When you stop at Starbucks and spend $4.86 on a “tall” cappuccino and a muffin, you don’t think of yourself as a luxury shopper — but you are. That’s because you’re paying a premium of $2.05 over the $2.81 you’d spend at Tim Hortons for the same two items.

The dollars involved are very small potatoes compared with the amount you’d spend buying a Cartier watch instead of a Timex, but the decision to go for brand name and quality is similar.

Everyday luxuries, such as Seattle-based Starbucks Corp. ’s coffee, have an advantage over pricey items such as watches. Because the price difference is so minor, consumers don’t notice the premium they’re paying, says Charles Burbeck, head of global equities at HSBC Halbis Partners in London. Even though they’re paying a significant premium for these items, customers don’t add up the difference. For example, buying a cappuccino and muffin every day for a year at Starbucks would cost an aficionado $1,774, vs the $1,026 he or she would spend at Tim Hortons — a 73% premium.

Coffee isn’t the only everyday luxury on which companies are making a bundle by providing high-quality products along with an attractive place to sit and consume them. Austin, Tex.-based organic grocer Whole Foods Market Inc. is doing very well with a similar formula. Although the premium for organic food is more noticeable, the company’s strong growth shows many customers are prepared to pay it.

Both Starbucks and Whole Foods believe they have products that are superior to those of competitors. But the prime reason for their success, the companies say, is their ability to create an environment that resonates with customers, who think of their stores as a “third” place — a place that is the customers’ own in the same way as work and home, but without the responsibilities and demands. This comes partly from the attractive surroundings, but mostly from the people who work there.

At the JP Morgan Gaming, Lodging and Restaurants Conference in Las Vegas in late March, Starbucks chairman Harold Schultz spoke about the emotional connection the company has made with its customers, which he believes is based on shared values. The company considers itself a leader in social responsibility — providing stock options and comprehensive medical insurance for all employees, including most part-timers, and contributing to philanthropic causes. Those initiatives have led to a connection and established a trust that is lacking for most brands and retailers, Schultz says. And that creates loyalty.

Whole Foods chairman, CEO and co-founder John Mackay also believes customers are making a lifestyle choice when they shop at the company’s stores, which he describes as “fun places” that offer a unique environment and a high level of customer service. Only 15% of customers shop at the stores primarily for organic products, he says.

Adding stores

The biggest challenge for both companies is to attract and retain the high-quality people they need to sustain their brands.

Both are still expanding. Starbucks expects to have at least 30,000 locations eventually vs the more than 11,000 it has now. Whole Foods has a target of US$12 billion in annual revenue by 2010, which would be more than double its current revenue of around $5 billion (all figures are in U.S. dollars).

Neither company’s stock is cheap, but, says Burbeck, “There are not, in general, many other companies in the global sector that have such good, reliable growth potential.”

At about $38 a share in mid-April, Starbucks was trading at 50 times estimated 2006 earnings and 41 times 2007 earnings. Whole Foods, at $65 a share, or 44 times 2006 earnings and 35 times 2007 earnings, is his first choice.

Granted, Starbucks is much more profitable, with an operating margin of 11% and a return on equity of 21%, vs 5% and 11%, respectively, for Whole Foods. Yet Burbeck, who expects both companies to increase earnings by around 20% a year over the next three to five years, thinks Starbucks will sustain current profitability levels while Whole Foods will increase them to levels higher than global competitors. Whole Foods’ operating margin is already higher than the average 3% for global competitors, but its ROE is less than the 15% average.

In an early April report, New York-based Argus Research Co. raised its 12-month target for Starbucks’ shares to $43 a share from $40, saying the current price “fails to reflect the company’s prospects for strong domestic and international growth.” The Argus report’s writers were impressed with the company’s long history of opening new stores without cannibalizing sales at existing locations.

@page_break@As for Whole Foods, Burbeck thinks the company can add another 100 stores in its home U.S. market. While different laws and consumer tastes make expansion elsewhere more difficult, he thinks Whole Foods could eventually have 100 stores in Europe.

Richard Nield, a portfolio manager at AIM Funds Management Inc. in Texas, considers Whole Foods’ valuation “very high,” but thinks there’s still growth to come. It has “great relations with farmers, excellent store layouts and affluent customers who are inclined to pay a premium because of health concerns,” he says.

Strong growth

Here’s a closer look:

> Starbucks. The company reported net income of $174.2 million in the 13 weeks ended Jan. 1 — the first quarter of fiscal 2006 — up from $144.7 million in the same period a year earlier. Net revenue was $1.9 billion, vs $1.6 billion; operating cash flow before the change in non-cash working balances was $609.3 million, vs $413.7 million. There was virtually no long-term debt as of Jan. 1 and shareholders’ equity was $2.2 billion, with 767 million shares outstanding. No one owns more than 10% of the shares.

Although it was established in 1971, the company didn’t begin major expansion until the late 1980s. Today, it has more than 11,000 locations and is opening an average of five new locations a day.

Starbucks expanded beyond North America in 1995 with a joint venture in Tokyo. It is now in 37 countries — including mainland China, a market in which it has 200 locations. China is Starbuck’s top expansion priority, given the 200 million people who fit the Starbucks customer profile.

The company opened its first store in Paris in 2003 — a success despite the fact that relations be-tween the U.S. and France were at their lowest ebb at the time because of the war in Iraq. It now has 20 locations in France. International expansion usually includes local philanthropic activities that show the company’s commitment to give back, such as the $5-million education fund for young girls in rural China. Schultz describes Starbucks’ strategy as one that “balances profitability with benevolence.”

Starbucks is in a new transformational stage, Schultz adds, that will see it leverage its brand to distribute more products, particularly in entertainment. The company is already selling music CDs at full retail price, something no other retailer has been able to do, and it has its own label with artists who are attracted by the distribution power that 40 million customers a week globally represent. Starbucks has also co-produced a movie.

> Whole foods. In the 16 weeks ended Jan. 15 — the first quarter of fiscal 2006 — Whole Foods reported net income of $58.3 million, vs $46.2 million in the same period a year earlier. Revenue was $1.7 billion, up from $1.4 billion; cash flow after net change in non-cash working balances was $88.2 million, down from $121.6 million the year prior. Like Starbucks, the company has virtually no long-term debt. Common shareholders’ equity was $1.3 billion as of Jan. 15, with 138,928 shares outstanding, of which no one owns more than 10%.

Whole Foods was founded in Austin in 1980, but through the companies it subsequently acquired, its roots go back to the early 1970s. The company was initially “on the fringe,” Mackay said at the Bank of America 2006 Consumer Conference in New York in mid-March, but as it grew, it became “hip and cool.” Now with 181 stores — including three in Canada and seven in London, England — Whole Foods has moved into the mainstream, as witnessed by the stocking of organic products in regular grocery chains.

Whole Foods’ same-store sales growth is remarkable, up an average 11.1% annually over the past five years. Even the oldest stores, those that have been around more than 11 years, saw sales increase 9.1% in the 16 weeks, while those less than two years old had a 32.3% gain. In addition, Whole Foods is increasing the size of its stores. The company needs space to create a better experience, especially in the high-volume prepared foods area, Mackay says.

Its staff is 90% full-timers, and 93% of stock options go to non-executives. As for its customers, they are affluent and generally college-educated. Initially, Whole Foods focused on large urban centres, but it has also done well in secondary markets.

Internationally, Whole Foods is waiting to see how its new 75,000-square-foot store in London does. “If it does as well as we expect, it opens up incredible expansion opportunities in continental Europe,” Mackay says. IE