Lingering customers just one hurdle for Starbucks China growth

A cup of Starbucks coffee sits on a table in a cafe in central Hong Kong January 16, 2011.

LOS ANGELES/BEIJING (Reuters) - Starbucks Corp has ambitious expansion plans in China, but like any big new emerging market there are teething problems, not least of which is that customers love it so much they stay for hours and hours and sometimes don't even buy a drink.

Chief executive Howard Schultz expects mainland China to overtake Canada as Starbucks' second-largest market by 2014 and some analysts believe it could one day rival the United States as the company's biggest market.

"The No. 1 opportunity for the entire company is China," Schultz told about 300 Starbucks employees and their family members at a company forum in Beijing. "This is where we want to invest, where we want to grow."

Starbucks has reorganized decision-making to transfer more responsibility to its China unit from its headquarters in Seattle.

"We now have a design team here, a real estate team here," Schultz said. "We recognize that the size of the opportunity and the size of the prize in China is the most significant opportunity we have as a company."

The world's biggest coffee chain is a symbol of Western affluence in a nation of tea drinkers. But the tendency for Chinese visitors to linger in cafes and their lower income levels means sales volumes are much smaller than the United States and other markets where taking drinks to go is the norm.

"For a decade the core business was expats and tourists. Without question, the core business today is Chinese nationals," Schultz told Reuters ahead of his trip to Beijing and Shanghai where he is also meeting store managers.

Xu Baoli, a 51-year-old stock trader in Beijing, said he visits Starbucks at least 10 times a month, but doesn't go for the coffee. He is taking a break, surfing the Internet and meeting with clients.

Observers note that Chinese customers will sometimes bring their own food to Starbucks and Xu admits that every so often he doesn't bother to buy anything at all.

"I like the concept," said Xu. "Chinese people used to think you needed a spoon and saucer to drink coffee. Now, walking around with a Starbucks cup in your hand has become a fashion statement for Chinese."

With the U.S. market maturing, few prizes are as enticing as China and its population of more than 1.3 billion.

Starbucks entered China in 1999 and now has more than 570 stores in 48 cities. By 2015, it plans more than 1,500 stores in 70-plus cities, though that would still only account for about half of China's major cities and would be just a fraction of the 10,800 stores in the United States.

"It could very well be exactly what's happening with Yum," Michael Yoshikami, chief executive of Destination Wealth Management, referring to KFC parent Yum Brands Inc. The U.S. fast-food company got an early foothold in China and now gets more revenue from that market than any other.

And while Starbucks' China cafes contribute less than 5 percent of company revenue, their store operating profit margins, at around 22 percent, are higher than U.S. cafes because they charge essentially U.S. prices in a market famed for its low labor costs.

HURDLES TO GROWTH

But even with that big silver lining, there are big impediments to growth including low incomes, rising costs and the fact that most Chinese don't have a coffee habit.

The market is still small, with specialist coffee shops such as Starbucks booking sales of $358 million from mainland China in 2010. That was up from $104 million in 2005, according to Euromonitor International. By comparison, the United States accounts for $8 billion in revenue for Starbucks.

Consumers in China drink an average of just three cups of coffee per year, according to an industry study, and for many Starbucks prices are simply out of reach.

Based on average wages in China, it would take 1.3 hours of work in the more affluent east of China to buy a Starbucks tall (12-ounce) caramel macchiato. That goes up to 1.6 hours in the west and 1.9 hours in central China, says Bernstein Research analyst Sara Senatore.

Affordability remains a top concern for analysts, who worry that as Starbucks' expansion progresses beyond the country's biggest cities, it will be less able raise prices to protect margins.

But CEO Schultz said income levels had not been a barrier to growth, adding that Starbucks' shops in non-core markets perform "as well or better" than stores in cities like Beijing and Shanghai, helped by pent-up demand.

Attracting quality employees when competition for skilled workers is intensifying as other chains also expand, is difficult, says Paul French, chief China analyst for market research firm, Mintel.

To that end, Starbucks announced plans to launch a training program called Starbucks China University next year. It also unveiled a 1 million yuan ($158,700) fund that will provide emergency financial assistance for Starbucks employees.

($1 = 6.3015 Chinese yuan)

(Editing by Edwina Gibbs and Matt Driskill)