Starbucks: Accept The Addiction

There's been a lot of varying analysis surrounding the direction of Starbucks (SBUX) over the past several weeks. There are two camps as always, the bulls and the bears. CrossProfit consensus was categorically in the bear camp from February 7, 2006 until mid September 2007 when the consensus broke. By mid October a new bullish consensus materialized. The historical, current and forward looking consensus can be seen in the 2007/2008 evaluation charts.

As an ardent student of the rating game played by analysts, I have often mentioned to colleagues that upgrades tend to be a trifle early and downgrades more often than not seem to inevitably miss the boat. I suspect that the recent belated Goldman Sachs (GS) downgrade is such a case. Sometimes the downgrades are so late that they are disseminated after the ship has sunk. Where was Steven Kron (GS analyst) six or nine months ago? The same question can be put to Jim Cramer. Lately it seems like Cramer has access to GS proprietary research and upgrades and downgrades from GS appear to follow Cramer. The opposite is a more likely scenario and I am not insinuating any collusion.

Contrary to common perception, no one is bottom picking here. When the market moves a stock up there inevitably is a top which is always over the top. Likewise, when the market moves a stock down there is always a bottom that is an overshoot as well. This is inherent for all stocks without exception; otherwise there would not be a market. To downgrade a stock when it is already fundamentally in the overshoot range is more likely than not one of those anomalies that Jim Cramer bragged about doing when he ran his hedge fund. We may never know the game plan, as the possible motives are endless.

I have the highest respect for Goldman Sachs analysts in general and Steven Kron in particular so this is not to be construed as 'bone picking' in any shape or form.

The Bear Perspective

In a previous CrossProfit consensus article, we stated the following:

For several months now, CrossProfit has been warning about Starbucks (SBUX) being overvalued. The first warning was issued on 02/07/2006 (see http://www.crossprofit.com News Bulletin Archives - green column). In the beginning of July when SBUX hit $36 we posted a yellow warning that there was still another 15% downside to come. It came sooner than we expected!

There are two factors at play. First and foremost, a general uncertainty regarding the well publicized U.S. economic slowdown. Bernanke recently reiterated this generally accepted phenomenon and labeled it a 'consumer slowdown'. Hence, retail stocks are taking a hit.

In hindsight, retail stocks took a big hit and though SBUX is in the leisure category, we spelled out in the article as to why we lump the two sectors together.

SBUX is classified in the leisure category and not retail. The idea is to point out that discretionary spending is going to take a hit during this part of the economic cycle. As previously disseminated, there are several types of discretionary spending. Though we are not talking about a recession, we will refer to this slow down as if it were one. Not all discretionary spending [DS] is recession sensitive. In fact some DS actually improves in a recession. There are three primary categories of DS.

Functional purchases: DS for items that are purpose oriented and provide a function but are not necessarily needed by the consumer. (i.e. a new and better computer, new skirt, another pair of shoes.)

Indulgence purchases: DS for items that bring consumers emotional gratification that can be justified without creating a sense of guilt. (i.e. flowers, candy bars, beauty parlor, computer games.)

Extravagant purchases: DS for items that are definitely more than needed and usually imply a status symbol. i.e. Tiffany, BMW, Starbucks…

Recession creates uncertainty, uncertainty creates crisis and crisis creates stress. It is well documented that during recessions and true for depressions as well that the consumers psyche shifts when under stress.

For functional and extravagant items times get tough. The sale has to address the psychological barrier of guilt as well as convincing the consumer that it’s not really totally discretionary as the product has an inherent value of its own and will also improve the owner’s quality of life.

Note that we included Starbucks in the 'extravagant purchases' as there really is no compelling force that obligates the average caffeine addict to spend $3.50 on a latte fix when $1.50 for a non drip brew will do the trick.

As an aside, I confess to drinking over three cups of coffee a day though the years of over ten cups a day are long gone. Last month I tried to quit and that lasted 3 days.

As stated in the previous article, P/E ratios would come down and they did. This was inevitable. Both Kron and Cramer are tardily reiterating the same argument that we articulated in the 03/14/2007 update.

Upgrades and Downgrades

A lot has changed since the former article and update were written.

First, the ttm P/E ratio has dropped from the 40ish range to the mid 20's. Forward P/E is hovering around 20. Now I'm not going to get into a full fundamental numbers analysis, just point out the basic concept. It is true to say that forward P/E is based on future guidance that is provided by the company. It is also true to say that SBUX management has given accurate guidance throughout the slowdown, though some analysts might complain that the final figures always 'just made it' within the guidance range. There is no reason to assume that management will miss in FY2008 (ending 09/2008) or FY2009.

