Smart Money Faceoff Review: Starbuck's Coffee

Starbucks (SBUX) is the subject of debate for the Face-Off column in this month’s (Nov ’07) issue of SmartMoney Magazine “Can Starbucks Serve Up Venti Profits?” If you are not familiar with this column, SmartMoney asks two experts to take opposing views on a company, and give five reasons on whether to buy/sell the respective stock.

Sharon Zackfia, analyst at William Blair gives the bull case and Mark Coffeit, portfolio manager of the Empiric Core Equity Fund responds with the bear case for Starbucks Coffee.

I have summarized the main points for both arguments below. I didn’t include all arguments from the article, just the most relevant.

BULL CASE: Sharon Zackfia

1. Sales growth will continue to be solid due to new breakfast & lunch offerings and international expansion (profitability in China is better than U.S.) Store count is expected to double in 5 years.
2. SBUX faces increased competition from McDonald's (MCD) but they are not fighting for the same consumer. Until 2003, coffee consumption had been declining, but 2006 was the highest level since the mid-80’s. In growing markets, all competitors can win.
3. P/E of 26x 2008 estimates is lower than the mid-30’s multiple SBUX has historically commanded. SBUX has maintained guidance for this year’s earnings since giving it August 2006. Growth is still impressive; It’s only large-cap retailer growing sales at more than 20% annually.

BEAR CASE: Mark Coffeit

1. Discretionary spending is slowing, and “I can’t think of anything more discretionary than a morning cup of coffee.”
2. Sales up 4% this year. “That’s not good for a retail company.” 26 P/E vs. 16 P/E for the Market. “Starbucks is priced for perfection” and the odds of it delivering perfection are the same for “tossing heads 10 times in a row.” “Could be dead money for five years.”
3. Breakfast will attract more customers, but the flip side is that new additions make the business more complicated thus prone for making mistakes and turning customers off.
4. McDonald’s has upgraded its coffee and will be offering lattes/cappuccinos that will cut into SBUX sales.

In the paragraphs below, I evaluate both stances and provide my opinion on the strengths/weaknesses of the contributors’ points.

Consumer Spending:
The first bear case argument: can’t think of anything more discretionary than morning coffee? That’s a totally absurd statement. I can think of many things a pinched consumer would cut back on before coffee: entertainment, travel, fashion apparel, leisure spending, and electronics to name a few. I think most all consumers would cut out an upscale dinner or new X-Box before giving up their morning coffee.

Ms. Zackfia believes that SBUX may not be immune to consumer spending downturns, but it is well insulated. I agree.

a) Caffeine is a highly addictive substance.
b) Drinking coffee is a morning ritual for many.
c) The unit price of coffee is low, thus not a blatant target for budget cuts.

I hear people all the time talk about “their morning coffee” and how they have to have it. It’s a daily pattern for some, which implies that the purchase decision process has become automatic. Coffee is closer to a staple than a discretionary good.

Competition:
Both agree that Starbucks and McDonalds product offerings are different, but Coffeit states that MCD provides a decent alternative. In my mind, there's much more to Starbucks than just its coffee. If that weren’t true, then SBUX couldn’t charge a premium. Additionally, if it were easy to duplicate SBUX model and offerings, many would have followed Starbucks years ago. SBUX has held of competitors since its incipience, so what makes them so vulnerable today? McDonalds and Dunkin Donuts have forever served coffee, likewise most every other restaurant.

Zackfia’s provides a stronger argument as to why MCD will not be a significant factor to SBUX sales growth since she cites evidence of growing coffee consumption.

I believe that MCD will only mildly impact growth in the sense of potential future new customers, not and will not steal current SBUX customers. I believe MCD is selling a good amount of coffee to customers who previously didn’t buy coffee neither from them nor from SBUX. MCD is just taking advantage of their high foot traffic already in place.

Sales Growth:
Coffeit’s statement about 4% sales growth is misleading; growth was 20% year/year and 4.6% qtr/qtr. Sequential growth of 4.6% is not bad since multiplying by four quarters is close to 20%, putting it loosely.

The bull argument cites new stores and international markets paving the way for sustained growth. The bear does not address growth prospects of SBUX store expansion plans.

Both participants say new food additions at Starbucks will increase traffic, yet Coffeit claims that is a reason for not buying the stock. He implies more harm can be done, than good, since SBUX store processes will become more complicated.

In my mind, Coffeit contradicts himself since he says MCD new offerings present a threat. If McDonald’s is rolling out new coffee beverages, such as lattes, then their business becomes more complicated too. They face the similar risk of driving away customers from poor customer service.

