CHAPTER 17
Crisis of Prices, Crisis of Values

It is by presence of mind in untried emergencies
that the native metal of a man is tested.

—JAMES RUSSELL LOWELL, “ABRAHAM LINCOLN,”

PRINTED IN NORTH AMERICAN REVIEW , JANUARY 1864

THE DAY THE FROST HIT

In June 1994, I awoke one morning to face the worst crisis in Starbucks’ history. It came without warning. It was no one’s fault, nothing we could have predicted, nothing we knew how to handle.

I had just set off on what I had intended to be my longest vacation in ten years. Sheri had suffered through a series of delayed or canceled vacations as I had become more and more preoccupied with growing the business. But I was finally convinced that Starbucks was in good hands and I could afford to take off a full two weeks. After four years as chief financial officer, Orin Smith had just assumed the responsibilities of president. Neither of us realized that he was about to be tested by fire.

I had rented a cottage on the beach in the Hamptons, not far from where Sheri and I had met, not far from where we were married. The kids would have a chance to spend some time with my mother, my sister Ronnie, my brother Michael and his family, and my other relatives in New York. Our cottage would be like a little island, a refuge in a place where no one knew us, where family and friends could come to visit without the daily demands of work and school. Sheri and the kids planned to stay for a month. I would spend the first two weeks with them, return to Seattle for two weeks, and then fly back to New York to pick them up.

The cottage was everything we had hoped for: a modest white shingle house with a big deck, only a hundred yards from the beach. The sun was shining brightly when we arrived, and the kids jumped into their swimsuits immediately. Sheri was smiling and humming as she got us settled in, the happiest I’d seen her in years. We passed the first two days setting the house up and exploring the town and the beach with the kids.

On our third morning there, Monday, June 27, I called the office to check in—a daily habit that, unfortunately, I’ve not yet been able to break. I had waited till 11 A.M. so that I could reach Seattle at the start of the West Coast business day. I was standing in the kitchen when I punched in the number, wearing shorts and a loose shirt, looking out over a small backyard where the kids liked to play. I had just come in from shooting baskets with my son and still heard the sound of his dribbling outside.

I heard the note of alarm the instant that Georgette Essad, my assistant, recognized my voice.

“You need to talk to Orin and Dave immediately.”

“What’s wrong?” I asked.

“You just need to” was all she would tell me.

My stomach clenched as a fast montage of ugly possibilities raced through my imagination. I could tell something serious had happened.

My phone call was patched into a conference room, where Dave Olsen and Orin Smith were waiting for me.

“Howard,” Orin said, his normally calm voice pinched, “there’s been a severe frost in Brazil. Coffee prices are going crazy.”

Brazil? Starbucks didn’t even buy any coffee from Brazil. Most Brazilian coffee ends up in cans.

But I understood the significance of that frost immediately. Brazil produces more than a quarter of the world’s coffee, and a serious shortfall there would send up prices for coffee everywhere. Because Starbucks buys only top-quality coffee, we normally pay a premium above the commodity price of coffee on the Coffee, Sugar & Cocoa Exchange in New York. The standard bellwether price for green coffee is the widely quoted C contract on that exchange, a composite price for green coffee, and when it goes up, our prices do, too.

That morning, Orin told me, the C contract was shooting straight up; it had just surged from $1.26 to $1.80 a pound, the highest price since 1986, and far above the 80-cent price we had counted on for the first four months of the year. In effect, one of our basic costs of business had doubled, and green coffee prices were still rising. Starbucks’ stock price began to drop.

The last time Brazil had had a serious frost, in 1975, coffee prices had soared as high as $3.40 a pound and stayed high for years. That legendary “black frost” had decimated much of Brazil’s crop. Back then, Starbucks had only three stores. Now, with 350 stores to supply, we had a huge exposure. What if the price doubled again?

Within five minutes I knew my vacation was over. I would have to take the next available flight to Seattle. Though they didn’t ask me to return, we all knew we had to be together to deal with the problem. It wasn’t right that Orin, in the first month of his new job, should have to resolve this on his own.

