StarBUCKS, Loyalty, and Breakage

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StarBUCKS, Loyalty, and Breakage

Whether you are a coffee drinker or not, I don’t think you’d be surprised to learn that 64% of Americans drink at least one cup a day. Coffee shops, of course, know all about our national addiction to the beverage, and they’re developing strategies to foster a sense of brand loyalty among their customers. 

Last week’s article (“What’s in a name?”) mentioned a “brand expression” document that was released by Starbucks. Today’s post considers another strategy of the Seattle-based company — Starbucks Rewards, their (VERY popular) loyalty program.

A couple of weeks ago, finance blogger JP Koning shared some insights about Starbucks’ financial statements. The piece reached a much broader audience after being picked up by The Browser. (Side note: The Browser is one of the largest paid newsletters — check out the Marketing BS article “Where Could This Go?”).

Some important context for those of you who don’t frequent your neighborhood Starbucks: many of their customers don’t use cash, credit, or debit to purchase their cappuccino. Instead, a growing number of patrons use physical gift cards — of the 15 most frequently bought gift cards in the US, Starbucks (#6 on the list) is the only restaurant. Moreover, almost half of all Starbucks customers pay for their order via an app on their smartphone. For the rest of today’s post, I’ll use the word “card” to include any of those payment options.

JP Koning begins his analysis with an observation about the amount of liabilities tied up in Starbucks cards

Starbucks has around$1.6 billion in stored value card liabilities outstanding. This represents the sum of all physical gift cards held in customer's wallets as well as the digital value of electronic balances held in the Starbucks Mobile App. It amounts to ~6% of all of the company's liabilities. 

I completely agree with Koning’s next point — while the word “liability” tends to be seen as a negative, these Starbucks liabilities are anything but:

Stored value card liabilities are the money that you, oh loyal Starbucks customer, use to buy coffee. What you might not realize is that these balances simultaneously function as a loan to Starbucks. Starbucks doesn't pay any interest on balances held in the Starbucks app or gift cards. You, the loyal customer, are providing the company with free debt. [Emphasis mine]

Koning contrasts the “interest-free” debt from Starbucks cards to the interest-bearing liabilities Starbucks pays to institutional investors of 0.46% to 4.5% per year. Taking a 2.5% average of that range, the $1.6 billion in gift card liabilities are saving Starbucks about $40 million a year in interest payments! 

My take: I think that reducing interest payments is clever, but it’s just a side benefit of the company’s emphatic promotion of its cards. Starbucks leverages their customers’ loyalty in many ways that don’t appear on their menu boards. But before investigating the Starbucks recipe for success, let’s reflect on the concept of consumer loyalty. 


Loyalty is not about Loyalty 

I built the core of my marketing career on the establishment and refinement of loyalty and reward programs. During four years as a consultant with McKinsey, I helped increase the lifetime value of existing and potential customers for telecom and retail companies. Following my time at McKinsey, I joined Expedia to oversee “Customer Loyalty and CRM.” In practice, my position involved supervision of two distinct teams: one was responsible for Expedia’s loyalty program (a partnership with Citibank), an obsolete “elite customers” program, and the Expedia Credit Card (also with Citi). The second team was responsible for customer-level analytics across the global business.

During my interview with Expedia, I said: “If you hire me, there’s a good chance that I will shut down your loyalty program.” To the credit of my prospective manager (Expedia’s SVP of Global Marketing), he replied: “If that’s what the data suggests, then I will back you up.”

Why was I relatively confident that the data would support the cancellation the loyalty program?

Because my years at McKinsey taught me that loyalty programs almost always destroy value. When we conducted quantitative assessments of companies with and without loyalty programs in a given sector (with the notable exception of hotels and airlines), the ones WITHOUT loyalty programs significantly outperformed the ones WITH loyalty programs. We all know that correlation does not equal causation, but our quantitative analysis substantiated some of our qualitative perspectives about WHY loyalty programs do not function in the ways that many marketers believe.

