Translation:They are drinking tea and she is drinking coffee.
Wasn't Sie formal only the 3rd person?
Sie formal is syntactically third person plural, i.e. it takes the same verb forms etc. as sie "they".
Thus Sie trinken "you drink" just like sie trinken "they drink".
Semantically, it's second person singular or plural (i.e. it refers to your listener or listeners).
Why is sie (meaning "her"), not capitalized?
Er, because it isn't.
We don't capitalise (most) pronouns in German -- like in English. We write sie singt and er singt like "she sings" and "he sings"; we don't write Sie singt any more than we would write "She sings" in the middle of an English sentence.
The first letter of a sentence is capitalised (again, as in English). But not pronouns.
(The exceptions being "I" in English and the polite Sie that means "you" in German.)