Second, Standard & Poor's Mark Bashan did an excellent overall analysis on SBUX as recently as 11/26/2007. Below are the highlights:

• SBUX plans to add at least 2,400 retail units annually for the next several years as it expands operations worldwide, and has a long-term global target of 40,000 locations. Partially in response to slowing U.S. economic growth, in our view, SBUX recently reduced its targeted new store openings for FY 08 (Sep.) slightly, to 2,500, from 2,600, including shifts to more cafe openings in international markets as well as to more licensed stores as opposed to company owned locations.
• We expect retail revenues to be up in FY 08 by 17% in the U.S. and 21% internationally, due to expansion. Average unit sales are expected to be unchanged, reflecting prices increases and lower U.S. traffic. We see specialty revenues rising about 16%.
• Our FY 08 EPS estimate is $1.02, versus $0.87 in FY 07. We believe operating margins will narrow slightly, with higher store operating costs partly offset by a price increase taken in Fall 2007. From a Q1 high in dairy costs, the company expects some moderation through the rest of the fiscal year.
• At about 22X our calendar 2008 EPS estimate of $1.05, the shares recently traded at a premium to industry peers and the S&P 500, but at the low end of the company's historical valuation range. Given what we believe is much better visibility for earnings in FY 08, we recently upgraded the shares to strong buy, from buy. We consider SBUX's long-term growth prospects to be strong, with growth prospects in international markets particularly appealing.
• Risks to our recommendation and target price include the potentially negative impact of price increases on customer traffic, lack of customer acceptance of SBUX's food initiatives, and the possibility that aggressive expansion in the U.S. will increase cannibalization rates.
• Our 12-month target price of $34 is based on our discounted cash flow analysis, which assumes a weighted average cost of capital of 10.4%, and 2007 cash flow growth of 37% falling over 20 years to a perpetuity rate of 4%. Our target implies a P/E multiple of 32X applied to our calendar 2008 EPS estimate of $1.05.

In a nutshell, S&P upgraded SBUX from a buy to a strong buy (5 stars). The name of the game is growth even if margins continue to contract. If there is enough new store growth to augment slowing same store sales growth in the U.S., coupled with overseas expansion, once again, management will continue to hit its targets and SBUX continues to be a growth story. Perhaps some of the dazzle and glitter is somewhat muted due to the overall economic sentiment, however, in the end of the day, revenue is revenue and income growth is what it is all about.

Contrary to previous SBUX statements, the 40,000 store target is long term and the company has stated that new store growth will be in the 2,500 to 3,000 per year range, including overseas. We had an issue with the '40,000 stores within 5 years', mentioned in past statements. SBUX has gotten its head out of the clouds and is now dealing with reality.

Far more important is the fact that SBUX management did not increase substantially the overall debt load in order to maintain the growth rate as was originally perceived as the devastating direction they were taking back in March 2007. For some strange reason no one seems to mention this.

Third, Goldman Sachs Steven Kron is quoted as saying:

Some investor concerns on Starbucks are warranted, such as declining new unit productivity and return on invested capital, softer traffic trends and still-rapid store expansion. Some pressures that are overstated include meaningful competition induced sales softness and a fractured brand, he said.

Now wait a minute. This is a mouthful and we need to dissect this item by item. The topics are:

1) Declining new unit productivity

2) Return on invested capital

3) Softer traffic trends

4) Still-rapid store expansion

I will talk about the overstated pressures later on and will make the argument that the competition is not only overblown but actually ends up feeding into the Starbucks emporium.

Declining New Unit Productivity

Honestly, I had to double check the figures and knowing Bashan, I'm sure he went and checked the figures again or called Bocian [CFO] for verification. Lower new unit productivity for the last reported quarter was strictly geographic specific and not on a national level. Sorry Steven, but this is a spin.

Return on Invested Capital

O.K., I'll give you this one. Any half twit can take a look at the balance sheet and compare FY2006 with FY2007 and will notice the bottom line. The net result was:

Total assets grew in FY2007 along with total liabilities implying a stagnant to lower return rate on invested capital. Does this warrant a P/E compression by 50%? I'm not calling Steven a half twit or anything of the sort, all I am saying is that Steven, you are stating the obvious yet at the same time you are leaving out the other half of the equation. Bashan seems to calculate a compression to the 32 range as more inline. At CrossProfit we are super conservative and derive at a $29 target which is a P/E of 27.6 based on $1.05 for FY2008. Personally, I think that Bashan is underestimating the overall negative market sentiment that is going to slightly depress ratios throughout 2008. We shall see in six months from now if SBUX is in the 29 range or the 34 range.