I believe SBUX is capable of better managing a new product addition due their better management and employees than MCD. It maybe a valid point, but all companies face that challenge when they introduce a new product line. It’s a part of business, and the odds are low that it will detrimentally affect either firm, but even less likely in the case of SBUX.

Valuation:
A multiple of 26x can be cheap or expensive depending on how one looks at it. The bear case is that SBUX is expensive because growth is slowing, and the bull case is that future growth can still be as high expected when SBUX traded at 35ish multiple. The bear states that SBUX is overvalued relative to a 16 market multiple.

SBUX should trade at a premium to the market because it has higher sales growth and higher returns on invested capital. SBUX has a valuable brand leading to a strong competitive position. Morningstar agrees, their economic moat rating for Starbucks is “wide.” A 26x multiple may be justified, but I would feel much more comfortable if it were in the low 20’s. It’s certainly not grossly overvalued at these levels as the bear implied.

Conclusion:
I was not impressed with Coffeit’s arguments because of his dearth of evidence, and the little he did provide was misleading (stating 4% growth incorrectly). Second, He appeared to inject too much unsubstantiated opinion such as his comments about “coffee is discretionary spending” and the odds of SBUX performing up to priced-in expectations are “tossing heads ten times in a row.” If one chooses to use hyperbolic exaggerations, then he needs to provide sufficient evidence to support his inferences. Otherwise, I get an impression that his commentary contains a unwarranted bias. Third, Coffeit’s logic regarding the possibility of complications from offering sandwiches is a stretch.

The bull, Ms. Zackfia, lays out a reasonable argument. None of her main points make SBUX a compelling buy, but she does give reasons against taking a bearish stance. On balance, SBUX faces more opportunities than threats. The major risk I see is that competition may limit SBUX ability to raise prices if costs (such as dairy) climb significantly higher, and disproportionately affect Starbucks more than its competitors. I believe that scenario coming to fruition is less likely.

I opined on Starbucks back in August with this article: Long-Term Hold (SBUX near same price then- $26), and my thesis was SBUX was attractive given a long-term investment horizon, but I wouldn’t be inclined to buy unless the SBUX dropped close to $20. I based this on the fact that SBUX price multiples had fallen to a more palatable level, and that the company’s future growth prospects and return on capital appear to be intact. I concluded that Starbucks shares were not bargain, but reasonable enough for consideration.

I reiterate my earlier (August 2007) position; Starbucks has moved from being very overvalued to reasonably valued, and SBUX would be very attractive/undervalued at a low-20’s share price.

Disclosure: I do not have a position in SBUX.

Comments

[Jonno1887]

Silly article. The author clearly has never worked in a fast-food restaurant and doesn't know the operational and logistical complexities within the restaurant when new product offerings are made. McDonald's has a much more robust menu and has proven month over month for the last 52 months (or so) how good it is at managing that complexity. Starbux simply hasn't. So, McDonal'ds still poses a serious threat to Starbux because new product offering can still continue to erode their sales...and conversely their inexperience with rolling out new product offerings will prevent them from reacting fast enough for it to matter. Your author in my opinion is another example of an arm-chair quarterback.

[T Muller]

