Starbucks Doesn't Need to Be Saved

After being thoroughly and utterly disdained by investors since late 2006, there is some sense of joy – relief might be a better word – at Starbucks (SBUX). News that the company would adopt a strategy shift along with the return of founder Howard Schultz to the CEO role sent shares up more than 8% Tuesday, the stock's biggest one-day gain since February 2006.

One question that is incessantly being asked by the media is whether or not Schultz's return will "save" Starbucks. I've seen some terrible headlines (e.g. "GM loses $39 billion this quarter"), but this one takes the cake. The crisis that is SBUX the stock is not in any way indicative of a crisis at Starbucks the company, unless investors can fairly blame management for their paying 50x earnings for a maturing company.

What is there to save at Starbucks? I would argue little to nothing. Starbucks is handily profitable and has an extremely good brand – something the company has defended in the past and will likely focus on even more now with the return of Schultz. If you want to talk about the turnarounds and saving that need to be done by newly-minted CEOs, then Jimmy Cayne's successor at Bear Stearns (BSC) will need to turnaround that company, and James Morgan will need to save Krispy Kreme (KKD). Howard Schultz is not saving Starbucks.

This isn't to say I don't like Howard Schultz coming back – it's very hard to dislike a commitment that is so antithetical to what one typically sees in upper management. By my count, Schultz owns (a diminished) $350 million in SBUX stock. He obviously doesn't need the money, he just really loves the job. This is all well and good, but is it worth the $1 billion in market cap that was tacked on to the company's valuation today?

I think the big story here isn't so much the return of Howard Schultz as it is the shift in corporate strategy to slow domestic expansion and refocus the attention and capital internationally. This really is a radical shift given the former expansion mentality of "a Starbucks on every street corner," which was under fire given concerns about diminishing returns. There are a couple angles at play here that warrant elaboration.

First, I wouldn't be surprised if the domestic shift is just a near-term move to appease Wall Street. With comps already coming in soft amid consumer spending worries, continuing to push store openings through will look stupid and reckless to an investor community that isn't very pleased with Starbucks to begin with. International growth stories are what people want to hear right now, and that's what Starbucks is doing. Thus, I wouldn't be shocked to see Starbucks start talking about reigniting domestic growth in late 2009. What I think everyone is seeing is a temporary shift in execution; I don't see Howard Schultz's vision for a Starbucks saturation being derailed for long.

So why the appeasement on the expansion strategy? It doesn't seem to have significant detriments long-term – basically, it won't result in the erosion of Starbucks' competitive position. More importantly though, I think there is a high probability that current EPS estimates are too high. The numbers seem too heavily weighted toward every quarter except this one (ending December '07, announcing January 30th) being good, so while Starbucks might disappoint on earnings and give soft guidance, the growth story can remain in tact and they can give some sense that positive steps are being taken.

As far as profitable growth goes, I think I (and several others) have been underestimating the company. Running the numbers from FYE2002-2007 makes it appear Starbucks does a very good job at deploying marginal capital in a profitable manner. Going back to what I said at the start, the problem with Starbucks is that people became much too willing to pay 50x earnings for a company that can reasonably grow around 25%. Paying twice the growth rate (PEG of 2) is generally the upper limit of what one wants to do. Still, consider the recent performance:

-Retail Revenues from 2002-2007 grew at a 23% compound rate
-Operating Income grew at a 27% compound rate
-Operating Cash Flow grew at a 23% compound rate

Those results should be hard to argue with. As for the profitability and declining ROIC – both absolute and marginal - I looked at changes in tangible capital (Total Assets – Goodwill – Intangibles – Accounts Payable) relative to changes in profits (both Operating Income and Operating Cash Flow). The numbers are lumpy as one might expect, but the overall signal is clear:

-Overall, ROIC as measured by Operating Income has increased from 15% in 2002 to 22.5% in 2007
-Overall, ROIC as measured by Operating Cash Flow has increased from 22.5% in 2002 to 28.35% in 2007

-Using Operating Income, marginal ROIC has fallen from 30% in 2002/3 to 20% in 2006/7
-Using Operating Cash Flow, marginal ROIC has held fairly steady around 25%

While it would certainly be best to have every indicator trending up, I find it difficult to complain about these results.

Another concern is the potentially growing expense of Starbucks' real estate portfolio, which it leases. Operating lease expense has increased, but no faster than profits – although total lease obligations are up 2.5x compared to tangible capital up 2.2x since 2002, so there is some degree of hidden leverage at work here because all operating leases are off-balance sheet. Still, operating leases due for the next year have grown in-line with retail sales overall (2.78x for leases vs. 2.86x for retail sales) and are down relative to profit growth. Operating Cash Flow coverage – my made up metric of OCF/Next Year's Operating Leases – has held steady at 192% for the 2002-2007 period and Operating Income coverage has increased from 128% to 152%. The same story reveals itself when looking at the total current lease obligations; OCF and OI coverage of both has increased overall.

What, then, is there for Howard Schultz to save? The hatchet job the market has done on SBUX is not management's responsibility, it is simply a consequence of investors overpaying for growth that can't continue forever. And, ironically enough, it looks to have more or less taken care of Schultz's problem: by my valuation, SBUX is reasonably priced using a 9% discount rate and 4% comps growth. Fair value? $18.30, or where the stock was priced before everyone got all excited that he was coming to save the day.

Comments

[kkin365]

Top mgmt deals with corporate strategy, with business model. Given SBUX's limited offering in editbles, what it does offer is atmosphere. Schultz talks about "drive thru" -- why pay $4 for a drive-thru cup of coffee when you can do the same for half of that thru MCD -- the latter is probably faster as well. A panelist on CNBC's Fast Money talked about the stock (before the changeover in top mgmt) being in the "teens" though he changed his view to a "buy" mode after the changeover. For me, being a senior citizen, I can buy MCD coffee at 50 cents max -- some stores offer it at 25 cents. And I can have a decent meal, salad and hamberger, as well. In a recent IBD meeting, 2 attendees said that they were short SBUX. I share their views.

[The Rogue]

Story is right on target. Jeffrey Sonnefeld has an excellent view as well on Squawk Box :www.youtube.com/watch?...

[James Cullen]

Rogue,
That's a good video, thanks for sharing it.