Starbucks Will Restructure and Rise Once Again

Starbucks (SBUX) reported fourth quarter earnings after the close on Monday. Analysts had been expecting profit of 13 cents per share on revenues of $2.58 billion. Well, the results were a disappointment to most as the company earned only 1 cent per share after restructuring charges (store closures, etc.), when, excluding those charges, the coffee retailer would have earned more like $.10 a share. Revenue did rise 3% from a year ago, but the input costs of coffee and dairy products squeezed the bottom line. Perhaps most troubling was the fact that same store sales were off by more than 8 percent.

Starbucks has been fighting an uphill battle for more than a year now, as their coffee is a discretionary luxury to most consumers. As the housing and credit troubles have been absorbed by the public, mocha lattes have often been replaced by the cheaper if less decadent homemade brew. The consumer spending environment continued to deteriorate throughout 2008, and by mid-summer Starbucks knew that it had to do something. So, management moved to close 600 underperforming stores and shed a fair portion of their workforce. This was a necessary contraction of their least profitable locations. In the good ole days, Starbucks had grown its business so rapidly that it seemed to make sense to open one on every street corner, in every grocery store, every airport terminal, etc. But somewhere along the way, it became less of a gourmet coffee experience than a coffee version of fast food (generally stand-alone Starbucks even have a drive-thru).

Since the closure of those 600 stores, there has been a corporate identity crisis of sorts. Starbucks needs to get back to its core competency, which I think more than serving good coffee, is being a community meeting place, a study hall, and a place to catch up with a friend. Their employees were competent and friendly, all of which added to the feeling of being a valued customer. Starbucks grew too fast to maintain strict business standards, especially at grocery store- and airport-Starbucks, which were employed by the grocer or the airport and not by Starbucks.

Starbucks has attempted more than a few initiatives to get the besieged coffee house back on track. They took strides to make their coffee more affordable, offering “treat receipt” promotions and frequent purchasing cards. They unveiled their Pike’s Roast blend of coffee, and began to offer smoothies. There was mandatory employee retraining, and the list goes on and on. Clearly this is a time of restructuring for Starbucks and their management.

Furthermore, Starbucks is facing increased competition from Dunkin Donuts and McDonald’s (MCD). This has had the effect of more competitors slicing up a shrinking coffee “pie”. However, while we realize that these cheaper alternatives are stealing sales from Starbucks, it remains to be seen if people will still “trade down” when the economy rebounds. Also, Starbucks would benefit from offering a more extensive (or at least improved) food menu. People are hungry in the morning and Starbucks often loses these customers to said competitors.

As you can see from our ratings chart, we have been bullish on Starbucks for well over a year now. While it pains us to see our performance get crushed on a particular security, the old saying remains true, “if you liked them at $25, you’ll love them under $10!” Seriously, Starbucks is undoubtedly cheap right now, and growth prospects in China and India remain compelling. We calculated the range of price-to-cash flow and price-to-sales in which Starbucks has normally traded over the last 10 years. For price-to-sales, that historically normal range is 1.86x to 3.13x, but price-to-sales is currently less than half of the low end of the range at .69x. Similarly, price-to-cash flow is currently 6.1x, which is less than half of the low end of the historically normal range of 14.5x to 24.5x. So, there is no other way to describe this stock other than “deep value”, and if you have a long time horizon, it is very likely that Starbucks will begin to creep up closer to its normal valuation ranges as economic conditions improve. The company is trying to find its footing during a tough period, but management will manage and earnings will begin to grow when restructuring is in the rear view.

Comments

[H.J. Huneycutt:]

I don't know --- it seems like the Starbucks brand itself is worn at this point. It's a coffeehouse with a cookie-cutter format all over the nation; I'm not sure how they did so well for so long as it was. They will probably be a value at some price point, but I'm betting their glory days are behind them.

2008 Nov 11 08:46 AM

[Jonny Rockit:]

I think the time has come for Starbucks to reinvent some of what they do. I worked for them for 3 years and the product seemed to get weaker and weaker. Pike Place Roast is Latin American coffee that is supposed to compete with the coffee of MCD and DD! Since when does Starbucks change thier taste profiles to meet the average coffees of those places? I think also that middle management seems a little hesitant to promote people from within and instead look to bring in outsiders to manage stores and so forth who do not quite get the Starbucks ideas, they seem to treat it as another fast food restaurant when in fact Starbucks changed the game with the benfits they offered employees. Those same benfits attracted partners who were artists, musicians, librarians, students, and other passionate people who in turn passionately sold Starbucks to millions of people everyday, enthusiastically! In the attempt to grow at break neck speed their pool of good partners dwindled and was spread to far and as a result the brand suffered. Good, passionate, engaging people spread too thin mixed with people who didn't care resulted in a waterdown brand. I think that it will be a few years before Starbucks gets back to $30/share.

2008 Nov 11 09:17 AM

[Chris B:]

A bet on Starbucks would be a bet against a seemingly inevitable trend that we are already seeing. One day our savings rate will have to rise above zero. One day the middle class, whose incomes have been stagnant for nearly a decade, will have to decide whether to cut back on their $5 lattes and make Folgers at home.

Starbucks sells a discretionary luxury item, just like pet massages or premium $50 boxes of chocolates. To view them as a fast food joint would be a mistake. Americans will have to cut back somewhere, and the 500 calorie $5 splurges Starbucks sells will be the first to go.

2008 Nov 11 09:17 AM

[John Sherman:]

SBUX lower your coffee prices and the drinkers of coffee will re-appear. Else, just keep selling coffee supplies for the drinkers of coffee like Target, Fred Meyers, and Walmart sells.