Softer Traffic Trends

This is like saying the same thing twice. The reason SBUX has a stagnant to lower ROI is because traffic growth has slowed. If you want, I can say the same thing in another three ways. Once again the other half of the equation has been omitted. Bashan has correctly pointed this out in his analysis ('and lower U.S. traffic') and explicitly states that the unit expansion in the U.S. (excluding overseas) more than covers this to yield a 17% revenue growth rate!

Still-rapid Store Expansion

Is this supposed to be a negative? This is the SBUX model! The more caffeine junkies there are, the more they (we) buy, the happier investors are. (I have never bought a cup of SBUX whatever in my life! I'm happy with my own poison.) Now I may not have had my third fix today, still, if you are implying that SBUX has reached the saturation point in the U.S. for non-cannibalizing locations, then I suggest you get a fix real soon! O.K., that was a bit harsh - wait, I'll get a cup and reword this…

The consensus is that there will be lower earnings growth in 2008 for the S&P 500. Most industries will find it difficult if not impossible to maintain current margins and expect to compensate with revenue expansion. In numerous fields, acquisition of competitors is the only and sometimes costly venue. SBUX is blessed to be in a segment that does not necessitate the acquisition of competitors.

Everywhere I go whether it is a conference or a wedding; there is a lot more coffee drinking going on than ever before. If anything, soft drinks seem to be in rapid decline and wine and coffee seem to be picking up, especially the latter. The next time you are at a shindig, look around and see what people are drinking for their 'last one for the road'! I lectured at a conference this past Friday and sure enough, I would estimate that 90% of the participants had at least one coffee during the break. I was at a wedding in Jerusalem Israel two nights ago and it was the same as in New York. Coffee addiction is global.

Addictive Recessionary Behavior

There are several schools of thought as to what happens to addictive patterns when the substance used becomes more expensive. A basic assumption is that discretionary spending [DS] otherwise known as discretionary disposable income is in decline therefore a cup of coffee costs more as a percentage of the remaining DS and the weighted cost factor intensifies with every price increase. For our purposes, we will use cigarette addiction for comparison.

In 1998, a Center for Disease Control (CDC) study was released that basically holds true until today;

According to the CDC analysis of 14 years of health data, smokers with family incomes equal to or below the study sample median ($33,106 in 1997 dollars) were more likely to respond to price increases by quitting than smokers with family incomes above the median.

For our analogy purposes we will say that the average SBUX addict is comparable to the above average median. The likelihood of reduced consumption due to higher prices is negligible.

Wait, this gets better.

One of the main themes touted recently by several analysts is the reintroduction of the black bean by McDonald's (MCD). In fact, there are even some reports out proclaiming that MCD coffee even tastes better. This could be true or not, I have never had a cup of coffee at McDonald's either.

The point is that part of the fix is the packaging and psychological experience as well. I read somewhere that private coffee shops are doing better now because they sell a cup of coffee out of a china cup/mug rather than a paper cup. I don't think this is the case and I am more inclined to believe that they are doing better because there are more coffee drinkers consuming more coffee. In addition, until recently I thought that I was the only meshigana (crazy person) that actually enjoyed drinking coffee out of a paper cup when no one was looking. I can't drink wine out of a paper cup, just can't.

Current thinking by some suggests that MCD is going to infringe on SBUX's client base. In reality, the infringement part is over with and what is happening now is that MCD is massively increasing the circle of addicts. The more chains that offer premium coffees, the more coffee is promoted as an acceptable mainstream beverage, the greater the number of caffeine addicts that in turn become potential SBUX junkies. The question remains regarding brand addiction, as in cigarettes.

A recent (July 2007) Columbia University study (sponsored by the CDC) showed that after a recent tax increase in NYC, a new concept arose known as "the $5 man".

Although interest in quitting was high among the smokers interviewed, bootleggers created an environment in which discounted cigarettes were easier to access than cessation services," said Donna Shelley, MD, MPH, assistant professor of clinical Sociomedical Sciences at the Mailman School of Public Health and the study's principal investigator. "Popular brands could be bought on the streets for as little as $5 per pack, and the phenomenon of the $5 man -- the commonly used term for a highly visible network of bootleggers who appeared after the tax increase -- emerged as a new source of low-cost cigarettes.

