Stock Price Still Too Frothy at Coffee Purveyor Starbucks

Starbucks (SBUX-$23.07) recently reported an in-line 4Q:07, but continued pressures from dairy costs and soft transaction comps in the U.S. prompted management to trim its share-net guidance for FY 2008, to $1.02 - $1.05 (representing 17% to 21% growth), from the prior $1.04 - $1.06 per share range (20% - 22% growth).

Comparable store sales growth was 4% for the quarter, all driven by a 5% increase in the average value per transaction (resulting from the two price increases implemented in fiscal ’07, offset by a 1% decrease in transactions).

On its year-end earnings’ conference call, the specialty coffee purveyor admitted that softer consumer spending and rising commodity costs will adversely impact 1Q:08 EPS. With ongoing dairy cost pressure, which in the first quarter alone will be $0.02 of headwind to EPS, and expectations of continued softness in the U.S. consumer and economic environment, management is currently expecting 1Q EPS of 28 cents.

For the full fiscal year range, management has factored in the impact of dairy costs, which are expected to ease the latter part of the year. All said, EPS expansion is expected to be greater in the second-half of fiscal 2008.

Seasonality

The 10Q Detective believes that caution is warranted, given that significant portions of the Company’s net revenues and profits have historically been realized during the first quarter of each fiscal year, which includes the holiday season. In our view, because of the prospect for a weak Christmas seasonal, additional cuts to EPS forecasts and growth rates will likely come.

Over-building

Starbucks remains highly dependent on the financial performance of its Unites States operating segment, which comprises about 80% of consolidated total net revenues.

The traditional Starbucks strategy for expanding its retail business in the U.S. was to increase its market share, primarily by offering a premium cup of coffee at additional stores in existing markets and to open stores in new markets where the opportunity existed to become the leading specialty coffee retailer.

In addition to opening new retail stores, Starbucks worked to increase revenues generated at new and existing Company-operated stores by attracting new customers and increasing the frequency of visits by current customers. The strategy was to increase comparable store sales by continuously improving the level of customer service, introducing innovative products and improving speed with service through training, technology and process improvement—executing on a brand image, called the Starbucks Experience.

Management targeted the opening of 2,400 net new stores globally and finished fiscal 2007 at 2,571 new stores; 1,788 in the U.S. and 783 in International markets.

Comparable store sales growth of 5% fell right in the midpoint of the stated range of 3% to 7% growth, while the traffic comp for U.S. business was below expectations (running at negative 1%).

Achieving growth targets by executing on its ability to open more new stores in the current year as well as future years than it opened in prior years is now a shopworn model. Investors are adjusting to thinking about Starbucks as a mature, slower growth company—and issues of cannibalization have arisen.

Given an expected continuation of a challenging operating environment, management modestly scaled back domestic unit expansion plans to approximately 900 new company-operated stores (from the prior target of 1,000). Licensed store openings remain unchanged at 700 units.

Competition

The Company’s primary competitors for coffee beverage sales are restaurants, specialty coffee shops and doughnut shops. In almost all markets in which the Company does business, there are numerous competitors in the specialty coffee beverage business. Of concern, fast-food chains (such as McDonald's) and other coffee chains—Dunkin’ Donuts and Canadian coffee chain Tim Hortons (which is expanding its own U.S. presence)—are expanding their proprietary lines of upscale coffee drinks at a lower cost.

International

International total net revenues increased 31% to $472 million in the fourth quarter of fiscal ‘07.
On the call, management talked optimistically about growth opportunities oversees, especially in China and Russia. International unit expansion targets remain unchanged at 900 stores. However, Starbucks is not the only Western brand to recognize the upside potential in overseas markets. For example, McDonald’s and Yum! Brands—which already have established footprints in the Far East—are pushing coffee on their respective menus, too.

Other FY 2008 Sales Initiatives

To provide a greater degree of access and convenience for non-pedestrian customers, the Company has increased development of Drive-Thru retail stores. At the end of fiscal 2006, the Company operated approximately 1,600 Drive-Thru locations. Curiously, not one analyst on the conference call mentioned the inherent contradiction of how this impersonal point-of-sales initiative dilutes the Starbucks Experience—““connecting with customers by delivering the highest quality coffee and hand-crafted beverages in a warm and inviting store environment.”

Fiscal 2008 Targets

In light of the weaker transactions experienced in 2007, a trend shared by many others in the consumer space, management now expects comparable store sales growth in the range of 3% to 5 percent.

Total net revenue growth is expected to be in the range of approximately 17% to 18%, to over $11 billion.

Management expects operating margin improvement in 2008 as follows: total company operating margin of 11.2% is expected to expand slightly year over year (contracted 30 basis points Y-O-Y in FY 2007). Given the continued pressure from dairy costs, along with the other factors previously discussed, Starbucks expects the margin to contract in the 1Q, but to improve in the second-half of the year. This will be driven by U.S. initiatives, such as “sharpening [the] focus on [the] core business and be uncompromising when it comes to executing to standards.”

In addition, the Company plans fewer product introductions.

“With our renewed focus, we believe we are poised to not only maintain our leadership position during these tough economic times but to capture significant growth in this business for the years to come,” said Jim Donald, president and CEO.

Aside from mentioning the launch of its first national television campaign highlighting the holiday promotion, Donald or any other Named Executive Officer did not offer any concrete examples as to the mechanics behind the planned service upgrades at the store level.

Management stated a shift in its growth paradigm—the premise that the company can grow EPS through operating margin faster than revenue. As we see it, additional menu price increases in 2008 will be necessary to offset higher cost products (food items) and the continued impact of higher dairy costs. As such, the 10Q Detective believes the frequency of customer visits to Starbucks stores will be adversely impacted in FY 2008.

Valuation Analysis

Does the stock of Starbucks deserve a 12-month forward price multiple of 22 times 2008 EPS?

Management expects much of the improvement in its operating metrics to be in the second half of fiscal 2008. Ergo, the price of Starbucks stock has built in a premium—market expectations for successful 2H:08 operating results.

Selling below its 50-day and 200-day moving average of $25.25 and $26.90, respectively, any failure to meet these turnaround expectations—for comparable store sales growth rates, margins, and earnings per share –could cause the share price of Starbucks stock to drop precipitously.

Editor David J. Phillips does not hold a financial position in any of the stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.