HBP Product ID: ST78

UST078

THIAN CHEW AMBROSE TONG

Pacific Balanced Scorecard: Operationalizing Strategies

Since Resource Enterprise Ltd. (CRE) acquired a majority stake in Pacific Coffee in 2010, the coffee chain had experience tremendous expansion particularly in mainland China (See Appendix for background information). Yet, remained the core part of the business, and Pacific Coffee could not afford to lose its leadership position in its home base. On top of this, the competitive environment had become more intense whilst the Hong Kong coffee consumers became more sophisticated.

Jonathan Somerville, CEO of Pacific Coffee, realized that while he needed to stay involved and on top of the business in Hong Kong, he no longer had the capacity to be involved day to day, when his “gut feeling” of what was happening in the business could explain what he saw in the financial reports he was getting. At the same time, he needed to motivate his Hong Kong team and give them direction when implementing strategies.

At the same time, there was an increasing saturation of coffee houses and intensified competition in Hong Kong, alongside a far more sophisticated and demanding customer base. Jonathan needed to develop a strategy to address these new challenges, and then operationalize these. He realized one got what one measured, and needed both a baseline as well as target metrics aligning to Pacific Coffee’s overall strategy and critical success factors to get there.

He had previously come across the Balanced Business Scorecard as an effective tool to link and align a company’s strategy to its operations: the scorecard considered customers, internal business processes, innovation, and growth, as well as financial factors when determining the health of a company and how it tracked its strategic priorities. By balancing financial and non-financial, as well as leading and lagging indicators, in one framework, Jonathan felt that this would be an effective tool to help his management team focus on what was important to achieve in the Hong Kong business going forward, as well as cascade these priorities down the organization.

Ambrose Tong prepared this case under the supervision of Professor Thian Chew solely as a basis for class discussion. The authors have disguised certain data to protect confidentiality. Cases are written in the past tense; this is not meant to imply that all practices, organizations, people, places or facts mentioned in the case no longer occur, exist or apply. Cases are not intended to serve as endorsements, sources of primary data, or illustration of effective or ineffective handling of a business situation.

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Appendix: Pacific Coffee, Pioneering Coffee Culture in Hong Kong

Pacific Coffee Company Limited, a Hong Kong-based chain, experienced a major change of ownership in September 2010. The new majority-shareholder of Pacific Coffee had been investing significant effort to establish and extend the brand and network in China. In the meantime, the management team had to maintain its leading position in the highly competitive Hong Kong market.

The Coffee Industry in Hong Kong

1980–2000: The Early Years

In the eighties and until the early nineties, it was difficult to get a decent cup of coffee in Hong Kong. While local tea houses served coffee, it was a far cry from the coffee served in Europe and the United States. The only places that served proper coffee were the occasional Western restaurant and the upscale hotels. At the same time, a trendy coffee drinking culture, led by , was taking off in the U.S. Lifestyle-themed started to proliferate across North America as holding a cup of such coffee became fashionable. Recognizing this unique opportunity, several American expatriates started setting up American-style coffeehouses in Hong Kong. These stores were characterized by quality service, comfortable lounge chairs, a relaxing ambience, and provision of useful media such as the latest editions of newspapers and magazines. As there was no Western-style coffee culture among local people, these first stores primarily targeted expatriates and tourists. They could be found in and around Central, the key business district of Hong Kong. Similar coffeehouses were seen in prime shopping areas frequented by tourists, such as Tsim Sha Tsui and Causeway Bay. Residential areas with a high number of expatriate residents like Discovery Bay also were popular store locations.