Rather than switch to less expensive brands, a demand for the same brand yet cheaper source flourished. This is documented as well in yet another research article (August 2003) where some brands are more addictive than others due to the additives that the manufacturers add to the cigarettes. Smokers rarely change brands as the body doesn't get the same buzz that it is accustomed to.

The same applies to coffee. There are many different types of coffee out there with many different tastes. At first, the coffee that tastes better and perhaps costs less is what will get people addicted. The brand that ultimately wins out is the one that may not taste better, but delivers a stronger 'pathological' and psychological buzz.

McDonald's may be the $5 man or maybe not, but from the looks of things the chances that a SBUX customer will quit because their wallet is pinched or switch brands because SBUX costs $0.30 or $0.70 more per cup is highly unlikely. Some SBUX customers may try a cheaper source but will stick with it only if they get the same buzz. If not, they will return to their original brand. I don't know enough about the MCD fix to say whether or not there will be a slow uptrend migration or not, though the possibility does exist. One thing for sure, if you need a fix and there is no MCD around, chances are you will fall on a SBUX first and give it a go. If you like the experience, SBUX hooks another.

As for the expensive lattes' here too the fix is in. I would like to see how many people are capable of quitting overnight. First of all, they don't want to. Secondly, it isn't as simple as it sounds.

Conclusion

Just like it is difficult for non smokers to understand the smoker's psyche, it is very difficult for non caffeine addicts to comprehend the behavioral patterns of coffee addicts. A $1.50 cup of coffee may well alleviate any physiology related to the addiction, but only the $3.50 latte will justify the expense to begin with. The psychological factors become more dominant during a downturn.

Current PEG ratio is below 0.90 and the earnings growth is going to be there whether we like it or not. MCD had a whole quarter to knock down SBUX sales and that didn't happen. The only thing that did happen is that MCD earnings went up through the roof and the company explicitly 'blames' coffee sales. This proves that MCD is a master pimp in the caffeine addiction arena with fallout heading SBUX's way. I wonder if MCD serves coffee to kids.

Owning shares in SBUX is almost like owning shares in crack houses with one big difference, SBUX is legal and McDonald's is willing to push for them. I hate to say this, but sooner or later MCD customers are going to opt for a more tantalizing experience.

After seeing last quarter's results, we all got it wrong. MCD is going to be feeding into the SBUX emporium and not the other way around. MCD isn't too concerned about losing even 10% of addicts to SBUX as it has over 80 million potential new customers to convert into addicts. Besides, hard core addicts don't switch brands that easily.

As we head into difficult times and disposable income dwindles, people are going to want to feel good and look good. I'm not sure that McDonald's delivers this message. From the way things look today, Starbucks delivers a perceived quality of life enhancement and is a heck of a lot cheaper than Tiffany, at least on a daily basis. Besides, I don't know anyone who is addicted to Tiffany.

Disclosure: associates are long SBUX (very new position).

Note: Figures in article exclude local tax.

Comments

[THofler]

I'm a SBUX drinker and shareholder & have been a bit incredulous over claims of MCD's superior coffee taste. I usually get my fix with whole SBUX beans from Costco, so for me it really is about the taste (and caffeine) fix & not luxury, atmosphere etc.

My take on the addiction is this: It is definitely a combo caffeine and taste fix. I like a mediocre cup of coffee just fine when going out, but it just cannot be confused with the consistently great coffee I can get at SBUX (or Peet's).

Who tastes the best? Try Googling "coffee taste test" & read past the headlines. The test results say that the serious coffee lovers prefer SBUX hands down.

[Ganesh Kumar]

I am a shareholder of SBUX. I started with a small position when SBUX hit 52 week low and have added little by little. My Average cost is now about 26.50. Now to the analysis and digging deeper.
I was also very passionate about SBUX and put in an 52-week low alert. Without looking at the numbers and without looking beneath the surface it is easy to be romanticized with Starbucks.
Of course wherever you look you see starbucks and which ever store you go there are people. I even sat at a store for about an hour to see whether the traffic slows down on a Sunday morning but could see a steady stream of people flowing in. I was more pleased!.