With that call, my whole life changed—not only for the summer but for the year that followed. In fact, it took two full years to finally work through the problems that hit us that day.

I hung up the phone and stood still for a second as the magnitude of the emergency hit me. I called for Sheri, who was in the next room, and she could hear the edge to my voice. When she came into the kitchen I could see, with a pang, that she was both filled with concern and bracing for disappointment.

“You’re not going to believe this,” I said to her. “I’ve got to go back to Seattle.”

SHOULD WE RAISE OUR PRICES?

I got a flight early the next morning and was in my office at 12:30 P.M. Orin had set up a meeting, so when I walked in I was immediately surrounded by the worried faces of Starbucks’ leadership. Our task was to respond to the worst crisis that had confronted us as a team. The fear and uncertainty of everyone in the room were almost tangible. I wanted to reassure them that we could handle this problem, but I was filled with doubts myself.

Seated around the conference table were the managers who represented every major area of responsibility: coffee buying, inventories, roasting, finance, planning, retail operations, mail order, and wholesale. First we needed to understand the breadth of the issues we were facing and the risks involved. The size and scale of Starbucks demanded unusual discipline and sensitivity to things that were not in our control.

Each person gave a status report—a term that in this case was really an oxymoron, since the situation was literally changing, from minute to minute, as coffee prices jumped.

Dave Olsen put the frost in a historical context for us. Ironically, for the past two years, he had been worrying that coffee prices were too low. In the late 1980s, coffee-producing countries in the International Coffee Organization had tried to prop up prices using an export quota system. But in July 1989, that agreement fell apart, and coffee prices dropped to historic lows. The world was awash in coffee as global production reached an all-time high, rising well above the level of consumption. By 1992, the C contract had drifted down to around 50 cents a pound, far below the cost of production.

You’d think that Dave and other coffee buyers would have been pleased with such low prices, but in fact, he was concerned about their negative consequences. Coffee growers around the world couldn’t afford to buy fertilizer and didn’t bother to prune, so in many regions coffee crops were weakening. Some farmers uprooted their coffee bushes and planted other crops, such as sugar cane. Although that cut world production back sharply, to well below the level of global consumption, the oversupply from earlier years kept prices relatively low for a time. By early 1994, the C contract had risen to only 80 cents, still low by historical standards.

Dave was actually relieved when prices began to rise in April 1994. He had traveled widely and worked for years to forge relationships with coffee growers and exporters, so he had seen firsthand the punishing effect low prices had had on them. More normal prices, he knew, were needed to ensure a continuous supply of quality coffee. In May, the market recovered, to a level above a dollar a pound.

During the time prices were low, Dave had, fortunately, locked in about a ten months’ supply of green coffee, through long-term contracts at fixed prices—more for some origin countries, less for others. Buying ahead was our normal strategy of protecting ourselves, the theory being that it was both necessary to ensure our inventories and a good investment for Starbucks’ capital. Long-term contracts also allowed us to lock in the more limited supplies of top-quality coffee. Overall, we were in a better position than many specialty coffee companies because we are vertically integrated: We buy and roast all the coffee we sell, rather than purchasing pre-roasted beans from independent roasters.

After the frost hit, I was relieved to hear we had so much inventory on hand. But what if green coffee prices kept rising? Should we buy more coffee now before they rose even further? Those weren’t decisions we could make that first day.

Over the next few days, the phones lit up as big shareholders, stock analysts, traders, and reporters called to find out how we were reacting. We had to make some decisions. Would we raise prices? If so, by how much and when? What impact might that have on sales?

The big three roasters, Nestlé, Kraft General Foods, and Procter & Gamble, increased prices immediately on their canned coffee. Between them, they control about 70 percent of the U.S. coffee market. With fewer months’ supply on hand and thinner profit margins, they had little choice. The price of Folgers jumped twice that week alone.