By the mid-nineties, these coffeehouses started to flourish as more local residents became familiar with this relaxed and cozy Western coffee culture. Hong Kong, with its high population density, was characterized by small apartments and an intense work culture. The coffeehouses offered a welcome respite from the crowdedness and stress. In the U.S., anecdotal experience indicated that as much as 80% of a coffeehouse’s business was derived from takeout customers, whereas the trend in Hong Kong was the opposite. Most customers in Hong Kong chose to take coffee breaks inside the stores. As coffeehouses gained in popularity, additional players entered the market. By the start of the century there were only a few coffeehouse chains, each with no more than 15 stores. Most Western-style coffeehouses were limited to a single location operating in a “mom and pop” style.

2000-2019: Emergence of Coffee Culture and Competition

From 2000 on, Hong Kong experienced a surge in coffee stores driven by both local and global coffee players. The U.S. and European coffee culture took hold in Hong Kong. But with this success and popularity, intense competition emerged and almost every prime location in Hong Kong had multiple coffeehouses. As the industry grew, a few chains emerged that dominated the industry. By early 2019, Pacific Coffee, Starbucks, and McCafé collectively operated around 400 stores in Hong Kong. Still, new brands and offerings continued to emerge and to challenge their dominance.

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Photo: Three Coffeehouses on Gloucester Road, Hong Kong (as of March 2019)

Source: Google Maps, March 2019

Starbucks Starbucks Coffee Company, the world’s largest coffee company, made its debut in Hong Kong in May 2000 with its first store launch at Central district's Exchange Square. Starbucks in Hong Kong was operated through a joint venture with Maxim’s Group called Coffee Concepts (Hong Kong) Limited (Coffee Concepts). Founded in 1956, Maxim’s Group was the biggest fast-food and bakery chain operator in Hong Kong. Maxim’s Group in turn was 50% owned by Jardine Matheson Group, a conglomerate established in Hong Kong more than 100 years ago.

Starbucks expanded rapidly in Hong Kong and opened its 100th store by mid-2008. In June 2011, Maxim’s Group acquired all of Starbucks’ shareholding in Coffee Concepts and therefore assumed full ownership of Starbucks shops operating in Hong Kong and . Hong Kong became a licensed market for Starbucks Corporation. By mid-2018, Maxim’s operated over 170 Starbucks stores in Hong Kong.

McCafé McCafé, a coffeehouse concept by McDonald’s Corporation, started opening coffeehouses in Hong Kong by occupying a portion of space at existing McDonald’s fast-food restaurants. McDonald’s had been operating in Hong Kong since the late seventies and had restaurants across the territory. This allowed McCafé’s stores count to expand quickly. By early 2019, there were around 110 McCafé locations across Hong Kong.

Together with Pacific Coffee these three chains constituted the majority of the Western-style coffeehouse market in Hong Kong. There were also other emerging but smaller rival chains providing similar beverage offerings. Another coffee chain under the Maxim’s Group, Simplylife, had six outlets. Caffé Habitu, a boutique coffee–oriented chain under The Habitu Group of Hong Kong, had eleven outlets and planned for a few more locations. 18 Grams, another specialty coffee chain, had six locations. These smaller chains differentiated themselves by their décor, specific offerings and unique environments.

The coffee-drinking culture in Hong Kong, though solidly entrenched by 2019, still had room for further development as the coffee consumption per capita in and Japan was higher.

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The Economics of the Industry

The typical coffeehouse store operated from 7.30 a.m. or 8 a.m. in the morning until 8 p.m. to 10 p.m. in the evening. Some locations in shopping and tourist districts would operate until 11:30 p.m. The upfront capital expenditure for setting up a coffeehouse included furniture, fittings and fixtures, machinery, and rental deposits (usually two or three months’ of rent).

