Bloomberg News

Schultz Transforming Starbucks Into Supermarket Supplier

March 22, 2012

At the annual Starbucks shareholders' meeting on March 21, 2012, in Seattle. Photographer: Elaine Thompson/AP Photo

At the annual Starbucks shareholders' meeting on March 21, 2012, in Seattle. Photographer: Elaine Thompson/AP Photo

Starbucks Corp. (SBUX) is looking more and more like Kraft Foods Inc. (KFT) all the time.

Since returning as chief executive officer in 2008, Howard Schultz has revived the company and is now guiding Starbucks well beyond its cafe roots. Increasingly, the Seattle-based chain is playing in an arena staked out decades ago by Big Food: the grocery aisle. While Schultz still presides over about 10,800 macchiato- and scone-selling cafes in the U.S., grocery revenue is rising almost three times as fast as store sales.

“We’re in the nascent stage of what we believe is our capability to do a number of things within food and beverage,” Schultz said in a telephone interview yesterday.

Starbucks rose 2.6 percent to $55.21 at the close in New York, after earlier advancing to a record high of $55.25. The shares have gained 20 percent this year.

While researcher IBISWorld Inc. expects grocery industry sales to stagnate in the coming years as more shoppers eat out, the Starbucks brand may give it an edge against niche rivals such as Naked Juice and Bolthouse Farms as well as big players like Kraft and Nestle SA (NESN), which both sell coffee and tea. In fiscal 2011, operating income for Starbucks’s global packaged- goods unit was 32 percent of revenue, compared with 19 percent for the U.S. business.

“You’re seeing investors recalibrating how they view this company,” Phillip Juhan, an Atlanta-based analyst at BMO Capital Markets, said in an interview. Starbucks is “no longer just a retail store business,” said Juhan, who rates the shares the equivalent of a buy.

Starbucks has slowly yet steadily been moving into grocery stores since 1995, when it began selling ice cream in such flavors as java chip frappuccino and caramel macchiato. It has since added packaged coffee, bottled drinks and Tazo brand tea.

Keurig Deal

Last year, Starbucks cut a deal with Green Mountain Coffee Roasters Inc. (GMCR) to sell capsules for Green Mountain’s Keurig single-serve coffee makers. It then paid $30 million for juicemaker Evolution Fresh Inc. and has plans to sell the flash- pasteurized juice in grocery stores.

In 2009, Schultz introduced Via, a single-serve instant coffee that took 20 years to develop. At the time, some analysts said Via, which sells for about $10 for a 12-pack, was too expensive and might dilute the Starbucks brand. Now many consider it a driver of overseas growth, especially in Asia where instant coffee is widely drunk. Schultz has said Via eventually will become a billion-dollar brand.

In Schultz’s boldest move yet to become a player in groceries, he last year wrested control of packaged coffee distribution from Kraft. The foodmaker sued Starbucks for breach of contract. The dispute has since gone to arbitration and probably will be resolved this year. Even if Starbucks winds up paying a large settlement, Schultz now has the power to demand the best shelf space for Starbucks products.

New Phase

“We think we can build a business that can be as a large as our retail business,” Jeff Hansberry, president of channel development, said in a telephone interview yesterday. The consumer-goods segment will continue to expand both organically and through acquisitions, he said.

This month, Starbucks upped the ante by announcing its own single-serve espresso brewer. Called Verismo, it will be sold in stores, online and at some Starbucks cafes by the holidays. The real money will come from selling the coffee capsules. Single- serve beverages are the coffee industry’s fastest-growing segment, according to Mitch Pinheiro, an analyst at Janney Montgomery Scott LLC in Philadelphia.

While the shares rose as much as 4.2 percent on the day after the Verismo announcement, the machine probably won’t generate profit until Starbucks’ fiscal 2013. Sales from the Verismo machine and capsules won’t surpass that of Starbucks’s K-Cups for three to five years, David Palmer, an analyst at UBS Securities LLC, wrote in a research note dated March 20.

Energy Drinks

Later this year, Starbucks will start selling 60-calorie energy drinks in U.S. stores. Called Refreshers, they are made with fruit juice and green-coffee extract. The energy beverage category is worth about $8 billion, according to the company.

The idea is to translate Starbucks’s 40 years of experience in coffee to juice and Refreshers, Schultz said. “We’ve done our homework, we understand how to execute that.”

As a percentage of revenue, earnings before interest, tax, depreciation and amortization for the company’s packaged-goods segment will rival that of the stores in five to 10 years, according to Juhan.

By then, it will be “more of a conglomerate and they’ll have a more diversified revenue stream,” says Peter Saleh, an analyst at Telsey Advisory Group in New York. “The biggest opportunity for them is on the packaged-goods side -- selling K- Cups and selling Via,” he said.

What’s Important

Still, 91 percent of revenue comes from Starbucks cafes, and management should be careful not to “lose sight of what’s important,” Saleh said. “My concern would be that they get distracted from the real revenue and profit driver.”

Packaged coffees are also more affected by commodity costs than its cafe business; margin for that segment will narrow to about 25 percent this year primarily because of higher coffee bean prices, Chief Financial Officer Troy Alstead said at an investor conference on March 14. By fiscal 2013, that figure should be back to the upper 20 percent range and approach 30 percent in the next two years, which is what Starbucks is targeting in the long run, he said.

Ultimately, Schultz’s move into groceries is necessary, according to Bill Smead, portfolio manager at Seattle-based Smead Capital Management Inc., which holds about $3.6 million of Starbucks in its Smead Value Fund. The company’s real value and growth potential lies in its brand, he said.

“They sell water, milk and coffee beans at boiling temperatures,” Smead said in an interview. “Warren Buffett says the best companies buy a commodity and sell a brand.”

To contact the reporter on this story: Leslie Patton in Chicago at lpatton5@bloomberg.net

To contact the editor responsible for this story: Robin Ajello at rajello@bloomberg.net


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