Starbucks is increasing its reach with bottle Frappucino's, Icecreams, choclates and Liquer. Some analyst once compared Starbucks to Amazons in the sense that as how Amazon was able to use its distribution/logistics capacity beyond books into everything now, Starbucks can use its distribution network to market and sell many more things than coffee.
In fact in one of economics book the author refers to Starbucks in London and Newyork and makes a valid point of how Starbucks has cornered all the prime locations in these cities and how it is very convenient for a consumer to get a Starbucks cofee. Would an average $50000 earner take the trouble to walk two block out of the way from his or her commute to find a coffee that is a dollar cheaper NO WAY. So all these are plusses right? I bough more SBUX shares and was patting myself in the back!

Now recently I thought that as I now own some serious amount of Starbucks stock, let me dig deeper myself rather than just listening to others opinion on Starbucks.

I downloaded the less flashy 10K report filed by Starbucks and patiently started reading it. Let me confess that reading through the 10K report requires a lot of patience than reading a blog or an Analyst report which is written in a sensational way (either arguing for bullish or bearish case).

There are couple of things that stuck me as I was reading the analyst report.
1. We all including the company agrees that the greatest growth potential for SBUX lies internationally not in US. SBUX has 171 stores in Manhattan alone!.
2. In many countries abroad, SBUX reports the revenue as "licensing revenues" wherever they have agreement with other partners (ALL middle east, Turkey, Russia etc)
3. I was very concerned about the leasing/Real estate costs for SBUX. I am also worried about their dairy and cofee costs but I think that they being commodities, Sbux can ride through these cycles easily.
As I was looking at these the things rather closely I found the following.

Regarding licensing revenues SBUX reported as follows:
"Licensing revenues, which are derived from retail store licensing arrangements as well as grocery, warehouse club and certain other branded-product operations, increased 19% to $1.0 billion for the fiscal year ended 2007, from $861 million for fiscal 2006. The increase was primarily due to higher product sales and royalty revenues from the opening of 1,229 new licensed retail stores in the last 12 months and a 20% increase in licensing revenues from the Company’s CPG business"

In 2007 SBUX reported 19% increase and licensed 1229 stores. Great right? not so soon. For 2006 you find the following:
Licensing revenues, which are derived from retail store licensing arrangements, as well as grocery, warehouse club and certain other branded product operations, increased 28% to $861 million for fiscal 2006, from $673 million for fiscal 2005. The increase is primarily due to higher product sales and royalty revenues from the opening of 1,156 new licensed retail stores in the last 12 months and, to a lesser extent, growth in the licensed grocery and warehouse club business.
In 2006, licensing revenues increased 28% and sbux opened 1156 new stores only! Remember that most of these licensed stores are abroad. The number of new licensed stores increased but the increase in revenues were much lower.I saw this as a warning sign.

I dig deeper. I started analyzing the margins for SBUX in US and abroad. Here is what I found:

For US, the cost of sales including store occupancy costs as a percentage of revenues is 40.2% and operating income as a percentage of revenue is 14.3%

For international, the cost of sales including store occupancy costs as a percentage of revenues is 48.6% and operating income as a percentage of revenue is 8.1%

The company has been telling that they would be able to leverage the fixed costs better as they open more stores internationally, I AM NOT BUYING it.

I doubt that Starbucks has to shell out a lot internationally for leasing costs for real estate and it is eating into its margins. Also I suspect whether SBUX has the pricing power it has in US abroad. Atleast in emerging countries like China, Middle east and Russia.

We all acknowledge that the major growth for SBUX is going to come from international sales. IF SBUX is pressured on margins for all the incremental sales, we may see revenue growth but not bottom line growth!.

Can some BULL analyst of SBUX dig deeper and give me good explanations why SBUX will be a good buy in the long run?

It is easy to fall in love with SBUX company as you see it everywhere and see a lot of people in the stores you visit. You may even like their coffee. BUT remember this may not justify the stock purchase as a great stock.

I have stopped accumulating (not sold my position yet). I am looking for some deeper analysis on the stock from analysts rather that saying SBUX is like crack and people got to buy it so buy the stock! Come on!

[Saul Sterman]

pop john,

Thanks for taking the time for writing you're carefully worded comment.

The bottom line is that you are requesting the numbers behind Mark Bashan's (S&P analyst) figures as to how he derives at a 17% revenue growth for U.S. and more perplexing to you is the 21% international figure for revenue growth in FY2008.

You are correct in stating that current margins from non U.S. operations are lower than U.S. margins for the past several years. SBUX management also confirms this and states as well that this will continue for some time though the spread will narrow over time.

