What’s Brewing at Starbucks?

The bucks tumbled for investors of Starbucks (NYSE: SBUX) when the star purveyor of premium coffee reported $0.15 EPS for the March quarter of 2008 versus $0.19 last year, a disappointing -21% drop (see conference call transcript).

The stock now trades around $16 per share, almost a -60% decline from its all time high of $40.01 reach in the company glorious days in November of 2006. Along with the bank stock owners, Starbucks shareholders feel pretty abused by life nowadays. Maybe the mood also affected their taste for the gourmet coffee they swear by every day, causing store traffic to disappoint. But behind the earnings disappointment and the heart-breaking decline in its stock prices, something tasty in the cup could be brewing.

The new Starbucks cold beverage platform this summer could be exciting.

Management predicted that the second half of 2008 will mark the beginning of an “exciting” wave of meaningful innovation coming to life in their stores. During the summer, they will launch a new, distinctive cold beverage platform, for which they promised excitement and uniqueness. To investigate what is going to come and to do tasting tests like Warren Buffett on the stage at the annual meetings of Berkshire Hathaway (BRK.A) (BRK.B), I went to the supermarket and bought home the Starbucks ice cream and its bottled cold coffee. I liked it! This was the first time I ever tried a cold coffee and I loved it. As to the ice cream, it was softer with less fat, tasting better than almost all the ice cream brands I had tried before. (The problem is, Starbucks’ goods are somewhat more expensive. And that’s how I missed its success story in the past.) But this time, from my first-hand tasting research, I do think they have the brewing to generate some buzz for the cold products this summer. And by that time, Wall Street would have forgotten about the earnings disappointment we face now.

Sales of packaged consumer coffee, tea and ice cream are still growing strong.

For their Global Consumer Products Group [CPG], total net revenues increased 22 percent, primarily due to increased sales of packaged coffee and tea. This data confirmed the findings in my tasting expedition. Ice cream and beverage businesses are very lucrative businesses to get into. It’s not hard to see Starbucks big future in that arena.

“Transformation” and “evolution” may work.

Part of the earnings disappointment is caused by investments in the “transformation” agenda and the next “evolution” of Starbucks. And I have to admit they do have a good track record once they are determined to innovate.

Strong international expansion still is the sizzle.

The sensational news of earnings disappointments also masked its impressive international growth. International total net revenues expanded 27 percent. They intend to accelerate its International unit expansion. International growth is expected to be at 20%, compared to 6% growth in the U.S. Since U.S. operations represent only 78% of Starbucks’ total net revenue, they still have plenty of room to grow internationally.

What’s in Starbucks' "kitchen sink"?

I also suspect that Starbucks played the “kitchen sink” strategy last quarter. In the press released, they cited the following reasons for disappointment:

• Costs associated with the implementation of its transformation agenda;
• Charges related to closing out unprofitable stores;
• Reduced frequency to U.S. stores. Their competitor Caribou Coffee Co. (NasdaqGM: CBOU) is facing the same slump while they struggle against cheap coffee offerings from McDonald’s (NYSE: MCD) and Dunkin’ Donuts.
• Higher occupancy costs and higher dairy costs as a percent of revenues, in the U.S. business.
• Lower income from equity investees resulting from product write-offs within their consumer product partnership.

More stock buybacks can help.

They also plan to substantially reducing our planned U.S. store openings and lowering their capital spending, which has proved to be a successful strategy for McDonald’s, one of their key competitors.

During the times of disappoints, we should never forget that Starbucks does seem to enjoy brand loyalty among the coffee addicts. That could be the durable competitive advantage that Warren Buffett talks about. On the flip side, management’s history of high compensations, extensive executive stock option awards, and relatively high valuation could still be a concern for the true bargain hunters.

So holding a huge can of Starbucks ice cream, my inner bull says, “Buy!” But my inner bear says, “Is this stuff still too expensive?” The arguments go on and on, for both the Starbucks products and the stock prices.

Disclosure: Brian Zen, CFA, is Chief Investment Officer of Zenway.com Inc., a New York-based investment advisory firm. He owns shares in Berkshire Hathaway and Starbucks, directly and indirectly. Brian appreciates your feedback at [e-mail] .

Comments

[adan:]

want some direct consumer feedback? (no positions in any stock)

my wife and i went to starbucks each and every day for years, and a couple yrs ago, began tapering off, and now seldom if ever go

we'll pick up some coffee at mcdonald's if its handy, but certainly no special trip just for coffee

# 1 reason we cut back? to expensive for what we got

in re to international sales, and certainly starbucks is not a lonely case, actually part of an expectant herd it seems like :-) , but really, don't you think the locals over there whereever are gonna eventually grow their own local hero coffee shop that'd like to frequent?

isn't that what we (the u.s.) did when europe thought we'd be their big money bags for products? we developed our own "buy american" home grown firms we like to frequent?

anyway, just my take :-)

i still very much like starbucks coffee, just wish it was more reasonably priced

2008 May 21 04:53 PM

[Superinvest...:]

Hi, Adan: I see your point. But do you feel Starbucks coffee taste better than McDonald's? What is the premium price you are willing to pay for that? To the dull tasting butt of a poor fellow like me, they are pretty much the same. I do have to say their bottled cold coffee does taste pretty good.

2008 May 22 01:01 PM

[NormanQ:]

The cold beverage platform will sink. Packaged coffee and Ice cream is not what makes Starbucks...Starbucks. Its high quality good tasting coffee and atmosphere is what makes people come back again and again. Until SBUX figures that out the stock is going sideways to down. Look at MCD & YUM brands. They all finally figured out what people wanted. FAST FOOD...duhhh. What do people want at SBUX? Good coffee in an interesting atmosphere. Not novelty cold coffee, ice cream, smoothies, Italian ice and all the other junk they're still pitching.

2008 May 25 10:53 AM