Let’s call a spade a spade: “Loyalty Program” is a completely hollow term. The mere act of calling something a “loyalty program” does not — in any meaningful way — generate loyalty for your company. A better, more objective description for most loyalty programs would be something like “a points-based rewards program.”

Before evaluating how loyalty programs work (or don’t), let’s take a minute to review their basic design

  1. The customer joins the program (and probably shares information about their age, gender, phone number, zip code, etc.)

  2. The customer earns “points” every time they make a purchase (with bonus points for posting on social media, etc.)

  3. The customer redeems points for merchandise or services (usually the retailer’s own merchandise or services).

The theoretical benefit of loyalty programs is straightforward: if a brand gives its customers a reward, those people will demonstrate greater loyalty to the brand. In some ways, that idea might be true. Imagine a hypothetical grocery store — let’s call it Food Place — offered a special currency (“Food Bucks”) that you could ONLY redeem at their stores. The next time you need to buy groceries, the value of the “Food Bucks” sitting in your wallet (physical or digital) might persuade you to visit your local Food Place. 

Here’s a real-world example: a few years ago, I received a coupon for 25% off from Diapers.com. I had never purchased anything from them before, but the discount convinced me to break my normal buying pattern. I went out of my way to buy something from the site (I have three small children, so it wasn’t hard…).

So…where’s the problem with the idea that rewarding customers will drive loyalty? 

The flaw has less to do with the concept than with the execution. The amount of “reward currency” provided by most loyalty programs is VERY low — usually on the order of 1% of purchases.

Let’s return to the Diapers.com example. Suppose, though, that I never started with a discount coupon. Perhaps I saw an online advertisement and decided to give them a try. I made a $100 purchase at Diapers.com and earned $1 worth of “Diaper Bucks.” Would $1 really entice me — no matter how thrifty I might be — to keep making $100 purchases from the company? I highly doubt it. If I DID continue buying diapers from them, it would be due to factors like price, quality, or convenience, rather than the one dollar sitting in my rewards account. (Side note: Diapers.com shut down in 2017). 

There are some retailers that offer a “currency reward” of much greater than 1%. For instance, many coffee shops distribute “buy ten, get one free” cards, which is essentially a “currency reward” of 10%. Beyond coffee shops, could other industries use a 10% reward to incentivize potential customers to collect their “currency”? A loyalty manager from Hotels.com thought so; he presented me with data from their Hotels Loyalty Program, which provided an effective discount rate of 10%. The manager’s conclusions? Members of their Hotels Loyalty Program spent A LOT more on the site than travelers who were not part of the program.

I discovered a fault with the manager’s “analysis” — a problem I could easily spot because I’d seen similar errors in presentations from other salespeople. What’s the blind spot in their logic? They never consider that the members of their loyalty programs were not selected randomly — they were customers who had already perceived a benefit from registering for the program. In other words: joining a loyalty program does NOT automatically make people spend more money; the people who already spend more money are the most likely to join a loyalty program!

If you’re looking for a more effective way to quantitatively evaluate the impact of a loyalty program, you need to analyze the changes in spend by customers from before and after they register. (If you’d like to read a detailed study, Unnati Narang and Venkatesh Shankar published an academic paper that assesses what happens with customers who download companies’ mobile apps). 

Many companies' research conclusions are complicated by the fundamental fact that most people only expend the time and effort to join loyalty programs when they plan to INCREASE their spending at a particular retailer (e.g., when a person pursues a new hobby or when a restaurant opens in their neighborhood). A person making a one-time purchase (e.g., a tourist passing through town) or reducing their spending at a specific store (e.g., when a person’s child outgrows the need for baby furniture) is unlikely to sign up for a loyalty program. 

For more accurate results, you could try running a true A/B test that only offers SOME members the ability to register for your loyalty program. This methodological approach can account for the fact that most people only join programs when they plan to increase their spending. During my time at Expedia, I supervised tests like this when we launched an in-house version of Expedia’s loyalty program. Our observations? We saw very little (measurable) change in behavior.

