The Starbucks Challenge -- Specialty-Coffee Maker Hopes New Products Won't Dilute Its High-Class Reputation

It's synonymous with Seattle, sophistication and specialty blends.

But is Starbucks' urbane image strong enough to withstand the effervescence of the Pepsi generation?

That's what the specialty-coffee king is attempting to find out. Less than a month ago, Starbucks began test-marketing its latest product, Mazagran - a lightly carbonated, chilled coffee drink - in two of its outlets in Santa Monica, Calif.

An outgrowth of its year-old partnership with Pepsi, Mazagran is the latest in a series of new offerings for the normally staid Starbucks.

"We're cautiously optimistic," said Howard Schultz, Starbucks chairman and chief executive.

But there's more riding on the tests than the future of a single beverage.

"Starbucks has created one of the most powerful and respected consumer brands out there," said Michael Moe, an analyst with Lehman Brothers in New York.

"Anytime Starbucks tries something new, it runs the risk that it will dilute its brand."

Call it the Starbucks challenge: to find a way to continue to grow at near break-neck speed - and to establish itself as the name in specialty coffees - without cheapening or institutionalizing its sophisticated, familiar image.

And at no other time has this challenge been as significant as it is today, as the company embarks on its most ambitious expansion plan yet in hopes of staking out new parameters of the specialty-coffee market.

"What you're seeing is the evolution of the business," Schultz said. "If Starbucks was a 20-chapter book, we're maybe in chapter 3 or 4."

The initial chapters of the Starbucks story had a consistent, conservative theme: Grow by doing more of what you do best, which for Starbucks meant building additional Starbucks outlets while sticking to a tried-and-true menu of specialty coffees.

Nothing too fancy or gimmicky. Just coffee with lasting power.

But in recent months, Starbucks has begun growing in other ways.

In April came the introduction of Frappuccino, a blended, low-fat iced coffee drink, which was the first new addition to the Starbucks drink menu in nearly a decade.

Company officials would not comment on how the drink is doing, but industry officials said it is performing far beyond expectations, offering some cushion to Starbucks should Mazagran not do as well.

At the same time, Starbucks showed its retail strength by branching out into the music world, launching a jazz CD with compilations from Capitol Records' Blue Note label. The CD, which is

in its third pressing, is being sold in conjunction with Starbucks' first new coffee blend in four years - Blue Note Blend.

The company is set to introduce its second CD sometime this week.

In addition, Starbucks began offering tea products this year under the brand-name Infusia. And it seems on the verge of expanding its food offerings, with the recent hiring of Carol Hayden, formerly head of food research and development at Pepsi.

And, of course, there's Mazagran.

"We recognize the importance of staying ahead and bringing new products to market to add value to the Starbucks shopping experience," Schultz said.

Based on a coffee and sparkling-water concoction drunk by the French Foreign Legion more than a century ago to combat the desert heat, Mazagran is Starbucks' most ambitious new offering yet.

The beverage, which is being tested in Santa Monica, has already cleared its first hurdle.

Starbucks and Pepsi are pleased enough with focus-group studies and early responses from Santa Monica that the two companies - through their joint venture, the North American Coffee Partnership - have decided to test-market Mazagran in a bottled version in stores in Santa Monica at the end of July.

If all goes well, the carbonated coffee drink could be launched nationwide as soon as next spring or summer.

The two sides are 50-50 partners in the North American Coffee Partnership. Starbucks brings its roasts and expertise to the table to go along with Pepsi's established marketing, bottling and distribution network.

Without Pepsi, industry observers said, it would have been too expensive for Starbucks to establish its own bottling and distribution system to roll out Mazagran.

Based on early reports, analysts have been generally high on Mazagran, which will bear only the Starbucks logo. But some caution that the product - offered in vanilla, berry, spiced and "fiery" flavors - could be viewed by Starbucks regulars as somewhat gimmicky.

"Starbucks customers pride themselves on having a sophistication for the taste of coffee," said Lehman Brothers analyst Moe. "Therefore, gimmicks and flavors might not be looked upon (that) positively. Some of the negative reaction (to Mazagran) is in this vein, though overall the response has been positive."