Most Western-style coffeehouses were situated in one of three general location types, namely, business area, area and government/public area. In office zones, some locations were at a corner or occupying a small space on the lobby floor. In retail areas, the presence ranged from street-level stores in residential neighborhoods to those occupying common spaces on various floors of shopping malls. In public areas, Pacific Coffee stores were at university campus, hospital premises or transport terminals. A rental contract contained the total lease period from two years to longer than six years. The typical lease contract included a fixed term of first three years1. Some leases contained rent-free clauses (one to three months) that typically started the beginning of the lease in order to entice retail chains to open at newer areas and provide time for construction and fit-out In shopping malls, food and beverage tenants usually paid the lowest rent rate. Other leases included performance-based clauses (e.g., revenue-sharing), which encouraged the coffeehouse’s performance to be more aligned with the objectives of the landlords. If the returns did not match expectations, the tenant could be told to vacate the space.

Unlike in the US where most customers customized their coffee drinks, the majority of consumers in Hong Kong ordered the standard offerings shown on the menu. The popular beverages included Cappuccino, Latte, Americano, Mocha, and Macchiato. As temperatures in Hong Kong reached tropical levels from April to September, cold beverage versions (iced or over crushed ice) of these popular beverages started making up a bigger portion of sales. The bigger chains were keen at introducing new beverage flavors in order to accommodate changing seasons and to keep their innovative edge. Still, the mainstream coffee drinks continued as key pillars of beverage income.

Pacific Coffee Company Limited

Pacific Coffee was founded in July 1992 by Tom Neir, an American expatriate from Seattle. He opened the first store at Bank of America Tower in Admiralty, a bustling Grade-A office district next to Central. To help scale up its operations in the mid-nineties, a few Hong Kong-based angel investors injected new capital to fund expansion. By 2000, Pacific Coffee had become an established retail chain in Hong Kong. In the same year, CVC Asia Pacific, a venture capital and private equity arm of Citigroup, became a significant investor in the chain. CVC also brought management and governance guidance to the business. Pacific Coffee grew to become a sizable chain with about 30 stores in early 2005.

In mid-2005, Chevalier Group, a family-run conglomerate in Hong Kong, acquired 100% of Pacific Coffee for HK$205 million. This price valued Pacific Coffee at roughly HK$4.6mn per store. The group envisioned that its connections in mainland China could help Pacific Coffee realize the next transformational growth opportunity. Pacific Coffee entered the mainland market in late 2005. As a newcomer, Pacific Coffee lacked brand recognition in its first two years of China expansion, which affected its ability to get favorable

1 Under the fixed-term period of a lease, a tenant would owe the landlord for rent over the whole duration. If tenant failed to pay, the landlord could sue to recover the lost rental income. A shop lease usually had a lease extension option, which both parties had to agree to mutually.

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This eventually led to the sale of an 80% stake of Pacific Coffee to China Resources Enterprise, Limited (“CRE”) for HK$327mn in cash in June 2010. At time of the sale, Pacific Coffee had more than 80 stores in Hong Kong and 5 in mainland China. CRE, a Chinese state–owned enterprise founded in 1938, was a publicly listed company in Hong Kong with annual sales turnover of HK$86bn for 2010. The conglomerate had more than 4,500 supermarket retail outlets throughout China as well as ownership of leading beverage brands. As a young member of CRE’s Retail Business Division, Pacific Coffee could leverage CRE’s influence and presence to help quickly establish its network in mainland China. The long-term goal was to position Pacific Coffee as a leading coffeehouse brand in mainland China. By June 2013, Pacific Coffee became wholly- owned by CRE as Chevalier Group sold its remaining 20% stake to CRE.

From CRE’s acquisition, Pacific Coffee expanded its network in Hong Kong and its expansion into mainland China was also quick as coffee consumption growth far outpaced that of tea. Under the CRE umbrella, Pacific Coffee’s CEO would participate in quarterly meetings among the business leaders of CRE’s various business segments [see Exhibit 1 for Pacific Coffee’s development timeline].

