Starbucks: Just Looking for Direction

On Monday (April 28, 2008) Starbucks (SBUX) let out an early warning to investors about how they are revising their FY 08 estimates below $0.87 EPS, with analysts expecting $0.83.

The question that I believe must be answered when surveying Starbucks is: What is the primary cause for the negative growth numbers? Is it internal, and can be resolved through better management, and tighter execution? Is it competitive, and due to a heightened attack on all fronts on Starbucks' core business? Or is it completely macro-economic, and the result of one of the worst environments for auxiliary spending, a frustrated and debilitated consumer, and a global commodities price boom?

What's clear is that Starbucks' itself has begun to confront all three possibilities. An attempt at a turnaround began with the rehiring of founder Howard Schultz as CEO. Since then investors have waited for action and have recently received it with a new focus on core businesses and a new "signature roast" in order to bolster its competitive stance. Yet, in the same time period, we have seen Starbucks's margins shrink due to a commodities boom that affects everyone in the food industry. But with prices already at a premium, and a flailing consumer, it's hard for Starbucks to find a way to pass on the price increases to its customers.

The Bull Case:

The bull case surrounding Starbucks is completely dependent on the return of Howard Schultz and the "turnaround" he is trying to oversee. Up until recently, investors had no idea what a "restructuring" of the company meant. Here are the main points of the plan:

• Slowing down US expansion - They will only open 155 stores through September 2008 in the US. And 400 stores in the next 3 years
• Focusing on international growth - They will open 975 stores in international markets through September 2008.
• Discontinuation of their sandwich products
• New signature coffee brew called "Pike Place Roast"
• Starbucks will no longer manage their music label Hear Music. Instead, the partner in the project, Concord Music Group, will manage day to day operations
• The development of a online social network called MyStarbucksIdea
• A Starbucks rewards card program
• A completely new type of espresso machine to ensure a better brew

Starbucks's most similar public competitor is probably Peet's Coffee & Tea. Although, some may be even further disappointed in Starbucks's 1^st quarter numbers due to Peet's meeting of the street's estimates, such comparisons are rather silly. Peet's currently has a market capitalization of $336 Million. In comparison, Starbucks has a market cap of $12 billion, nearly 36 times larger than Peet's. Even though Peet's was able to meet street estimates for the quarter they did so on the back of growth due to the opening of more stores, a mere 9 stores. From Peet's 1^st quarter 8k:

"Retail net revenue increased 14% to $44.6 million for the 13 weeks ended March 30, 2008 from $39.0 million for the corresponding period of fiscal 2007. The increase was primarily attributable to new retail stores opened in the last 12 months, and to a lesser extent, sales growth in the existing store base. The Company opened nine new retail locations in the quarter."

"Cost of sales and related occupancy costs increased to 47.6% of total net revenue, compared to 47.3% for the corresponding quarter last year. The increase over last year is due to higher commodity costs, particularly green coffee and milk, partially offset by waste and cost reductions and by a retail price increase on some drinks in January 2008."

I mention Peet's performance because although Peet's is doing well, it is so small that it isn't even close to the brand name that Starbucks is. People like to compare companies within a sector. But once stocks are priced per share the market caps can often be overlooked. Peet's is a good company indeed. But let's be real, it barely even nicks Starbuck's super paper cups right now. That is what Starbucks has become all about. To invest in it now, and for the long term, is to invest in the belief that the strength of its brand name will endure. The easy thing is to analogize Starbuck's current situation, to McDonald's (MCD) circa 2002. Then McDonald's too was expanding too fast, spending too much money opening up additional stores while not letting revenues match the growth in spending. They also were opening too many stores in the US, which was becoming a saturated market.

Will all those initiatives that Schultz laid out work to reinvigorate Starbucks's stock like McDonald's did once before? Perhaps. Speaking of McDonald's, it along with Dunkin Donuts are taking quite the swipe at the coffee market. In a 3^rd party taste test McDonald's coffee was even found to taste better than Starbucks. Yet these are still different segments of the coffee market. It's like advertising on TV. If you want to go after the teenage crowd, you advertise on MTV. If you want to go after the business people you advertise on CNBC. McDonald's is targeting a different type of coffee drinker—one that is on the go, and wants the coffee for caffeine more than the experience. The protypical example used to argue McDonald's threat to Starbucks is that if you're at a business meeting and you decide to get coffee for your colleagues, would you dare buy them McDonald's? Starbucks, like McDonald's has established a brand.

This brand is what will carry the growth for Starbucks. For food chains, most revenue growth is due to an increase in the market that you reach, rather than more penetration in your current market. Therefore, Starbucks greater international expansion will be that which lifts the stock back up. Note however, that opening more stores doesn't necessarily mean reaching more of your market. Hence, Starbucks realizes that it needs to scale back its US expansion. It reached the point where my small city of 80,000 and 2.5 square miles had 4 Starbucks all to itself. There is an art and science to finding locations, because you have to make sure that the location of your store makes you the most accessible to your target market. Starbucks is beginning to realize this, and hopefully can cut down on operating expenses and increase margins with this in mind.

The Bear Case:

Despite having a strong brand name, the pressures that Starbucks's is facing are overwhelming. Regardless of any initiatives management may take, Starbucks is still at the mercy of certain uncontrollable macro-economic factors.