Once you are convinced that the revenue growth will occur as projected by both analysts (S&P, CrossProfit and even Goldman Sachs, though the latter has a slightly lower target resulting in a $26 target price), you will see that an investment opportunity like now doesn't come along every day.

Before I knock your socks off with a one paragraph explanation of Bashan's numbers, first let's talk about the larger picture and how history tends to repeat itself though few rarely see it in the making and kick themselves in the pants when hindsight is visible to all.

For our history lesson we will use another (less) addictive beverage. Coca Cola (KO) is a global goliath. Today, KO has so many competitors that the combined sales of all of its competitors easily outsell KO on both volume and a revenue comparison. One competitor in particular has gained global market-share, but even with Pepsi at its current size, Coke is still king. At one time Coke had the opportunity of buying out Pepsi for a song and probably regrets today not acting on the opportunity. In the end of the day, there is only one company in the cola business that sets the tone for the rest. All the rest, until today, measure themselves as to how they are doing against Coke (KO).

Overseas, there are countries where not only the local brands sell for HALF of what Coke sells for, but Pepsi as well, in order to compete sells in line with local competition. In these countries Coke may not be the largest bottler but more often than not, Coke is the most profitable. When a brand can command a 50% premium and sometimes 100% premium over the local competition and still make the numbers work, then you know that you have dominated the marketplace.

SBUX is nowhere near reaching the KO global status in coffee. People who want a cola will ask for a "coke" even though they are pointing to a Pepsi bottle. When people who want a coffee ask for a Starbucks at the restaurant and everyone knows that it just means a coffee, this is when SBUX can change from its growth/domination strategy and work on the same retention/marketing approach as KO. Even after this happens, the total sales from competitors will far outstrip SBUX's revenue. The only difference is that just like with cola, there will be a clear global leader that sets the comparison benchmark.
When KO was building its global imprint there were times that margins contracted and there were times that margins expanded. This did not derail them from their basic strategy. From an investor's point of view, the KO story is very similar to SBUX. There were times that KO retracted 50% from recent highs only to present a second chance to get on board. It didn't happen very often, but those who looked at the bigger picture realized that this was an opportunity and not a long term derailment from the business model.

Likewise now, net growth is coming down for the next year or two to 17/18% from 22+%. Revenue growth has/will slowdown a bit. Yes, milk products have gone up and may go up further hurting margins a bit more etc. Big deal…the questions you should be asking yourself is;
1) Has Pepsi (McDonald's) delivered a knock out - no!
2) Can Pepsi (McDonald's) with all their might deliver a knock-out over the next year or so - no!
3) Will Pepsi (McDonald's) by introducing a 'me too' product take away business and if so how much, or will they just end up adding customers to the overall segment, growing the business primarily for themselves however there will be growth fallout for the competitors as well?

The answer to this is just look at what happened to all the stand alone coffee shops with the advent of SBUX. They are all doing better today in comparison with the timeframe prior to the SBUX phenomena.

When the cola wars erupted in the U.S., this was when the market had reached saturation. First, we are nowhere near saturation. Second, on a global basis the untapped source for coffee addiction is still in its infancy. Today, more British drink coffee than tea but this is still not the case in Asia. In other words we are still years away from an all out coffee war and SBUX is poised to be one of the goliaths that will partake in this endeavor when the time comes. McDonald's is now positioning itself to be a player when the war starts, but still has a long way to go both in the U.S. and overseas to match SBUX revenue in coffee.

SBUX is growing the business for itself and as always there has been fallout for competitors. Had it not been for SBUX, MCD would not be as successful in premium coffees. This is a two way street and it takes a lot of time for any one player to declare victory.

The 17% Growth Rate

Mark Bashan's revenue growth analysis to put it simply is straightforward. Take 15,000 stores; add 2,400 and you get 16%. (2400 divided by 15,000 = 16%). Take the worst quarter possible where same store total 'unit' sales growth (not total revenue growth which was higher) was only 1% and you get 17%! For overseas, add in exchange rate differences, improving economy of scale and in some countries throw in vertical integration and you get at least another 4% on those outlets. Also, overseas you are starting with a lower margin basis (as you mentioned) and improving traffic conditions. This works as a positive for year over year growth comparisons. Now remember that 2,400 stores are below the anticipated 2,500 so there is plenty of room for any error! The analysis is based on worse case scenario, not best! Still have your socks on?

What If?