Do any customers actually care about retailer-specific “currency” programs? 

Absolutely. And who are these people? They’re the people who are ALREADY loyal customers of that retailer. Let’s return one last time to the Diapers.com situation. Suppose I love their price, quality, and/or convenience so much that I am already spending $100 a week at Diapers.com. You can be certain that I will not only pay attention to the $1 in “Diaper Bucks” I’m earning every week, but I will also make sure to use it the following week (reducing my spend to $99 for a weekly supply). As a committed customer, that discount — no matter how small — would be a welcome bonus.

What happens when you point out this information to loyalty marketers? Their story quickly shifts from “I can prove that loyalty programs drive loyalty” to something like this, “Well, in that case…isn’t it great that we’re discounting prices for our highest-spending customers? Don’t we want to drive loyalty with them the most? Isn’t it more important to keep an existing customer happy than it is to acquire a new customer?”

Of course, there’s a clear problem with those justifications: your most frequent, highest-spending customers tend to be your LEAST price-sensitive customers. These are people that have already decided that (1) your product meets their needs, and (2) they want to purchase from you on a regular basis. They are the LAST people you should be plying with discounts. Instead, your company should focus its discounting strategy on potential customers who need an incentive to get over their resistance to trialing your product — in other words, target the people who currently care the least about your “in-store currency.”


Make Loyalty Work for You 

Marketing BS subscribers know that I spend a fair amount of time arguing why certain strategies don’t work, but I’m actually more passionate about sharing ideas that DO yield positive results. With that in mind, let’s consider some effective tactics. 

Points-based rewards programs work exceptionally well for hotels and airlines.

Two reasons:

  1. The Buyer/Payer Divide: A lot of business travel is purchased by an individual customer, but paid for by their company. These people might be price sensitive in their personal lives, but price insensitive in their business travel — since their company is picking up the tab. Suppose a business traveler needs to choose between two hotels. The Hyatt charges $200 a night and the Marriott $220, BUT it offers $10 worth of points for their reward program. Assuming location and quality are comparable, the second option is far more attractive to the business traveler. The $20 price difference is (mostly) irrelevant for the company paying the bill, but the individual employee gets to pocket the $10 in Marriott points for their future PERSONAL travel. When the buyer and the payer are different people, expect points-based rewards programs to thrive. I suspect this principle explains why Uber started (in 2018) rolling out a multitiered system for rewarding its users. Can you think of other industries where the buyer and payer are separate entities? I wonder if US hospitals could benefit from a points-based rewards program (although insurers might be more inclined to balk at price discrepancies between comparable providers)?

  2. Low Variable Cost: From a customer perspective, hotels are very expensive. But for a hotel, the cost to place one additional person in a room for a night is minimal. As such, if points are distributed for business travel and then redeemed for “discretionary” personal travel, the cost to the hotel is close to zero. Technically speaking, an opportunity cost exists if the traveler would have (1) booked a room at the property anyway, and (2) paid full price, even if it wasn’t discounted. This type of opportunity cost is a bigger reality for airlines than hotels, which explains why it’s generally more difficult to redeem airline points than hotel points.

For companies in most industries, though, the two reasons above are not applicable, and points-based rewards programs can end up costing a company more than they help. This reality is especially painful for retailers, who have (1) very high variable costs, and (2) a very low total of “business expensed” and “discretionary consumer” purchases.

And yet, many non-travel companies have managed to create vibrant points-based rewards programs. You can find lots of successful examples at gas stations, movie theatres, and fast food outlets. 

Starbucks, of course, has built an entire culture (some might say cult…) around their loyalty program. Let’s take a look at how the Starbucks Rewards program provides not only some well-known perks for customers (free coffee!), but also some significant benefits for the company.


Starbucks Rewards: a Venti Success

Let’s review the nitty-gritty details about the design of Starbucks Rewards.