The Hong Kong market, however, remained a core part of the business. Not only was it critical to retain a dominant presence and brand in its home market, the Hong Kong operation also provided vital operating cash flows to the coffee-chain group. Going forward store and revenue growth in Hong Kong was expected to expand at a modest pace. The key focus of Pacific Coffee’s Hong Kong strategy shifted from expansion to optimizing profitability at existing stores. With Chevalier Group still retaining a 20% stake in Pacific Coffee, cross promotion between the coffeehouse chain and Chevalier’s Café Deco group of restaurants (around 30 outlets in Hong Kong as of early 2019) was also initiated.

By March 2019, Pacific Coffee’s system-wide store count exceeded 430. It had around 115 stores in Hong Kong and over 310 stores spread across over 20 cities in China, respectively. Within the system, there were also 9 locations in Macau and 5 in Malaysia.

A core differentiating factor of Pacific Coffee was its emphasis on coffee quality. It only used Arabica coffee beans, from which 22 varieties of coffee were developed. Its espressos had three distinct blends for customer choice. In 2011, Pacific Coffee was awarded “best coffeehouse” by readers of Hong Kong Economic Journal for its focus on coffee quality excellence. As its market share grew in Hong Kong, Pacific Coffee continued to tweak coffee quality gradually.

At our scale now, we cannot offer coffee drinks that are too niche or too premium in flavors —Jonathan Somerville, CEO, Pacific Coffee2

CEO and COO of Pacific Coffee

Raymond Tong Kwok-Kong was recruited as the new CEO of Pacific Coffee in September 2010 after CRE took control. Raymond graduated from the University of Pennsylvania with dual degrees in Electrical engineering and finance. He began his career as a management consultant at McKinsey & Company’s Hong

2 Presentation by Jonathan Somerville at HKUST.

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Kong office. Before this CEO appointment, Raymond served as vice president of Sumitomo Corporation Equity Asia, a private equity arm of Sumitomo Group of Japan. At Pacific Coffee, Raymond used all of the skills he had acquired previously to push Pacific Coffee’s transformation forward. In March 2013, the company was restructured under two units, namely, China Operations and HK& Overseas, reporting to Chairman and CEO Lan Yi, a key member of the CR Management. Raymond was promoted within CRE and became general manager of the corporate development department at CRE’s Retail Business Division. He retained an overseeing role in Pacific Coffee as one of the board directors.

Jonathan Somerville was appointed COO of Pacific Coffee in 2008 after spending nine years at Igor’s Group, and was subsequently promoted to CEO of Pacific Coffee, a Hong Kong–based chain of Western-style restaurants acquired by Chevalier Group in early 2007. A British national born in Australia and raised in Hong Kong, he obtained his hotel and hospitality–related university degree in the UK. Before joining Igor’s Group, he worked at Marco Polo Hong Kong Hotel for five years.

Customer Groups

Pacific Coffee served on average more than 25,000 customers daily. Customer groups would be classified by the following three location-specific categories:

• Office (30% of all customers) —customers at these stores included professionals who used stores as a “second office” by having meetings there, as well as office workers getting takeout.

• Retail (50%)—These stores were frequented mostly by shoppers and tourists as a place to meet outside work hours and during holidays. Stores in residential areas were included in this category as well.

• Others (20%)—The “others” category included stores at universities. Coffee and studying went hand in hand with the limited space in Hong Kong; the stores were ideal places for study. Although not as profitable in the short term, this segment was also seen as attractive over the long term because lifetime brand recognition and affinity was built during this period of a customer’s life. It also included stores in government offices and hospitals serving both workers as well as visitors. Last, this segment included stores in Hong Kong’s airport and mass transit rail terminals serving commuters.

Company Operations in Hong Kong

With its retail network spread over Hong Kong’s key business and retail districts, Pacific Coffee had a tested and well-run central sourcing, logistics, and procurement team. Stores were replenished with fresh products on time at the appropriate inventory levels. The central headquarters also comprised teams specializing in evaluating new food and beverage products; handling human resources and training; managing locations that included finding, negotiating and renewing leases; financial management and accounting; marketing ranging from in-store promotions to advertising in media; building proprietary information systems; and high-level management decision making. All these teams reported to Pacific Coffee’s COO. Another team managed by the COO was the retail service team, the largest within the company, with approximately 700 staff. This team comprised an operations manager who supervised 16 area managers, under whom were all store managers. An area manager usually covered seven to nine store managers [see Exhibit 2 for Pacific Coffee’s organization chart].

