Starbucks on Sale (Part I)

Starbucks (Nasdaq: SBUX) is probably not the first company that comes to mind when thinking of a value play. As discussed here, small-caps usually offer the best opportunities when it comes to finding stocks trading at discounts to their intrinsic values. With a market cap north of $11B and a large analyst following, one could argue that for Starbucks there is little room for market inefficiency. However, the recent challenges facing Starbucks in today’s weakened economy have likely caused its share price to be unjustifiably over-punished by the markets.

Starbucks has shown an average annual growth in revenues and operating income of 23% and 26%, respectively, since 2003. Meanwhile, over the past year, its stock price has been beaten down from $40 to $15. This relentless fall is usually attributed to its recent challenges: rising food costs, over-saturation of US markets, and new competitors such as McDonald’s (MCD) and Dunkin’ Donuts entering the premium coffee market.

The harmful effects inflation has on companies is discussed here. For Starbucks, rising prices of milk and other commodities is an issue, but an issue for competitors as well. In a free market, I would expect supply to increase as a result of higher prices, and therefore these high input costs would subside in the long-term eliminating this issue altogether. In the case that high costs sustain for an extended period of time, Starbucks will be forced to find ways to make their menus more cost-effective.

Over-saturation of the US market can be seen with the recent announced closing of up to 600 domestic stores (due to cannibalization of existing store sales). While this news has not had a positive effect on Starbucks’ share price, it is good to see this rationalization taking place sooner than later. With Howard Schultz back in the driver’s seat, he is quickly identifying recently-opened stores that are not making sufficient returns on its invested capital, and therefore not creating long-term shareholder value. Instead, he is redirecting investments towards Starbucks’ growth potential abroad, since only 30% of its current store portfolio is international. Meanwhile, Schultz’s domestic focus will be to increase same-store sales through bringing back the customer experience that has been lost in recent years.

As for the competition, McDonald’s seems to be the current major threat to Starbucks. There is plenty of debate on which coffee tastes better between the two. At the end of the day, I don’t think it matters. What matters is which company has the stronger brand that draws more people to it. McDonald’s will always have customers eating their burgers and breakfast meals. I doubt many people will want to go to McDonald’s solely to have a latte while studying, reading a book, on a date, or on the way to work. At best, better coffee will make McDonald’s a better place to have breakfast. I just don’t see McDonald’s and Starbucks playing in the same ballgame when it comes to the demographic of customers it attracts.

As a result, I see all these challenges being overcome in the long-run, but instead have caused investors to overreact in the short-term. The fears of recession, credit crisis and therefore a weakened consumer have further depressed the stock price.

Starbucks has admittedly grown too fast recently, and is now taking one step back to grow two steps forward in the right direction. Today, Starbucks has some of the most prime locations in the US. It has a strong CEO that has returned to the helm. And finally, it has a superior brand that has become synonymous with coffee. In my recent trip to HK and Tokyo, I saw stores packed with people drinking Starbucks coffee in blistering hot weather; this is the power of branding.

Starbucks’ recent challenges, in conjunction with today’s economy, have resulted in a share price that is definitely near bargain territory, if not already there. The traditional measures of P/E and Market/Book may not meet the criteria of a disciplined value investor as discussed in Graham and Dodd's Security Analysis. However, given its strong earnings power (to be discussed in Part II), Starbucks may be a worthwhile value play.

Disclosure: Author has a long position in SBUX

Comments

[Stephen Fra...:]

starbucks has given away so much free stuff over the past six months. first, free hot coffee on wednesday from like march-may, free iced on wed from may-last week, and free smoothies to card holders just last friday. i guess during a "restructuring" period you can give away stuff to bring people in, but that's not a great strategy overall.

starbucks has different competition it faces.

mcd/7-11/sheetz for a the discount, standard coffee buyer... as other places have improved their normal brew, there's not reason for quasi-connoisseurs to go to sbux.

peets/caribou/the neighborhood coffee shop - many places now offer a similar "experience"for, once again, a smaller price.

2008 Aug 01 08:39 AM

[Randy Fay:]

SBUX is a value trap IMO. The key word in the last sentence is MAY. It may also continue drift lower due to continuing problems.

2008 Aug 01 09:04 AM

[root:]

They would attract a lot more customers if they made their wifi free like Panera Bread.