We decided not to raise retail prices right away. It wasn’t fair to our customers. We remembered how outraged everyone had felt when gasoline companies jacked up prices the minute oil prices rose, to reflect replacement costs, even though they had months of inventory on hand. We decided to wait and see what happened to green coffee prices.

Exactly two weeks after the first shock, we got a second. On July 11, another Monday, I woke up and heard the worst. Brazil had suffered another frost, this one even more bitter. Early estimates had suggested that the first frost had damaged 30 percent of Brazil’s crop; this one appeared to have destroyed another 10 percent, at least. Starbucks stock responded by dropping to a three-month low that day.

Within days, the green coffee price jumped to $2.74 a pound —more than 330 percent of the level just three months earlier. To me, it felt like it happened overnight. It was a body blow.

We held daily conferences, hushed and hurried. I don’t think most Starbucks people really understood the gravity of the situation and how fearful we were. Earnings had been growing more than 50 percent a year for four years, and Wall Street investors were counting on a continuing stream of profits in coming years. If we failed to meet their expectations, our stock price might drop so low we would have trouble raising funds for future expansion. Traders were now predicting coffee prices might reach $4. All the information we had at hand—about the 1975 frost, about depleted world coffee supplies, about lower production everywhere—led us to believe those estimates could well be true.

The big three once again quickly raised their prices.

Inside the company, we debated intensely about whether and when to raise retail prices. Some board members urged caution, saying price hikes tended to be easy, short-term fixes that discouraged the hard work of lowering costs and improving efficiency. They thought it would put us at a competitive disadvantage. But with our main raw-material cost skyrocketing, we had to respond.

On July 13 we announced that we would increase prices by just under 10 percent on July 22. Although coffee drinks went up only 5 cents or 10 cents a cup, our whole-bean coffee prices rose by around $1.25 a pound, on an average price of about $8.50. How would our customers react? Our prices were already higher than supermarket coffees. Would our whole-bean coffee sales volume drop?

We consciously chose a different path than the oil companies and the big packaged goods companies. We did not raise our prices to cover current replacement costs, passing raw material price rises immediately on to the consumer. If we had, our prices would have gone up far more dramatically, as the canned supermarket coffees did. Instead, we tried to offset only our actual cost increases for fiscal year 1995.

During those days, my role was to provide the company with the leadership to instill confidence that we were going to get through this crisis intact. I also took the lead in communicating with the outside world about the problem. We had a lot of constituencies to deal with, not the least of which was Wall Street, where investors worried about the extent to which Starbucks was exposed. They were making bets on the short and long side. With Dave Olsen, I explained the situation to our partners, and then Orin and I discussed it with investors. We made frequent conference calls and left voice-mail updates nationwide, as well as posting signs in our stores, trying to keep people abreast of the situation.

What we tried to do with our customers was to honestly and directly explain that our costs had risen and we had no choice but to pass on a certain amount to them in order to continue to do business. We were fortunate in that the relationship we had built with our customers and most importantly with our partners gave us license to do what we needed to do. For the most part, they responded by being willing to pay higher prices for coffee they knew was best of class.

THE LONG-TERM COST OF SHORT-TERM DECISIONS

Behind the scenes, we had other tough decisions to make. Should we buy more coffee at current prices, lest they surge even higher? Or would $2.74 be the peak, and would it be better to wait and buy at lower levels? When the market was at 80 cents, we had dreamed of 70 cents and worried about $1. Now that the market was around $2.50, we dreamed of $2 and worried about $4.

The issue came to a head on one tense day in July, when we had to decide whether to commit to buying a substantial quantity—thousands of bags—of Colombian coffee. At these high levels, it was a multimillion-dollar decision, three times the amount of money we would have paid for the same coffee a few months earlier. The purchase could be either a wise hedge against even higher prices or a disastrous obligation incurred at the top of the market.