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At the store level, the majority of the sales came from sale of coffee, other coffee-based beverages (e.g., Chilinos), and non-coffee drinks such as bottled fruit juices and water. Beverage income averaged 60%–70% of a typical store’s sales turnover. Within the beverage products, those that contained milk accounted for the majority of revenue (around 70%). Food products, such as doughnuts and sandwiches, were available as well to help provide a comprehensive service offering and made up 20%–25% of sales. While most sales were conducted in cash, about 12% of the total store revenue was transacted using Octopus cards, a widely used electronic cash storage and payment system in Hong Kong.

Since 2008, Pacific Coffee had also run a loyalty-card program so that repeat customers could accumulate points on their cards. They could then use the points as a discount off their future purchases. In addition, to encourage sales by employees from certain companies located in the same building on a store, Pacific Coffee offered a 20% discount for purchasing coffee. Loyalty membership income, together with merchandise sales, constituted 5% of store revenue.

The chain was also pushing for more business-to-business sales by placing coffee machines in corporate offices and profiting from supplying coffee beans or coffee capsules on long-term contracts. These services and products were branded under “Coffee Solutions”. Pacific Coffee serviced and supplied more than 300 corporate clients. Business-to-business sales turnover accounted for about 10% of overall revenue.

Major costs included the wages of the store manager, the baristas, and other supporting staff; coffee beans, milk, and other food costs; rental expenses; utilities and gas; and depreciation of the furniture and fixtures. Operating hours differed from store to store, depending on each store’s main customer segment and neighborhood, but usually ran from 7 to 7:30 a.m. until 8 to 10 p.m. Ingredient costs had been volatile due to changing global demand for commodities such as milk and sugar.

There were four categories of store size. Large stores were between 1,500 and 2,000 square feet; medium stores, between 800 and 1,500 square feet; small stores, 500 to 800 square feet and corporate locations, 250 square feet or more. Since the economic recession in late 2008, the Hong Kong property market had experienced significant growth in prices and rental rates. Pacific Coffee, on average renewed or entered into new leases 20 times a year. With some landlords asking for rent rate increases ranging from 20% to 50% above their previous levels, Pacific Coffee had to be very careful in assessing the economic viability of existing and new locations.

F&B’s pay the least rent in shopping malls . . . they typically make up 20% of tenant mix. —Jonathan Somerville, CEO, Pacific Coffee3

Most stores were headed by one store manager. Reporting to the store manager were 1 to 10 staff handling all operations (baristas and cashier) depending on the store size. Store staff’s working hours were 240 hours a week spanning six working days and three shifts per day. A major key performance indicator (KPI) for store managers was the amount of food wastage their stores incurred, as coffee beans and milk could usually last for at least a few days. Service quality was imperative at the stores, and Pacific Coffee prescribed a comprehensive staff training plan and policy. As the company kept expanding its scale in Hong Kong and abroad, able employees were able to pursue long-term careers. Owing to the Hong Kong government’s legislation for minimum-wage floors since mid-2010, Pacific Coffee had also faced upward staff cost pressures, although it never paid staff at minimum wages. Staff costs increased 10% and retail staff turnover was kept relatively low across the company (around 6% per year). Retail workers who joined for less than

3 Presentation by Jonathan Somerville at HKUST.

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HKUST Business School Thompson Center for Business Case Studies three months contributed most to the turnover. After six months of joining, staff turnover trend became more stable. Quarterly bonuses were given to performing staff, which depended on customer feedback. The management team received customer feedback forms directly for evaluation.