Nonetheless, Moe said Mazagran won't harm Starbucks' reputation.

Jean-Michel Valette, an analyst with Hambrecht & Quist in San Francisco, agrees.

"There's concern in any brand-line extension that you could jeopardize the brand equity, but as far as Mazagran, I've tasted it and don't have any particular worries about it," said Valette. He added that he thinks Starbucks' management team has so far done a good job steering clear of trendy concepts.

Starbucks knows all too well how easily its reputation can be hurt. In recent weeks, for example, an irate customer in the San Francisco Bay Area placed several ads in The Wall Street Journal criticizing Starbucks for selling him a less-than-satisfactory cappuccino maker and for failing to follow-through on customer service.

To be fair, Schultz said, "When you look at the company, you have to look at what we're not doing as well."

Starbucks refuses to franchise its 574 stores to ensure quality control, he said. In fact, all 1,500 outlets Starbucks intends to have by the end of the decade will be company-owned and operated as well.

What's more, Starbucks isn't allowing Pepsi to market Mazagran or other Starbucks drinks at Pepsi-owned fast-food restaurants such as KFC or Taco Bell.

And Starbucks wrote language into their agreement that allows it to back out should their products turn out to hurt Starbucks' reputation.

Already, research is under way for the next Pepsi-Starbucks beverage, said Pepsi spokesman David Egner, though he would not say what kind of a drink it would be.

The relationship has been so successful - at least in the eyes of analysts - that there is heightened speculation that the two sides could strengthen their relationship or that Pepsi might some day acquire Starbucks.

"People have wondered about that," said Diane Daggatt, a Pacific Crest Securities analyst. But thus far, no one is aware of anything concrete.

Starbucks and Pepsi officials said there is nothing to the speculation.

In fact, the two sides signed a "stand-still" agreement limiting Pepsi's ability to buy Starbucks stock or to take steps to acquire an interest in the company during the duration of the agreement - which lasts 75 years - and for five years beyond that.

Pepsi can make such moves only if Starbucks allows them.

Starbucks officials would not comment on whether they specifically asked for this protection. Pepsi does not currently own any stock in Starbucks, officials said.

Still, the two sides foresee a long-term relationship.

According to Daggatt, Starbucks is close to announcing an international joint-venture partner, perhaps as soon as the end of the fiscal year.

And on the surface, Pepsi, with its international marketing experience and system, may provide a good fit, Daggatt said.

Others agree.

"Pepsi clearly has a global infrastructure and, conceptually, it does make for an interesting partnership," Moe said. "Assuming that their current endeavor is going well, (Pepsi) would be on the short list of potential partners to Starbucks."

In the meantime, analysts continue to differ on how to rate Starbucks stock.

Even though several analysts are down on the stock because of its high price-earnings (P-E) ratio, Starbucks hit an all-time high recently, closing at $33.625. The stock closed Friday down 62.5 cents at $34.

The stock has rallied as short sellers, betting on the stock to drop, were proven wrong and were forced to buy immediately to cover their losses. Short-sellers try to make a profit by selling shares they don't own and by buying them back when the stock price falls.

Analysts tend to avoid stocks if their P-E is too high, often measured against the P-E of the stock market. Starbucks' P-E is now hovering over 60, while the market is at about 17.

Those who recommend buying the stock do so based on potential future growth.

Investors tend to overlook a company's P-E if the company is relatively young and if the market it operates in has tremendous room for growth.

"There's still a lot of untouched territory here," said Jeff Babcock, vice president of the Specialty Coffee Association of America. "There's still a lot of market share that needs to be taken up."

Babcock noted that coffee bars and cafes - a category that Starbucks' outlets fall under - will comprise the largest percentage of all coffee-related business by the year 2000. And the ready-to-drink coffee market, which Starbucks hopes to enter with Mazagran and its Pepsi partnership, is even less explored.

"There's nothing in the (ready-to-drink) coffee world that comes even close to being a Snapple (iced-tea beverage)," said Hellen Berry, vice president of marketing research for Beverage Marketing Corp.

"If (Mazagran is) successful, this market will take off," Berry said.