While we all agonized, Orin’s calm manner and training in financial markets helped maintain our equilibrium. “It’s futile to try to outguess the market,” he advised. “Let’s look at it this way. Assume there are two equally likely risks: On the one hand, the coffee price might go higher; on the other, it might go lower. Which is a more acceptable risk?” We debated and finally agreed that it would be better to go long, buying extra inventory at current prices. If the price were to fall, Orin reasoned, we’d be stuck with high-priced contracts, but we could manage through it. If it were to rise to $4, we would definitely fail to meet our financial expectations. So we insured ourselves against a further increase. We also examined the option of hedging our long position against a price decrease, but the cost was prohibitive.

As it happened, we purchased that batch of Colombian coffee at what turned out to be nearly the peak. That summer we also had to buy other types of coffee, in smaller quantities, to fill in specific inventories that were low. It took two years to work through all the high-priced coffee in our warehouse.

After July, green coffee prices came down. What we hadn’t understood at the time was the degree to which speculative trading had driven up prices. When the speculators dropped out of the market, the price retracted quickly relative to how it had behaved in earlier years. Within a few months, we saw a price more reflective of supply and demand, close to $1.10 by year’s end.

Because we bought coffee in July 1995, we were left with a high-priced inventory that lasted so long that we had to raise prices slightly again the following year. That decision was hard to explain to our customers, who didn’t realize we had protected them against the full impact of the increase after the frosts. But given what we knew, we made our decision the right way.

Despite the burden we had taken on, there was never any finger-pointing or attempts to place the blame for the ill-timed purchase. Given the tremendous fear and confusion and concerns that were affecting us all, it was important that we keep our balance through absolute harmony and trust in one another.

To me, what’s even more remarkable about our decisions during those tense months of June and July is that we never once wavered in our dedication to providing the highest quality coffee. The easiest thing for us to have done, without question, would have been to tell Dave Olsen and Mary Williams, our coffee buyers, “Okay, the time has come. We want you to start buying lower-quality coffee. We have to keep costs under control and protect our profit margins.” That conversation never took place; no one even considered it as an alternative. We could also have tried the tactic other companies seemed to be using: blending high-grade coffee with cheaper beans and raising the price anyway. Many customers would not have noticed the difference. We would have saved a ton of money, but we would have had a different kind of crisis on our hands.

. . . AND LONG-TERM BENEFITS

Once prices started to fall, the immediate crisis was over. But a messy aftermath now awaited us. We did not charge the customer for the full financial burden, so how could we meet our earnings targets?

Orin came up with a game plan, insisting we could find the answer in our backroom. We could make up for the increased green-coffee cost by becoming more efficient and taking advantage of economies of scale. He called it the “profit improvement plan.”

I was skeptical at first. Starbucks had never before turned to the backroom for cost savings and efficiencies. When you’re growing at 50 percent a year, you can’t cut back on the support side. You need the flexibility of those systems. Many of our hardest-working, most committed partners were working in less visible jobs in accounting, legal, finance and planning, production, and management information systems. They were already feeling the strains of rapid growth; it seemed unfair to ask them to do more with less. But we had no alternative.

Putting his plan into action is where Orin really began to demonstrate his leadership skills. He hired an expert to direct the effort, formed committees, and began holding regular meetings with every department. He transformed the crisis into an opportunity to begin to manage the company in a more systematic, professional way. We discovered that there were a lot of synergies we weren’t taking advantage of, chances to renegotiate contracts, to lower other costs, to plan better, to work smarter, to use our resources more wisely. We probably would have gotten around to making these improvements sooner or later, but this emergency forced us to recognize, earlier than we might have, the need for a tighter ship.

We knew that many of the savings would have to come from our warehouses and roasting plants. Ted Garcia, who joined us from Pillsbury to take over supply-chain operations in April 1995, had already begun to raise our roasting, packaging, and distribution operations to a world-class level. He led an effort to install state-ofthe-art, computer-integrated manufacturing systems that improved our efficiency and lowered cost-per-pound by 8 to 10 percent a year for three years. At the same time, our manufacturing was becoming more complex, as we began to need many new package sizes as well as more ground coffee for United Airlines and other large customers. Ted’s group also cut transportation costs and paper-cup costs significantly by renegotiating contracts. He set a five-year goal to continue lowering costs through the year 2000, without compromising quality.