What happens if SBUX doesn't use the 100 store reserve and FY2008 growth is back up to 22%? Then the S&P $34 target price doesn't look high at all. I say that they will use some or all of the reserve and still grow at 17%, hence the $29 target price. Also the S&P analysis assumes that there will not be any price increases in FY2008. This may be true in the U.S. but may not be the case in other countries where the local currency doesn't appreciate sufficiently against the dollar. Where it does appreciate sufficiently, this constitutes a price increase on its own.

I said 'only one paragraph' so I won't go on but you should know that it gets better as you look deeper into the overseas growth story. Essentially SBUX is grabbing prime store locations in every major population center on earth. They are focused on expanding at an achievable rate of 2,500 to 3,000 locations per year. In order to do so, many will have to be lower margin franchises at first and there is nothing wrong with this approach. KO did exactly the same at this stage of its global expansion; franchises make sense. As in the case of KO, when the time is right, some local franchises that meet specific metrics will be bought out. The franchise owners are counting on this as well. Everyone in this game knows the rules. Besides, if you didn't notice, MCD has a higher franchise percentage than SBUX, but that is about to even out over the next few years.

[ballsschweaty]

Let's keep it simple fellas. Charbucks Sucks!

I go to local indie coffee shops and they all blow away Charbucks in terms of quality, freshness and service.

[Ganesh Kumar]

Thanks for the reply. I think there is a big difference between Coke and Starbucks in that Starbucks is spending a lot of money in capital expenditures to open stores.

I am interested in knowing how much Starbucks is spending on just leasing costs (for real estate)and what is the clause for increase in lease rents every year.

In emerging markets real estate is red hot and I am worried that Starbucks may pay too much in leasing costs at the top of the bubble.

I like licensing the stores. I wish Starbucks licensed more stores and preserved cash and use it wisely for Advertisements, brand promotion and may be start a dividend.
I was just warning that Starbucks has licensed more stores in 2007 but the % increase in licensing revenues has come down.

[Saul Sterman]

pop,

First, SBUX bought back $342M shares last quarter, see:
research.investopedia....

They took out a $550M loan at 6.5% interest, which leaves them with $200M for further buybacks. Citi (C) had to pay 11% so a 6.5% rate in the current credit climate should tell you everything you need to know about SBUX. More important, this tells you what Wall Street really thinks about SBUX for the long term. For the short term, this could be a play to buyback at $22 and sell at $30 in 2008. So far, on 12.6M shares the profit would come in about $100M. I wouldn't be surprised if GS had its fingers in the kitty.

Second, got to the company site and you will get the projected breakdown between franchise (or as you put it 'licensed') both for U.S. and international. This is very clever of management. The percentages are way up for 2008. As they go into major metro areas overseas where rents are very expensive, coupled with a possible recession both in U.S. and perhaps globaly, it makes sense to continue store expansion through licensing. This reduces risk and as you put it, the need for heavy up-front investment. Likewise, SBUX does not carry the leases on its books. In other words, SBUX management is one step ahead of you, so don't worry too much about new leases at the top of a possible rent bubble.

The fact that more new stores will be licensed and not company owned may indeed lower the per store license income as the locations become more and more expensive. This allows for the operator to make a profit. Should the rents collapse, SBUX loses nothing and can renew at the renewal interims at a better negotiated price. It still beats shelling out big bucks for prime locations under the current economic environment.

The company does not disclose the other information that you requested.

[Saul Sterman]

pop,

I just noticed that in my first reply to you I addressed you as 'pop john' instead of 'pop'. I don't know where I got that from...sorry.

[giggy]

Nice article Saul. Just my 2 cents on SBUX. I'm a Daytrader. I have been very actively trading SBUX since 1 NOV. My level II screen is on all day. My bread and butter are small order imbalances (more buys than sells) where the stock can pop up 10-15 cents in 2 minutes. In the last 2 weeks i've noticed a little anomaly. Sometimes when there's too many buyers, GS has been plopping a 100,000 sell order in. The first time I saw it I paid it no mind. But when it started to happen more often, I had to think about it a bit.
Its obvious that no-one wants to sell for less that they cound get. So why are thet doing it? My feeling is that these big blocks are nothing more than sacrificial lambs aimed at stopping the stock from heading higher. This leads me to believe that GS must be holding a massive short position in SBUX. I may be completely wrong about this, but for the time being, I plan on continuing my strategy with this in mind. I dont think we have reached a bottom. When I start seeing GS start offing short positions and taking buy positions, thats when I'll start looking for an upward trend. Mark my words, when this happens, GS analysts will come out with a buy since SBUX is oversold. Cheers Giggy FWIW my initial investment money for this SBUX project is up 55% in 6 weeks :)