2008 Nov 11 09:26 AM

[watagared:]

I know what their problems are. The music they play too loud in the store sux to no end. Put the XM on 46 and leave it there! The coffee is so strong you could strip paint with it! The employees are in never never land, just filling time until their Abecrombie and Fitch modeling job takes off.

I was in one last week behind another customer that the barista knew. She spent so much time flirting with him that I finally walked off. I went up 20 minutes later the same girl walked by, I was the only person in line, and twice said "i will be right with you". I walked off again. SIX people working in there and i could not get waited on. These people need some adult supervision.

They also need to hire a bus person and assign them to clean up the place. I am so glad I sold my stock at $32.50!

2008 Nov 11 09:43 AM

[Sarahmonster:]

Starbucks has been setting up shop next to privately owned coffee houses for years and putting them out of business. They purposely look for new locations near an existing privately owned coffee house as they know there is already a demand for coffee in the area. Once they establish that location, they usually end up taking away the business/sales from the privately owned coffe house, ultimately, putting the local shop out of business within 1 year of Starbucks setting up shop. This hurts the small business man and also our economy. I think it's about time Karma came back to bite them in the ass!

2008 Nov 11 09:58 AM

[kris23:]

I too have been bullish on SBUX but it seems collective sentiment for the company has become particularly bearish www.predictwallstreet.... and that over 56% of predictors have predicted SBUX down. While I still have faith in this company, I too agree that they need to change a lot of things internally and externally if they ever hope to compete in the coffee market again. Lowering prices could be a great advantage, but at the same time Starbucks has positioned itself as luxury coffee. Our economy is going to have to become a lot stronger before consumers ever resume there normal spending here.

2008 Nov 11 12:23 PM

[Kevin_S:]

People in my workplace are holding starbucks cups; I don't see them holding Mac Donald cups at all. No question starbucks is a better coffee, but people are choosing to look expensive, not cheap.

When I was still a university student, that sense was even stronger - you definitely don't want to look cheap walking around campus!

2008 Nov 11 01:04 PM

[mikebrah:]

The thing that attracts me to SBUX is that it is a mature company still trying to operate like a young growth company. As this transition continues and they start cutting some of the fat out of the current model, they can slow their growth and turn SBUX into a cash-flow cow ala MCD. Opening less stores less rapidly will contribute to a much bigger bottom line.

With a nice 3-5% dividend and a more realistic 9-12% longterm growth rate this company (and stock) will be a beast again.

2008 Nov 11 01:06 PM

[Clamdigger:]

Take a look at GMCR (Green Mountain Coffee Roasters) and their Keurig single serve brewer if you want to see the replacement business model for SBUX. These brewers are exploding off the shelves and the company is growing like a rocket. Very good coffees and teas and cocoa too. Have one at home and one in your workplace. GMCR coffee is also being sold by MCD. SBUX is a dead model. Really, you chould check it out.

2008 Nov 11 04:33 PM

[Larry House:]

I think you are overly optimistic. The very points you discuss make your conclusion less likely. Unless they find a way to sell their coffee for $2 instead of $4 and make more profit than they did at $4 AND get more traffic in their shops, they will not rise from the ashes. People are breaking the habit of SBUX. There is no growth in sight.

2008 Nov 11 10:34 PM

[delcape:]

I've owned SBUX since the 90's...
Just lucky, I sold 1/2 (400 shares), just a few years ago @ $37... now what I own cost me nothing. I'll wait it out, thanks.
It DOES seem tempting at less than $10.00

2008 Nov 12 08:35 AM

[Mowog:]

Starbucks stores in Japan, land of deflation, seem to be doing well. Service excellent, even by college kids (well, this is Japan), and the chain model works well here. Clean stores, usually no free WiFi (useless with Japan's cell phone network). Domestic competitors either look chintzier (Excelsior Caffe) or cater to a cheaper/older demographic (Doutor, owner of Ex. C.). Tully's has WiFi and might be able to hurt Starbucks, but SBUX has locked the style and snob factor here. Too bad Starbucks Japan is years behind the US, which is why I overpaid on my shares.

2008 Nov 13 07:03 AM

[yeswak:]

Amen!!!
I worked for Starbucks for 2 1/2 years and couldn't agree more with your assessment of starbucks decline. I personally had to leave since I was a student. They changed hour requirements on me that I just wasn't going to be able to meet. Unless they change they will continue to push away and alienate their most precious asset, their partners at the local level. These partners are the public face of starbucks to all of their customers. I also was interested as a high performing shift supervisor in a potential promotion to assistant manager but always seemed to get ignored. All the while our district added several outside hire managers and assistant managers.


On Nov 11 09:17 AM Jonny Rockit wrote:

> I think the time has come for Starbucks to reinvent some of what
> they do. I worked for them for 3 years and the product seemed to
> get weaker and weaker. Pike Place Roast is Latin American coffee
> that is supposed to compete with the coffee of MCD and DD! Since
> when does Starbucks change thier taste profiles to meet the average
> coffees of those places? I think also that middle management seems
> a little hesitant to promote people from within and instead look
> to bring in outsiders to manage stores and so forth who do not quite
> get the Starbucks ideas, they seem to treat it as another fast food
> restaurant when in fact Starbucks changed the game with the benfits
> they offered employees. Those same benfits attracted partners who
> were artists, musicians, librarians, students, and other passionate
> people who in turn passionately sold Starbucks to millions of people
> everyday, enthusiastically! In the attempt to grow at break neck
> speed their pool of good partners dwindled and was spread to far
> and as a result the brand suffered. Good, passionate, engaging people
> spread too thin mixed with people who didn't care resulted in a waterdown
> brand. I think that it will be a few years before Starbucks gets
> back to $30/share.

Apr 20 01:07 PM