On face value, the program looks like the ones at many other companies. Customers earn two “Stars” — their branded name for reward points — for every $1 they spend. You can redeem 50 Stars (a $25 spend) for a “hot brewed coffee” (which costs, at my local Starbucks, about $2). Some quick math (2/25*100) reveals a pretty rich 8% value from the program — much higher than the standard 1% you see from many retailers. (Note: the redemption valuation for Starbucks’ iconic “fancy” drinks are less generous; there are many websites that provide tips for finding the sweet spot in the Star system). 

Generally speaking, coffee shops operate on very high margins: this site estimates that the margin on a single cup of coffee is over 90%. This simple fact doesn’t mean that coffee shops are particularly profitable — they just make high margins on any given sale. And it takes a lot of $2 coffee sales to pay for the costs of the staff and the real estate. With that in mind, Starbucks is essentially a retailer with the dynamics of a hotel chain: high fixed costs, low marginal costs. Starbucks could basically give away their coffee for free, as long as those drinks went to people who wouldn’t normally buy one (giving free drinks to customers who would regularly buy them at full price isn’t a winning strategy…). 

How can Starbucks afford an 8%-back rewards program? Perhaps the goal of Starbucks Rewards is driving incremental purchases? Give away a free coffee in hopes that the customer will purchase a muffin and a sandwich as well? 

What do you think: does Starbucks Rewards drive incremental purchases? 

I don’t have any insider data, so I can’t say with certainty. Based on my experiences looking at similar programs, though, I would expect that Starbucks Rewards drives a very, very small increase in purchases. Why only a small increase? Because most people who join the program are customers who are already buying Starbucks’ (addictive) product — with or without the discount. I assume the program causes some activity on the margin, by attracting an occasional customer to walk past a rival coffee shop in order to earn the extra Star from Starbucks (an occurrence that probably happens more often during “Bonus Star” promotions). All in all, the rewards program might be giving Starbucks a ~10% lift in sales, but I doubt it would be much higher.

In a previous paragraph, I stated that companies should focus their discounting strategies on POTENTIAL customers, not their most frequent, highest-spending ones. Starbucks appears to have agreed with this logic, as evidenced by their decision to radically restructure their Starbucks Rewards program in March of this year

The changes to Starbucks Rewards tiers garnered significant (and mostly negative) attention from coffee drinkers on social media, as well analysis in places like MarketWatch:

Ted Rossman, industry analyst at CreditCards.com, told MarketWatch that “occasional Starbucks patrons will likely benefit, but the most frequent Starbucks-goers could lose out,” from the new rewards plan. He added that Starbucks is making a “bold move” here, because businesses usually try keeping their highest spenders happy.

With respect to Rossman, the changes are not such a “bold move” if you understand that loyalty programs are not about rewarding loyalty.


The Something Else 

The recent changes to Starbucks Rewards should put a little bit of extra money in Starbucks’ pocket (as did a tweaking of the program back in 2016). But even with these moves, I think it’s unlikely that Starbucks Rewards increases sales enough to make up for the value that the company gives away. Starbucks needs “something else” in order to make the program profitable.

The “something else” is the Starbucks Card Mobile App. You might be surprised (especially if you’re not a coffee drinker) to learn that Starbucks has the most frequently used payment app in the US — ahead of Apple Pay, Google Pay, and Samsung Pay. 

Take a close look at the titles for the three sections on the sign-up page — you can see Starbucks’ strategies hiding in plain sight.  

First of all, the app increases customer convenience. The ability to pay via a smartphone app reduces user friction. The ability to order ahead further reduces user friction. And we know that friction reduction DOES MATTER. Waiting 30 seconds instead of 2 minutes for an order will, on the margin, increase the number of orders any given individual will place. Many studies have calculated the impact of website performance. Mobify, for instance, discovered that for every 100 milliseconds of improvement in website load time, “conversion to checkout” improved by 1.11% and “checkout to sale” improved by 1.55%. Ordering ahead at Starbucks saves a lot more than milliseconds, as does scanning a payment app (instead of pulling a card out of your wallet, interacting with the machine, and waiting for approval, or — even slower — handing over cash and waiting for the barista to count your money and return any change). Any reductions to transaction time can improve convenience and drive true incremental purchases. Convenience matters.          

