Inflation Seen Through a Cup of Starbucks Coffee

| About: Starbucks Corporation (SBUX)

Starbucks (NASDAQ:SBUX) has been known for a great place to get a cup of coffee, cappuccino, or in my case a Venti whole milk extra hot latte. With the economy and the markets starting to teeter, I have switched from my usual latte to just a Venti coffee. I save about two dollars a visit on this trade-down. Now I get the bold coffee, but recently I have noticed that the bold is not so “bold” anymore. I asked some of the baristas why this was the case. They told me Starbucks has changed the formula and they are now using less coffee in the brewing process.

I truly hope that Starbucks is not raising prices while simultaneously lowering quality ... although it would not be a surprise if this was the case. Higher input commodity prices have skyrocketed in recent years. Coffee has risen from $1.42 per pound in June 2010 to $2.18 per pound as of June 15 -- an astounding 53% increase in just a little over one year. Now you can’t have coffee without sugar, which has increased 72% in that same time frame. And you can’t get the coffee from Colombia, Ethiopia, and Sumatra to your local Starbucks without gasoline, which has increased 53%. You also need labor … but I’m sure you get the picture.

Everyone acknowledges that there is inflation in the system, except the U.S. government. To it, I suggest a rather unconventional idea that unsophisticated laymen such as myself could easily understand and explain to others. Let’s have Ben Bernanke and company factor inflation to a cup of coffee instead of the CPI. We preemptively apologize to CNBC’s Steve Liesman and Rick Santelli, whose debate over this would be classic.

Let’s ask the question: “Is a Venti still a Venti if it is still 20 ounces, but less strong?” It’s time to stop having a core rate and just have one inflation rate that we can all understand and agree upon. So let’s peg inflation to a cup of java. After all, a good portion of America’s total income is spent on gasoline, eating, and climate controlling their residences, which in my opinion makes the core rate useless.

Any way you slice it, Starbucks is one of America’s most affordable indulgences. Despite these economic times, many still have some disposable income for a special treat now and then. A $5 beverage that allows you to get out of the house, relax, or even people-watch for an hour so is still probably a cheaper alternative to that of any other leisure activity out there. This may be some of the reason why Starbucks remained profitable during 2008 and has since tripled net income with an astounding 500% increase in its stock price. Starbucks has gone from $7 a share in November of 2008 to $35 today, compared to an S&P 500 that's now up less than 200% since the lows hit in March of 2009. It should be noted that Starbucks is more of an “elastic” company with a Beta of 1.31.

We think that Starbucks should hold here rather nicely in the $35 a share range, with strong support at around $29. Starbucks offers shareholders a relatively high P/E of 25 with a modest yield of 1.5% and earnings growth of around 20% year-over-year. Store net growth has remained flat at around 16,500 in 2008 to around 17,000 today, due to the closures of unprofitable stores, mainly in the United States. Despite all of this, Starbucks still has tremendous upside as it ventures into many new markets, with the Chinese market still virtually untapped.

The other intangible of Starbuck’s business model is that it can open stores in almost any location with a minimum amount of square footage need, giving it a huge advantage over its newest coffee rival, McDonald’s (NYSE:MCD).

We believe that a very mild, non-consumer-based double dip recession could actually be a plus for Starbucks, assuming unemployment doesn’t rise above 11% as calculated by Uncle Sam. High unemployment is a double-edged sword for most companies. Starbucks could benefit from this by lowering its labor and commodity input prices. A reduction in commodity prices should well offset any decrease in sales.

We see Starbucks being able to raise its profit margin from 9.8% to our estimate of 12-13%, as consumers give up the more labor-intensive specialty drinks coupled with additional cost cutting efforts. A very mild recession combined with the expected help from the Federal Reserve’s QE3 should help temporarily lower commodity prices. We stress the word "temporarily" because you can only kick the can so far down the road. If Ben and friends do not give the market the stimulant that it expects, you could see the market acting as grumpy as the person who has not had his cup of morning joe.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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