There's been a lot of varying analysis surrounding the direction of Starbucks (NASDAQ: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 (NYSE: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.
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 (NYSE: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.
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.