Moreover, the ability for users to “add money” to the app provides a windfall for Starbucks, thanks to interest payments and breakage.

Let’s return to JP Koning’s piece on Starbucks liabilities:

Each year Starbucks recognizes that a portion of its stored value liabilities will be permanently lost. This is known as breakage. Starbucks recognizes this amount as profit. In 2018 the company recognized $155 million in breakage, around 10% of all stored value balances. Wow! Starbucks already pays just 0% on its debts to customers, but add in breakage and that equates to a roughly -10% interest rate! [Emphasis mine]

PLUS (as if the 10% breakage isn’t impressive enough), I imagine that the Starbucks app is designed to reduce the company’s credit/debit card fees. When users load money onto their Starbucks account, the default amount is $25 (although options will allow a user to select a lower amount). By processing a single transaction of $25, Starbucks would end up paying less in credit/debit card fees than they would for processing ~12 separate purchases for $2 cups of hot brewed coffee. Depending on the details of their agreements with financial institutions, Starbucks could probably save somewhere in the range of ~2% by bundling transactions together.   

So far, there are two figures we can’t determine with precision: (1) the ~10% lift in sales, and (2) the ~2% reduction in credit/debit fees. Let’s pretend for a moment that neither of those factors exist. We know Starbucks Rewards is STILL economically viable, because it saves Starbucks the ~2.5% in interest charges (from the $1.6 billion in gift card liabilities) plus ~10% in breakage. That is well over the ~8% discount they are providing to customers. 

But wait — there’s even more. I expect Starbucks is understating the breakage impact.

When I led the work to create the Expedia Rewards Program (which replaced our partnership with Citibank), we spent a lot of time trying to measure our projected breakage. Eventually, we settled on an estimate in the neighborhood of 50%. When we shared our plans with the accounting team, they immediately recoiled at that number. In fact, they hesitated to accept ANY breakage number. In their opinion, if we issued points to customers, those points were a liability that needed to be recorded at 100% value on our financial statements. The only way to remove that liability was by eliminating those points from the customers.

Recording the full value of outstanding reward points (or gift cards) is a standard practice among many companies’ accounting departments. That decision makes the rewards programs look much worse on an accounting basis than on a true cash flow basis. And because so many companies care about accounting statements, you can often read fine-print policies that allow reward points to “expire.” As soon as the points expire, the company can declare a write-down on those liabilities; in other words, the company realizes a “profit.” (Side note: many companies used to include expiry dates on gift cards, until governments prohibited the practice).

If you fly United, you probably received a recent email informing you about changes to their Loyalty Program, highlighted by a new policy that “points never expire.” I expect this change was less about generating customer goodwill than it was an accounting departments’ decision to allow the writing off of X percentage of reward point liabilities.

Starbucks’ accounting appears to be sophisticated enough that they are writing off 10% of their outstanding reward-uploaded cash every year. For clarity’s sake, that doesn’t mean those liabilities have gone to zero — it just means that 10% is the maximum amount the marketing department has convinced the accounting department to write off at any given time. And since accounting departments are notoriously conservative, I expect that figure to be the absolutely highest write-off Starbucks will see from this program in the future.


Final Thoughts 

I hope that I have conveyed one key message: loyalty programs are rarely about loyalty. Airlines and hotels use loyalty programs to bribe business travelers with low marginal cost travel. Starbucks is using its loyalty program to increase customer convenience, while paying for it through no-interest loans and breakage.

Before you try copying the “obvious” elements of other companies’ success, it’s important to look under the hood at the true drivers of success. They are rarely as obvious as you think.

Keep it simple,

Edward

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Edward Nevraumont is a Senior Advisor with Warburg Pincus. The former CMO of General Assembly and A Place for Mom, Edward previously worked at Expedia and McKinsey & Company. For more information, including details about his latest book, check out Marketing BS.