2008 Aug 01 09:21 AM

[Big Dog:]

They can't be doing too bad up here in NH. There is a SB here in Plastow. It is always crowded. Now, they are just finishing another SB down the road from the first, about 3 miles down the road. Business must be good if they are building them that close together.

2008 Aug 01 09:54 AM

[pearl2k:]

Why do people keep insisting McDonald's, a fast food restaurant, is competition Starbucks, a coffee house? It's an entirely different experience. I don't care how good the coffee gets @ MCD. No one, except old people, is hanging out drinking coffee there. Take a look sometime.

2008 Aug 01 12:22 PM

[najdorf:]

pearl2k: Coffee to go is a similar experience at any place that sells coffee, and a lot more people take their coffee to go than drink it in house. It looks like a lot of people drink their coffee at SBUX because the store is always full of people, but that's because of the line and the fact that laptop fools camp out like they're at their college library and use tables at which 4 people could socialize for hours of computer nonsense that they could do at home or the office. I almost always get coffee to go, so my concerns are quality, speed (counting location) and price, which are areas where anyone can potentially compete with SBUX. They have pretty good quality, speed and convenient locations. The weak spot is price. Latte/cap/frozen drinks are so much more expensive than coffee/iced coffee, and then SBUX is higher even on basic coffee.


Stephjen: Giving away stuff is a great strategy, especially when you are introducing new products, shifting your locations, and trying to recapture old customers and bring in new ones. Every successful retailer uses some sort of give-away strategically: mail coupons at Bed, Bath and Beyond, shopper card savings at most supermarkets, samples at Trader Joe's, new product give-aways at Dunkin Donuts and McDonald's, etc. People love free stuff and will patronize places that offer it, even if they don't get free stuff every time they go. Setting aside the lost profits from those who would have paid if the product were not free (which are significant, though offset somewhat by the idea that the giveaway is a loyalty reward for regular users), the cost to give a new customer attracted by advertising a free cup of coffee is in the ballpark of 15 cents. If they come back and buy even one thing, or pick up a cookie along with their free coffee, the store is already in the black.

2008 Aug 01 03:51 PM

[Mathman Pro...:]

I had done a case study on Starbucks 6 years ago, though since then I have not revisited the company, nor have I really cared. However, one interesting finding was that each store opening infringes on other stores within the vicinity. This did result in net sales to go up, so the general effect on their bottom line was positive. The investment on each store was paid back after 3 years of operation. Nonetheless, I recall their high growth expansion plan was to achieve for 1 store per 50,000 people. That was 6 years ago. From the looks of it, they were opening stores in line with that goal, but ignored the concept of saturation. Their business model should be more inline with Coca-Cola; as they got big growth should be slow and steady. Instead, it looks to me as though they kept pursuing their high growth model.

Instead of opening more stores, they should just have more than 1 bar inside each store. Yet management opted to change their cup logos from green to brown, give away promotions, and lock down all of the stores for 3 hours of training?! I can't help but laugh.

Cheap? Perhaps... but I wouldn't delude myself into expectations that it will rebound to previous valuations any time soon.

2008 Aug 01 03:52 PM

[najdorf:]

On the other hand, it does look to me like SBUX is entering a multi-year restructuring. There are a lot of people wishing/hoping that this process works and earnings come back, and that holds the share price up relative to earnings. If the company continues to blow it, the share price might have further to fall. The last earnings report was even worse than expected, but the stock hasn't really been punished further - to me this indicates that some recent buyers have gritted their teeth and decided to hold on for a few quarters, while new buyers continue to be attracted by the idea of a value price on a former growth heavyweight.

It seems like SBUX is in a position somewhat like C and BAC at the end of last year or earlier this year; all over the place you hear "ok, now that the bad quarter is out of the way let's get this earning power at a bargain price!" I know BAC looked great to me at 37, and although buyers at 37 aren't too far underwater now, they could have bought it down in the 20s with a little bit of patience. I mean, last month you could buy profitable banks at 5-10x their depressed earnings of the last few quarters. That's a value pick with some margin of safety. SBUX at 23x its depressed earnings? More of a speculative gamble (although it could pay off).

2008 Aug 01 04:01 PM

[E Nuff Sed:]

SBUX real potential is international.