You’re correct. I have never worked at McDonald’s or any other fast food restaurant. I understand that there are complexities involved with new product roll-outs,
Mr. Coffelt stated that Starbucks should increase foot traffic and ticket price with new food offerings but the business becomes more complicated and easy to turn customer’s off.
My contention was this was weak point he gives as a reason for not buying the stock. His implication is that SBUX do more harm than good, by attracting customers and then running them off. I think the chances of that happening are remote, as I said in my article
My point was that I don’t expect SBUX or MCD to have significant issues the new offerings are a natural line extensions to their current business. It’s not like the two are getting into something vastly different than their current operations.
I agree with the fact that MCD has more experience, they have the best operations designers and engineers and they exert a great deal of effort in research and testing to deliver taste without sacrificing efficiency.
I remarked that MCD faces a similar challenge. So, that’s not a real valid argument against buying SBUX.
I also said that I felt SBUX probably could execute the roll-out better than MCD. Because the roll-out ultimately gets executed by front-line employees on the floor, not the corporate process designers and research gurus. SBUX attracts higher quality employees. They are better paid and more educated. Second, SBUX stores are corporate operated, so they maintain a high level of control over front-line operations. MCD is mostly franchised stores, and maintaining control and consistency is more difficult.
It didn’t have to look at the data here: ACSI Datahttp://theacsi.org/index.php?... Table to know that MCD is ranked last in customer service. Starbucks scored top rating. Thus, it’s reasonable to assume that a restaurant with the best customer satisfaction, meaning they do their job well, could execute a product extension better than a restaurant that can’t even manage to deliver satisfactory service currently.
Additionally, MCD get 2/3 business drive thru, and majority in the morning hour. They can service customers quickly because breakfast menu is simple, and McMuffins, Biscuits, McGriddles, can be cooked and shelved before an order is made, to be subsequently placed in an upcoming order. Steaming and frothing milk requires time, and I am not sure to what extent it’s possible to prep pre-order. But, if lattes and the specialty coffee based beverages slow up the service line, that will not be good. So these issues are why I leaned towards SBUX over MCD.
To me, this isn’t a major issue, like I said they both have challenges and both have adequate resources to be successful. It’s a part of business adapting to change and the tastes and preferences of consumers. There may be small amount of risk, but it’s already priced in.
The purpose of my article was to evaluate both arguments are provide my opinion as to which expert did a better job- providing rational and pertinent points supported with some type of factual evidence.
I felt the expert recommending not to buy wasn’t as compelling as the expert for buying SBUX

[SonicAllstar]

Nice Job Turley. i tend to agree with your points, although I hope 26 is the low ;-)
Starbucks greates asset is their employees who they treat well and who actually go to work and do a good job. It is hard to quantify this in numbers, but I have never walked out of starbucks thinking, the space or employees needed to be cleaned up. A great example is McDonalds...Only in Chicago have I been impressed with McDonalds. the rest of the time I have health concerns and double check the change I get.
I have been trying to think about how Starbucks can monetize their branding better and it is truly a difficult problem. Teaming up with Bookstores was a great idea, maybe venturing into stadiums and ballparks so we have a good alternative to beer (sorry hops lovers). I would buy their refridgerated drinks more if they had less fat and calories. Last but not least, they should move with a little more force into the energy drink market. A double shot is not exciting, but a quadruple shot calls my name loud and clear.
You are correct, people will downgrade their dinners before they give up their morning coffee, it is a small way of feeling good as people go into work, where they do not all feel good. The real question on the board for Starbucks is how do they improve the quality of their coffee so you do not want other coffee?

[SonicAllstar]

Nice Job Turley. i tend to agree with your points, although I hope 26 is the low ;-)
Starbucks greates asset is their employees who they treat well and who actually go to work and do a good job. It is hard to quantify this in numbers, but I have never walked out of starbucks thinking, the space or employees needed to be cleaned up. A great example is McDonalds...Only in Chicago have I been impressed with McDonalds. the rest of the time I have health concerns and double check the change I get.
I have been trying to think about how Starbucks can monetize their branding better and it is truly a difficult problem. Teaming up with Bookstores was a great idea, maybe venturing into stadiums and ballparks so we have a good alternative to beer (sorry hops lovers). I would buy their refridgerated drinks more if they had less fat and calories. Last but not least, they should move with a little more force into the energy drink market. A double shot is not exciting, but a quadruple shot calls my name loud and clear.
You are correct, people will downgrade their dinners before they give up their morning coffee, it is a small way of feeling good as people go into work, where they do not all feel good. The real question on the board for Starbucks is how do they improve the quality of their coffee so you do not want other coffee?

[SonicAllstar]

Nice Job Turley. i tend to agree with your points, although I hope 26 is the low ;-)
Starbucks greates asset is their employees who they treat well and who actually go to work and do a good job. It is hard to quantify this in numbers, but I have never walked out of starbucks thinking, the space or employees needed to be cleaned up. A great example is McDonalds...Only in Chicago have I been impressed with McDonalds. the rest of the time I have health concerns and double check the change I get.
I have been trying to think about how Starbucks can monetize their branding better and it is truly a difficult problem. Teaming up with Bookstores was a great idea, maybe venturing into stadiums and ballparks so we have a good alternative to beer (sorry hops lovers). I would buy their refridgerated drinks more if they had less fat and calories. Last but not least, they should move with a little more force into the energy drink market. A double shot is not exciting, but a quadruple shot calls my name loud and clear.
You are correct, people will downgrade their dinners before they give up their morning coffee, it is a small way of feeling good as people go into work, where they do not all feel good. The real question on the board for Starbucks is how do they improve the quality of their coffee so you do not want other coffee?