Although not anywhere near as visible or dramatic as jumping into the ice cream or music business, what Orin and his team accomplished that year was firmly in Starbucks’ tradition of defying the odds.

The high-priced coffee inventories didn’t start hitting the bottom line until a year later, in the fall of 1995. Quarter after quarter, Wall Street analysts doubted that we’d make our numbers. Some quarters it was touch and go. But by the end of fiscal 1996, we had sold almost all of the high-priced coffee, and earnings for fiscal 1996 hit the mark. We signed on some large-volume customers during the year, but the main reason was the slow, methodical process of trimming costs, rooting out inefficiencies, and improving processes.

I’ve always been struck by the irony that a business is more likely to attract attention when it loses money, or lays people off, or fails spectacularly. Pundits can wisely analyze what went wrong and what should have been done. But pundits are not as proficient at analyzing success. What does it take to achieve 50 percent annual growth in both sales and profits for six years in a row? What enabled Starbucks to do that was a combination of discipline and innovation, process and creativity, caution and boldness that few companies have mastered.

When Starbucks made its numbers after two years of working through a crisis of such magnitude, I was elated. So was Orin. But no one asked us: How on earth did you accomplish that?

It may sound trite, but I believe that managing through the coffee-price crisis made Starbucks a better company. It made us aware of our vulnerabilities and it forced us to develop skills we hadn’t possessed.

Starbucks reached maturity that summer. Before 1994, everything we touched turned to gold. Every time we tried something daring, it succeeded. When this crisis hit us, without warning, it forged our managers, a group that included many new senior executives recruited from other companies, into a well-bonded team. It demonstrated Orin’s courage under fire and forced me to learn a new dimension of management.

Great companies need both a visionary leader and a skilled executive: one for the top line, the other for the bottom line. As Fortune’s Ronald Henkoff wrote in November 1996, “The businesses that thrive over the long haul are likely to be those that understand that cost cutting and revenue growing aren’t mutually exclusive. Eternal vigilance to both the top and bottom lines is the new ticket to prosperity.”

It humbled me to realize how vulnerable we could be to outside forces that could instantly and dramatically change the course of the company. It taught me that we had to be in a constant state of preparation and vigilance. You can’t manage just for the known; you have to manage for the unknown as well. Starbucks today is more prepared for the unknown crisis around the corner because it faced this one down.

When coffee prices again doubled in early 1997, we had a clearer idea of what it takes to weather such a storm. That time we knew how to calculate the costs, and we understood the need to take action while the news events were still fresh in the minds of our customers. Again, our increase covered only the incremental costs, not the replacement costs, of the higher-priced coffee.

The more profound lesson of the 1994 crisis hit me months after the event. What if we had opted for the easy solution and cut corners on our coffee?

We could save millions of dollars every year if we bought even slightly cheaper coffee. Starbucks spends more money per pound of coffee than almost any company in the world, even though probably fewer than 10 percent of our customers can tell the difference.

If you can raise profits by shaving costs on your main product and 90 percent of your customers wouldn’t even notice, why not just do it?

Because we can tell the difference. Inside Starbucks, we know what great coffee tastes like. Authenticity is what we stand for. It’s part of who we are. If we compromise who we are to achieve higher profits, what have we achieved? Eventually all our customers would figure out that we had sacrificed our quality, and they would no longer have a reason to walk that extra block for Starbucks.

But long before that happened, all of us inside Starbucks would have realized it, too. What, then, would keep us coming into work every day? Higher profits, at the cost of poorer quality? The best people would leave. Morale would fall. The mistake would eventually catch up with us. And the chase would be over.

Every business has a memory. The memory of sacrificing quality for profit would have been fixed in the minds of Starbucks people forever. It would have been an impossible price to pay.