In terms of gross margins, beverages yielded 65% while food commanded 50%–55%. Half of overall beverage costs was attributed to milk whereas the other half included chocolate (for Mocha, etc.), coffee beans and packaging materials. Drinks that contained less milk generally commanded higher margins. The overall group gross margin had been consistently trending at around 60%.

When Chevalier Group was still the sole owner of Pacific Coffee, Pacific Coffee invested in a central kitchen that produced food products for the coffeehouse locations as well as for external customers. As the network grew, the central kitchen gradually evolved to just serving the chain’s own stores and orders from other companies within CRE. The central kitchen was the Pacific Coffee’s only owned property and employed 100 staff. Before noon each day, store managers ordered food products from the central kitchen for the following day. The food products were produced afterward and packed before midnight. The logistics team subsequently picked them up and delivered them to the stores during the early hours of the next day. The kitchen also provided a centralized platform for food research and development. Pacific Coffee also had a warehouse that stocked more than 300 items. For example, coffee bean shipments sourced directly from overseas roasters were received twice a month. The coffee beans were then roasted before being delivered to stores. Unlike some of Pacific Coffee’s competitors which held coffee bean inventory for three to four months, the chain’s coffee beans were usually consumed within one and a half months. This helped to ensure the freshness of the beans in order to achieve consistent coffee quality.

Like other chain-store-based businesses, Pacific Coffee stores collected money up-front as transactions were made on site. Cash custody and management at stores was vital and the store managers followed strict rules for handling the cash after each business day. Cash at stores was collected twice daily. With an established supplier network and a good reputation, Pacific Coffee could wait for 30 to 45 days before actually paying the third-party vendors. Essentially leveraging vendors’ trust and credit, this model helped Pacific Coffee collect a steady stream of cash flows at proven stores. The cash, in turn, aided the funding of the expansion and improvements of the network. Additionally, the company could use fewer of its own assets for working capital and thus optimize its investment returns.

Pacific Coffee developed its point-of-sale (POS) system in-house. Terminals of the system were installed at stores. The system was used not only for recording daily revenue, but also for monitoring the food inventory level at stores. It controlled daily and weekly reorders to help analyze and minimize wastage over time. Staff attendance was also monitored by the system in order to accurately reflect staff wages and, indirectly, their performance.

Future Trend

In the midst of a sizable and stable market, the Hong Kong consumers-continued to become more sophisticated as new technology created both growing opportunities and threats. As a result, the focus of Pacific Coffee had gradually changed from store expansion and top-line growth, to operational and profitability optimization.

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Exhibit 1: Pacific Coffee’s Development Timeline

Year Key Developments

1992  First store founded in Hong Kong

1995  Setup Coffee Solutions to provide coffee solution to corporate clients

2000  First overseas store in Singapore

2005  Acquired by Chevalier Group  Setup of central kitchen

2008  Launched loyalty-card membership program: “The Perfect Cup Card”  First franchise store in Macau

2010  Acquired by China Resource Enterprise, Limited

2011  First self-operated store in after CRE acquisition  100th store in Admiralty district, Hong Kong

2012  Launch of Pacific Coffee capsule coffee machines  Opening of new flagship store: Pacific Coffee Emporium in Causeway Bay, Hong Kong  100th store in China (Silk Street area, ) 2013  Chevalier sold remaining 20% stake of PCC to CRE

Source: Information provided by Pacific Coffee Company Limited.

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Exhibit 2: Organization Chart of Pacific Coffee

CEO

COO

International Business Information Retail Administration Food & Beverage Franchise Development Projects Marketing Coffee Solutions Finance Technology Operations & HR Development Development Leasing

Area Central Managers Kitchen

Store Managers

Source: Information provided by Pacific Coffee Company Limited.

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Exhibit 3: Customer Traffic of Store X (in Central, Hong Kong)

Source: Information created by authors.

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