They should split the company up into 2 - a US "value" company focused on cost controls and maximizing profits (paying fat dividends) and an "international" growth company focused on geographical expansion. Atria has recently done this by carving of Phillip Morris and GM may do the same.

2008 Aug 01 09:30 PM

[shershar:]

Starbucks should be made to provide help groups for those so addicted to caffine because of them. Their coffee cups should come with a warning to the public regarding this addiction.

2008 Aug 02 02:24 PM

[Pch101:]

As a sometimes contrarian, I enjoy the naysaying, schadenfreude that you hear about Starbucks in many articles, because it tells me that the bottom is close and a buying opportunity will occur.

It's pretty straightforward -

-Brand: This is one of the best brands in America, with high identity and a good deal of loyalty from a diverse, aspirational demographic. Most companies would kill for a brand this good; Starbucks just needs to be sure to keep that brand intact.

-Market share: In its space, Starbucks probably has about 80% market share in the US market. Its rivals such as Caribou, Peets and Coffee Bean and Tea Leaf don't come anywhere close; none have a plan to dethrone the leader.

-Revenues: Sales continue to grow, despite a gloomy economy. This suggests that consumers are hanging on to the product, despite difficult times. They may decline a bit as troubles deepen, but this is a product that many consumers will fight to keep in their lives.

Starbucks doesn't so much as sell coffee as it does lifestyle. If it can keep its brand intact and manage its costs effectively long enough to ride through the downturn, it will emerge from the economic rebound.

I'm not completely sold on some of the project initiatives and I suspect that 2009 will have slowing revenue growth as the economic crisis deepens, but otherwise they are well poised to ride the tide upward. I expect that the stock price may slip more if the indexes take a hit, but on the fundamentals, it's a good company that will recover and eventually will merit a long position. The questions now are when, and by how much.

2008 Aug 02 04:56 PM

[knight722:]

People who are changing habits because of $4 gasoline will be prone to change their habits toward "elitist" coffee. It is expensive -- period. If this economy continues to weaken, and unemployment continues to rise, there isn't a coherent strategy available to Starbucks to avoid an erosion of their customer base.

2008 Aug 02 05:20 PM

[trader_murf:]

I want to believe in this stock, I really do. I gradually took a position earlier in the year and held it for a bit. I listened to Q2 conference call and it seemed more like motivational speaking from the late 1980's than anything solid to get the company back on track. I mean retrain the 20-somethings to pay attention to the customer and make a cup of coffee - duh. Then I was particularly disillusioned after being with 2 friends and not being able to get a seat in a SBUX in NYC. NO, it wasn't that the place was loaded with customers the tables were taken up with laptops, some empty beverage containers and at least one apparently homeless person. We went to a nearby SBUX about a block away. Counter service was okay, we were able to get seats but had to clear the dirty table we were finally able to get. The tables and floor were generally dirty, if there was any management there was no evidence of such. The final turning point was when SBUX was still hiring and an extremely competent, experienced but older (50's) friend of mind went on a cattle call interview. The interviewer was apparently clueless and when SBUX was hiring there was absolutely age bias against older workers. Well great, clueless motivational management, prejudice against hiring experienced workers, filthy tables, seats taken up with laptops and empty cups. I sold my entire position for a modest profit at $18.40. Hiring, firing, high prices, giving stuff away, this company doesn't know which end is up. I have not listened to the Q3 conference call. If this thing turns around I don't think it will be any time soon, rather I think it will be dead money especially in this economy. If I were in it I would definitely check the charts and see where support/resistance is. I haven't looked at it in a while but if there is nothing underneath I wouldn't hang around at this time.

2008 Aug 02 06:01 PM

[sundrenched:]

To pearl2k and najdorf's point, I read in a recent interview with Howard Schultz that 80% of Starbucks' sales is takeaway. That number is very significant with regards to the threat posed by companies like McDonald's, Dunkin Donuts, etc. This means that the whole experience thing (which is real) is only relevant to 20% of customers. The other 80% should be in play as far as competitors is concerned. I think that's very scary from Starbucks' point of view.

I'm very skeptical of SBUX at its current price. My feeling is that people are staring themselves blind at yesterday's growth, and are going to end up overpaying. Also, it's a "cool" company, the kind investors fall in love with. (I, on the other hand, invest to make money!)

