Starbucks: Trouble in Latte Land


The company responsible for the ubiquity of coffee shops finds itself struggling with flagging growth, increased competition, and a declining stock price

As expected, shares of Starbucks (SBUX) took a cold latte (with a splash of peppermint) to the face on Nov. 16. The stock tumbled more than 7% in Friday's session, to a new 52-week low, but recovered somewhat by the close, off nearly 4%, to $23.17. Volume was more than six times the normal 10.6 million shares. Given the company's weak outlook after the market close, the debate over whether Starbucks is a buy still rages around the financial blogosphere.

My aggregated take: no. Starbucks has always been a hot-growth story, and investors pay a premium for a company that's growing much faster than the economy and regularly outstripping the expectations of analysts. For investors to return, they'd have to be convinced hot growth has resumed or the share price has been so beaten down it's now a compelling value play. But at least so far, there's a lot of skepticism on both counts.

Slow to React

As has been widely noted, the company is under a massive assault from McDonald's (MCD), Dunkin' Donuts, and seemingly every other retailer (BusinessWeek.com, 7/18/07) with a brew pot in the back.

The company's key problem, however, was precisely identified by founder and Chairman Howard Schultz, way back in February: In its monster grab for growth, the Seattle company lost touch with its roots and culture as a coffee house, opening the door for competitors with no coffee bona fides to steal its high-margin business. And yet, here we are months later, and the chain's answer is to slow the opening of new U.S. stores over the next year by less than 10% and start running TV commercials. There's been some reshuffling of executives, no serious new blood brought in, and, again, a promise to introduce fewer new beverages. But that hardly seems sufficient to ward off the increasing assault.

Troubling Numbers

For the past three months, Starbucks reported satisfactory financial performance: Revenue rose 22% and net income per share was 21¢, but the firm hacked its guidance for the next 12 months, something the market absolutely hates. Instead of same-store sales growth of up to 7% in 2008, as the company had projected in August, the high end now caps at 5%. The high end of revenue growth could hit 17%, again a significant slowdown from the previous year, and 1% lower than the August projection. And maximum earnings-per-share growth of 21% reflects a slight cut from the 22% previously offered.

The 1% decline in the number of sales transactions during the quarter was also troubling. Only thanks to two price increases—and likely the expansion of hot breakfast offerings to more locations—was Starbucks able to report a 4% increase in same-store sales. On a conference call with analysts, Chief Financial Officer Peter Bocian also revealed somewhat vaguely that the performance of stores opened in 2006 was below the average of stores opened longer, and stores opened in 2007 were even "slightly below the '06 class."

A great site to get the best thinking of value investors is Minyanville, where many so inclined hang out. Jeff Macke, president of his own money management firm in San Francisco, weighs the case and finds Starbucks wanting. He's in my camp, agreeing the company doesn't grasp the problems confronting it: "Starbucks is a play on Starbucks' ability to sell high-margin caffeine related beverages," he writes. "It isn't selling enough of those beverages. Why was Starbucks a sell going into the report last night and a sell even this morning, down almost 10%? It doesn't understand the problem. Its business model is post-peak and Starbucks stock is too expensive for a slow-growth, commodity pricing play. Starbucks strikes me as a classic walk-away story. I don't want to short it, I don't want to try to trade it long."

Weak Branding

What about a potential growth revival with Starbucks' plan to blanket the nation with TV commercials touting its holiday beverage and gift lines? Brand expert Rob Frankel, author of The Revenge of Brand X: How to Build A Big Time Brand on the Web or Anywhere Else, is skeptical. He's pegged the company with a poor job of branding—not far from Schultz's own critique in February.

What's the prognosis for the TV campaign? Frankel writes: "No matter how fast Starbucks dances, the Titanic will keep sinking. Sure, they'll try all kinds of cross-merchandising with all kinds of products they hope and pray will add to their coffers. But until they've defined why Starbucks is the only solution to their prospects' problems, Starbucks will keep playing hit-and-miss. There are only so many unemployed writers that can occupy floorspace with their laptops before a store's per-square-foot revenue sinks like a proverbial stone."

Finally, James Cullen, a finance major at Boston College posts a more quantitative look at what's gone wrong on the College Analysts site. He zeroes in on the company's return on its investments in new stores and the like, and finds the "return on invested capital" is weak and getting weaker.


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