[SmartGuyStocks.com]

This article and level of discussion is excellent. However, I can't help but notice that everything I've read about SBUX has been overly concerned with ghetto MCD rather than the true marketshare threat: Dunkin. People who like the SBUX brand will not be caught dead with a MCD cup. However, Dunkin has managed to create a brand that people feel comfortable associating with. Further, the coffee is cheaper, loaded with caffeine, and is highly regarded for taste. Bags of Dunkin recently appeared in my local TGT, and I imagine this roll out will hurt SBUX.

I want to believe that this is like the time Buffett bought KO at a huge discount and went on to become a legend. However, until someone can show how SBUX intends to play defense against the increasingly popular Dunkin (kudos to Dunkin's new management), I think everyone is ignoring a major issue. (By the way, pop star Rachael Ray proudly drinks Dunkin.)

Thoughts?

[Paul Bunyon]

One competitive advatage that few have yet to point out is Starbuck's superior real-estate holdings. Put simply, Starbucks has secured many of the nations best coffee-centric store locations. These include, for example, the highest traffic street locations/corners, including prominent corners on the right hand side of the road (easy to stop in on your way to work...). Few (if any) other brands can tout such a competitive advantage, giving me one additional reason--in addition to the commonly cited factors--to believe that Starbuck's has established a long-term, sustainable competitive advantage.

Admittedly, stocks trading at ~20x earnings are rarely considered "value" stocks; at current prices, though, SBUX may be one exception.

Cheers, Steve.

[THofler]

In response to Smartguystocks: We bought a bag of whole bean Dunkin's recently at the supermarket, and frankly I thought it tasted one notch short of bad. We have also bought bagged Peet's at the same store and it tasted very good, but not as great as a Peet's shop walk-in.

I suppose Dunkin's evolution is smart & their in-store coffee is much improved over the years, but I miss the huge selection of dognuts from years gone by. Most of the new pastries don't interest me.

But this is all anecdotal. Read the coffee taste test results. Perhaps they are statistically significant?

[dNova]

Leave Cramer alone.

He's doing fine !!!

Whenever I go against his advice, I always make money.

He's as close to a "sure thing" in the market that I've ever found.

[dNova]

THofler

I work at a veterinary clinic.

We've got loads of dognuts here.

Usually, we send them out as medical waste. But, if you want to stop by, I'm sure we could part with a few.

[cswalker21]

dNova,
I almost dumped my ESLR about 6 months ago when Cramer said the whole sector was a "SELL SELL SELL." It has more than doubled since then. When he trashed SBUX, I averaged down. I'm hoping this "anti-Cramer"... strategy pays off again!
I think this company is still growing, still offers a good product and has very loyal customers. Sure there are risks, but I think SBUX will re-gain momentum.

[Johnny Bitchdog]

Comparisons to McDonalds franchise model and Coke's distribution model only confuse matters. Both are fine growth companies, as is Starbucks, but folks tend to want to assume that just because Coke and McDonald's growth went on forever, Starbucks must be a great buy right now.

I actually agree if you are talking about the long, long term but who cares......all good growth companies are good buys in the long term and there is no reason to chit chat about it.

However, McDonald's stock price was stagnant for 10 years from 1973 to 1983 - dead money for 10 years.

The important question for Starbucks right now is whether it is dead money for a long period of time, not whether it is going to cease to become a growth company.

And it's not too hard to figure out the reasons for the 50% fall:

- removal of sillly froth and blind momentum money
- slowing traffic
- input cost inflation
- wisdom or lack thereof in price increases / pissing off customers
- removal of housing / credit bubble taking money away from spenders
- general uncertainty about how customers might behave as the US slows down

International is a fine reason to buy as a long term investment, but it's not going to overcome U.S. based slowing, and contrary to the hype in the media, US slowing will also be a problem abroad (my opinion).

I wouldn't expect Starbucks earnings to start falling, but there are lots of good reasons to believe that input cost inflation and falling traffic are going to hit cash flow significantly in 2008.

Short term - avoid Starbucks as there is a quarter or two of bad news coming before the stock price fully reflects the U.S. slowdown.

Long term - perfectly reasonable investment, but buy in increments.....it's not going anywhere wild anytime soon.

Johnny.