By the way, I live in Singapore and Starbucks does very well over there (as well as elsewhere in Asia), but they better hurry up, because there's plenty of good-quality chains already eating away at the same market. There's some smart entrepreneurs with deep pockets back there also, and they're not waiting for Starbucks to show up. And frankly, some are doing a better job than Starbucks (better pastries, fresher coffee, cleaner shops, more comfortable seating...) My point is, I have no doubt that Starbucks has a lot of growth potential in Asia, but don't take it for granted, and be wary of overpaying because it's a glamour stock.

I used to own Starbucks (thought it was time to go bottom-fishing at 18.6) but bailed out of it after it slid to 15 and rose back up to 18). I might go back in if it drops to 12, but I'm not sure as there's so many other opportunities.

2008 Aug 02 06:31 PM

[icandoitdon:]

it's a coffee company boys. where is the competitive advantage for a coffee company with a commodity product, growing competition and a shrinking store base?

sell it.

2008 Aug 02 10:59 PM

[bobaka:]

the new dumbed-down 'pike place roast' sucks. big mistake.

2008 Aug 02 11:27 PM

[gksmar:]

Comparing mcd coffee to sbux coffee is insane. dunkin dougnut and mcd coffee is like drinking hot water. SB coffee is rich and tastes like coffee.
When you compare sbux and dunkin, compare the size of the cups, amount of coffee powder they use to make each cup, etc.
SBUX is a much better coffee. mcd only the cup looks good, same crap inside it.

2008 Aug 03 12:52 AM

[najdorf:]

gksmar: Investing based on what tastes good isn't a way to make money. Of course SBUX has great coffee and DD/McD have coffee-flavored water - that doesn't mean they'll provide a good return to stockholders. What makes you think the average American has any idea what good coffee tastes like? People use Folgers and Sanka. DD is massively popular in spite of being terrible. Our #1 beer is Bud, and I can name 50 American beers that are better than it, starting with Sam Adams, which is actually pretty widely available. Our top imports are Corona and Heinken, and those are probably the 2 worst imported beers available in the US, a nation that imports hundreds of amazing brews from all over the world. If people cared about taste, Olive Garden wouldn't have crushed so many local Italian restaurants, Belgian beer would be more popular than swill from Mexico, and people would buy any of the excellent Australian wines rather than Yellowtail. Marketing, pricing, and location move product. SBUX, McD and DD are all very strong in all these areas and so we have a real contest to look at here.

We all need to get it out of our heads that SBUX derives any significant advantage from taste. It derives most of its competitive advantage from being cooler and more connotative of wealth than Dunkin Donuts (does Britney Spears know what excellent coffee tastes like?). Dunkin Donuts derives most of its competitive advantage from being cheaper and more "blue-collar" than SBUX (plus the donuts taste better than anything SBUX produces and cost under a dollar, but this doesn't really matter because people will eat anything). I tend to drink whatever's more convenient/whatever the people around me are drinking, but Boston construction workers are never going to drink SBUX and NYC celebrities are never going to drink DD. The marginal consumer will follow the crowds, their budget needs, the marketing, and the location quality.

2008 Aug 03 01:28 AM

[sundrenched:]

Actually, DD has a corporate policy to throw out any unsold brew after 18 minutes. The number one thing that makes a difference to coffee flavor is that it has to be fresh. Fresh-brewed Folgers will taste infinitely better than Illy that's been sitting on a boilerplate for 3 hours. Anyone every tried ordering the decaf brew at Starbucks outside peak times? It's downright awful, and shame on them for pretending to be about premium coffee. So now Howard Schultz announced with a lot of noise that from now on unsold Starbucks brew will be thrown out every 30 minutes. Better late than never I guess. It's still inexcusable that they had the gall to sell 3-hour old swill with all the aroma boiled out before.

As for McDonald's coffee, I'm talking about the premium McCafe coffee, not the regular stuff that's sitting on the boilerplate (there, it will be the luck of the draw, if it's fresh-brewed or not). Just try it one day, the premium coffee. It is actually quite good, better than Starbucks, and market research shows that most people prefer the taste over Starbucks coffee. And why wouldn't that be so? MacDonald's is not stupid. If they decide to go after the premium segment, they can hire some people who know about coffee to get the product right. This isn't rocket science.

2008 Aug 05 03:08 PM

[mkreisel:]

All the bashers here make me feel that buy point for SBUX is near.

2008 Aug 09 03:06 AM