"Schultz didn't pause long on questions of additional store closings, commodity prices, or plans to maintain margins. Some wonder how effective the initiatives announced on Wednesday will be at driving profit in the short term, especially given a retail environment that Schultz himself acknowledges is bleak. While fully bullish on Starbucks' ability to right its course, the company's chief characterized the U.S. economy as "in a tail spin," saying he saw no end to economic problems in sight.

'Perhaps we haven't witnessed in 30 years this level of pressure on the consumer," Schultz told reporters. "You've got Alan Greenspan saying the economy is in its worst condition since World War II.' "

There are two main factors here, the fledgling consumer and the massive rise in commodities prices. The problem is, a rise in "costs of good sold" should generally be passed on to the consumer with higher prices. However, with an economy nearing recession, and consumers themselves needing to spend more on commodities, Starbucks risks losing customers with a price increase. Starbucks markets its coffee as a premium product, but markets it towards the upper and middle classes. This is where you'll see Peet's divergence. Currently, most of Peet's locations are in affluent areas. This allows Peet's to pass on price increases with much less deliberation (which it recently did in January 2008). While Peet's is selective about their expansion, Starbucks was overly aggressive. And we see the acknowledgement of this now that Schultz plans to close down stores with lagging sales. Still, Starbucks needs to be the mainstream premium product, because that's what its huge brand and massive size require for it to grow.

So Starbucks is stuck between a rock and a hard place—at least for the near term. One might ask why aren't all food companies in the dire situation Starbucks is in? Why isn't McDonald's facing depressing margins due to the commodities boom? The answer is Starbucks is in a very unique predicament. Coffee is still a luxury. It's addictive, yes. But it is still a luxury product, especially at Starbucks's price points and especially for the middle class that represents such a large portion of Starbucks's customer base. Even with an increase in prices, which McDonald's has implemented, Big Macs and fries are still some of the most affordable foods one can get. The same can't be said about Starbucks's coffee.

In the near term, Starbucks is partially a play on the commodities markets. Part of the reason we see constant downward revisions of earnings estimates is that I don't believe management was fully aware of the forces pushing commodities up. If they were, then they would have been invested in Potash and Mosaic call options. So, we must ask ourselves, do we believe Schultz and his team were better able to forecast their COGS and commodities prices with the latest $0.83 EPS figures? Schultz definitely is very aware of the deteriorating environment that he faces. It's written all over his language when he's trying to quote Alan Greenspan about the condition of the economy. However, with fertilizer recently selling for record prices I imagine that soon farmers will even further increase the prices for their crops. I imagine there is at least one or two more surprises in store for Starbucks's margins in the next year or less.

Starbucks is doing the right thing in focusing on international growth. Currently 11,434 of their 16,226 stores were US based. There is much international growth to be had. But how easy will this growth come? According to some amateur international investors, it's a lot harder than we would think.

"- Cups. Austria has a very long tradition when it comes to coffee houses. We are used to drinking from decent, solid cups. Paper or plastic cups might be acceptable in emergencies or for a quickly improvised sports event, but certainly not for a coffee house. Even if you get your coffee in a "real" cup or mug the experience is spoiled for most when there are paper cups on the tables around you.

- Quantity. Like almost everyone outside the U.S., we are not used to huge portions, be it food of beverages and also don´t consider it such a good thing, in fact, many of us feel a bit intimidated by it. Whenever I´m in the States I wonder how people can actually eat and drink the amounts offered as "small" or "regular", and when I look at the soda cups marked "small" - "medium" - "large" I think in terms of "huge" - "bucket" - "barrel."

- Price. Starbucks' products are outrageously overpriced, especially for the kind of quality they deliver here in Austria. Even if the quality were better, they would simply be too expensive for the majority of "average Austrians."

What it all boils down to:

The answer the question posed in the introduction, Starbucks's predicament is due to all three factors. It indeed needs to execute better, and make more sound decisions. It appears to be on the right track to do this. Starbucks also faces much more competition than it did in the early 2000s. Yet, this is expressed in its greatly compressed p/e ratio. And still, the coffee market, or at least the one Starbucks targets is far from filled. It is easy to overlook the Coffee Bean & Tea Leaf because it is a privately held company. But, it has been a strong competitor to Starbucks for a while now. And they both have flourished. Finally, the increase in commodities prices, though extreme and extended, is far from over. The price of oil may not be accurately reflecting is fundamentals, but the agriculture industry has to accommodate a growing world population and increasing world standard of living while growing enough crops to provide corn ethanol for inept governments. Still, the stickiness of the situation is exacerbated by the weak consumer. So there are two solutions to the commodities problem: 1) the economy escapes this period of stagnant growth 2) the commodities bubble gets popped. Either of which are destined to happen, and should only be considered near term drawbacks.

The Starbuck's bull case is completely long term. The bear case is definitely near term, with the potential to extend itself quite far. That means Starbucks is definitely a value play right now. With a value play you will be taking near term volatility and maybe a near term hit in your portfolio. Be aware, because at $16 the stock doesn't seem to have much downside risk. And it doesn't in terms of dollars. But a $2 drop equates to a 12% loss. And that is no insignificant value. If you're going to be a value investor you have to make sure you have the stomach to take these short term hits, believe in your projections and stick with the company as it regroups. Personally, I would rate the stock a hold. I wouldn't invest right now, but I would definitely stick with it if I owned it. Yet, with the need to exit a Kohl's position it may be a good way to have a little less exposure to a weaker consumer. Remember, caffeine is addictive, while Kohl's apparel can leave a bit to be desired.

Disclosure: None