perhaps toward some interesting parallels.

China, of course, is one of the principal emerging market growth stories of the decade—some might argue of the century. (As economic historians—or historical economists—never tire of pointing out, China, along with India, have had the largest share of global GDP for most of recorded human history.)

Earlier this year, China overtook Japan as the second largest economy in the world. And, as the more anxious or xenophobic never miss an opportunity to point to with trepidation, most commentators accept as a truism the notion that China will overtake the United States as the largest economy in the world by GDP at some undefined point in the future. The precise timelines for when this historic shift will occur are varied—but the most dire predict that the reordering may take place in less than two years.

Nonetheless, the broad point remains: The rise of China —in economic, political, and military terms—is among the most significant global narratives of the new century.

However, despite its inexorable march toward superpower status and aggregate economic superiority, China remains—in many ways—a very poor country, particularly in per capita terms. The International Monetary Fund ranks China 99th in per capita GDP—between Algeria and Guyana. And China's population of 1.3 billion remains an enormous denominator to contend with on every level. And a very large percentage of that population still lives in rural areas — despite the remarkable rise of China's middle class. (Note: Rural Chinese are not likely Starbuck's target demographic.)

According to figures cited by The World Bank, the average annual income in China is $2,025 in US dollars—or about $5.50 a day. (The World Bank figure cited is for 2006, the most recent year they provide data on.) Euromonitor, a large privately owned business intelligence provider, states that Chinese spend approximately 25 percent of their income on food. A simple calculation based on those numbers results in a figure reflecting an average Chinese per capita food expenditure of a little less than $1.40 per day.

By way of comparison, a Venti Toffee Mocha Frappuccino at the Starbucks across the street from my apartment costs $5.45. The implicit correlation, of course, is a bit of hyperbole: No reasonable person would assume that Starbucks intends to offer the Chinese US products at US price points—but it does make you wonder a bit about the Chinese consumer. How much will the Chinese be willing to spend—at a total of 1400 Starbucks locations in China, including the stores both proposed and existing?

And then there are the issues concerning the Chinese economy in a broader sense.

Far brighter minds than mine have expended countless hours searching for a method to determine how one might asses the possibility of an asset bubble in a nation like China, where the government so tightly controls the economy—and the flow of information.

A Bloomberg article from earlier this month discussed the broad picture of the Chinese asset bubble, as well as some of the attendant risks: "U.S. policies and low rates are fueling 'overheating local asset markets,' said Irina Fan, an economist at Hang Seng Bank Ltd. in Hong Kong. At the same time, 'wealth effects from soaring property prices' may aid consumer demand, she said."

And, quite germane to the issue of Chinese property valuations, and the consequent wealth effects they may engender, an article in the Wall Street Journal recently detailed the 83 percent drop in profits at E-House, a Chinese real estate services company. (The speculation is that official Chinese government policies, seeking to limit the risks of price inflation and economic overheating, are to blame for the enormous reduction in profits.)

But analyst's alarm bells—and actual bad news—not withstanding,money from across the globe continues to pour into Chinese asset markets.

It makes you wonder about the assumptions inherent in U.S. corporation's emerging market investment strategies—some of which may have seemed too obvious, or too self-evident, to question. An article in the British newspaper The Telegraph, dating back to 2004, explores exactly this broad philosophical point. In fact, even the title of the article itself seems ideally suited to point us in the right direction: "Oriental risks and rewards for optimistic occidentals".

The article in The Telegraph, not surprisingly, makes reference to that great conceit most symbolic of the 1980's Japanese real estate bubble: Namely, that the grounds of The Imperial Palace in Tokyo were calculated to have a greater worth than all of the real estate in California. I suspect that, at some point in the perhaps not so distant future, there will be a metaphorical equivalency — some totemic representation of the overdevelopment in China -- that will be on par with the Japanese Imperial palace allegory. And perhaps that story will include a cup of Starbuck's coffee.

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