On Monday (April 28, 2008) Starbucks 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 1st 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 1st 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 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 3rd 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.
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