Starbucks Looks Toward Franchise Strategy To Caffeinate European Business

Starbucks Corp. SBUX -0.20% in Europe has rolled out loyalty programs, localized store designs and opened coffee shops in less ritzy locations in an effort to fix a wobbly business. Now it is trying something else: letting others run its cafes. Starbucks has long avoided franchising - even as the strategy has gained popularity among other U.S. restaurant chains - saying it wants to control its brand. But in Europe, where it stumbled by opening stores mostly in high-rent shopping areas in big cities, Starbucks sees franchising as a way to make quick inroads in more remote areas where its executives have little familiarity.

Starbucks has begun franchising some stores in the U.K. In February, the company opened its first franchise-owned store in the world, in the British village of Liphook, and it now has 45 franchise-owned stores in the U.K. owned by nine franchisees. It plans to soon open its first such outlet in France, and roll the strategy out elsewhere in the region.

Franchised cafes are still a small share of the nearly 2,000 Starbucks stores in Europe, the Middle East and Africa, and are only in the U.K. for now. But working with franchisees "has allowed us to go into many geographies that we hadn't considered before," said Kris Engskov, who heads the EMEA region for Starbucks. "It's given us a new opportunity in retail in the U.K. and we will continue to look across the continent to see if that makes sense for other countries." Mr. Engskov, an Arkansas native who was a close White House aide to former President Bill Clinton, was promoted to his current job in May, tasked with accelerating turnaround efforts for the EMEA business. In addition to using franchisees, Starbucks has closed stores in expensive locations and tried to improve customer service. Operating profit in the region, after dropping by nearly three-quarters in its 2012 fiscal year, rose sharply in the company's latest fiscal year to $64.2 million and restaurant traffic grew 3% in the year's final quarter, ended Sept. 29.

Starbucks has been widely criticized by consumers and politicians in the U.K. for not paying corporate taxes for several years on the basis that its business in Britain hadn't been profitable. In response to the pressure, Starbucks in June made a tax payment to the British government and plans to make more payments. A company spokeswoman said the tax controversy hasn't affected its sales.

U.S. restaurant chains have long worked with franchise partners overseas, with McDonald's Corp. relying on the model for decades world-wide. Burger King WorldwideInc. BKW -0.52% recently signed a franchise agreement with a partner in India to start opening restaurants there. Many other chains are using it more in the U.S., too, to limit business volatility and ensure more predictable profits from royalty fees collected from franchisees. Burger King, Wendy's Co. and DineEquity Inc. DIN +0.27% 's Applebee's chain have been selling company-owned restaurants to franchisees recently.

Sharon Zackfia, an analyst with William Blair & Co., said the franchise model is particularly appealing for companies in Europe's weak economy. "Investors would prefer they spend more of their capital on markets with higher rates of return," she said.

While Starbucks has traditionally avoided franchising, it has long operated a minority of its stores in China through a joint venture with a Chinese company and last year entered into a joint venture in India. Starbucks also has licensing agreements world-wide, typically involving a retailer or travel company operating small Starbucks kiosks in places like grocery stores and airports. Its licensing partners in the U.S. include Target Corp.TGT -0.75% and Safeway Inc. A Starbucks spokesman said it has no plans to franchise its full-scale coffee shops in the U.S.

In Europe, Starbucks plans to expand those licensing deals as well as increase franchising. Of the more than 200 Starbucks stores the company will open in the Europe, Middle East and Africa region in its current fiscal year, approximately 75% will be with licensees or franchisees.

Franchising carries risks in the event franchisees don't live up to company standards or relations otherwise sour. Starbucks has been aggressive about guarding its brand. It terminated a partnership with Kraft Foods KRFT -0.51% in 2011 because it alleged Kraft wasn't properly promoting and stocking Starbucks' bagged coffee in retail stores. An arbitrator this month ordered Starbucks to pay its former distributor nearly $2.8 billion for prematurely severing the agreement. Starbucks said it disagreed with the ruling.

Mr. Engskov acknowledges the need for caution. "The way you mitigate those risks is you take a lot of time to pick the right partners," he said.

Starbucks has gotten to know prospective franchisees and their families over dinner and has taken some to its Seattle headquarters to learn its ways, Mr. Engskov said. "It's very personal," he said. "We have to make sure they understand the culture of Starbucks." Anil Patil, owner of the company's first franchised outlet in Liphook and former owner of 20 Domino's Pizza shops in England, said the process to become a Starbucks franchisee involved attending a three-day workshop at the regional headquarters in Amsterdam where he learned about how the company procures and roasts its coffee.

He said that for "a company that historically believed franchising was anathema" to decide otherwise when the business necessitated it "shows that they're nimble with their strategy." Mr. Patil, who currently owns five Starbucks stores, will build another seven by the end of the fiscal year and hopes to build another 15 over the next two years.

Starbucks plans to limit its number of franchise partners to fewer than 25 in the U.K. The franchisees, who sign 10-year contracts with Starbucks, are expected to open 10 or more stores and must have experience in real-estate development or with operating branded retailers - not to mention liquid assets of at least £500,000 (about $805,000).

One of its new licensed stores in Europe is on a Swiss commuter train. The cafe, operated by Switzerland's national railway company, reflects Starbucks's parallel strategy of getting its brand in front of customers wherever they are.

"It's clear to us that we need to be more flexible in how we come to market in Europe. We've been traditionally known as a high-street retail store, but people expect high-quality coffee wherever they go and that's a big opportunity for us," Mr. Engskov said.

The chain has begun opening small self-serve cafes in office buildings in Europe and is introducing its Seattle's Best Coffee brand in Asda, a unit of Wal-Mart Stores Inc.WMT +0.10%

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