Starbucks (SBUX): Time to Buy the Broken Growth Story?
November 16th, 2007 by 
James Cullen
Following some weak near-term guidance from Starbucks (SBUX), the stock fell almost 8% to about $22 in after-hours trading today. A rough calculation of the company’s new market cap is $16.6 billion, relative to $1.33 billion in operating cash flow the company just reported for last year. While Starbucks’ expansionary store strategy is resulting in relatively high levels of Cap. Ex. (over $1 billion in FY2007) and thus free cash flow is relatively low, but at 12.7x EV/operating cash flow for a company that just posted 21% revenue growth, my first reaction is that this is a broken growth story worth buying.
But at the same time, I’m still cautious because:
1. That’s how I am
2. I’m not completely sold on the store expansion model (need we have 40,000 Starbucks stores?)
3. The differentiation vs. commoditization factor of coffee
To break that down further (skipping #1):
-Starbucks currently has 15,000 stores total; 10,000 of these are in the US. I know when I go through downtown Boston there are multiple Starbucks within sight of each other. Is this the best use of capital? While the full-year 10-K isn’t out yet, I remember looking at a few of Starbucks’ previous SEC filings and zeroing in on the operating leases they use to rent stores - if one includes those off-balance sheet items in ROIC calculations, ROIC for that period declined to 10%, or a rough estimate of cost of capital. What does this mean? In short, it is questionable how much shareholder value the company is creating in building out store base. On the conference call, the company announced it was going to decelerate expansion plans somewhat in the face of a weakening economy, and I’m going to monitor whether or not the increased selectivity of openings leads to any sort of improvement in profitability metrics.
-One word that keeps coming up in discussions of Starbucks with management and customers is the “experience,” and how that creates customer loyalty and ultimately differentiates Starbucks from McDonalds (MCD) and the like. As someone who is perfectly content with a $2 Dunkin Donuts coffee, I don’t quite understand the Starbucks phenomenon, but nonetheless… other people apparently do, and are willing to pay up for it. While I don’t believe Starbucks is a fad (like, ahem, Crocs - CROX - or Heely’s - HLYS), I’m also not sure how loyal the customer base will be as McDonald’s and others make aggressive pushes into the coffee space. Starbucks’ store traffic was down a full 1% most recently, and little color was given on the causation being macro-related or due to competition.
There are reasons to be optimistic, though:
-The valuation for a historically strong grower is low.
-If I’m underestimating that brand loyalty, it could be a huge positive.
Hopefully I’ll get more time to touch on valuation in-depth either later Friday or over the weekend - that is a post unto itself. Strong brand loyalty, however, is crucial here: it is one of the few true economic moats, and if the “Starbucks Experience” creates that brand loyalty, I’m all for it as an investor. Attachment to the name making the drink is what makes Coca-Cola (KO) a $150 billion company; does Starbucks have the same thing? Not for me personally, but I would like to see others respond with their take on the commoditization of coffee - do you only buy from Starbucks? If so, why?
It is difficult to make a call either way on SBUX right now because we haven’t seen anything other than after-hours trading; but my gut instinct is to wait here. I’m basing this partly of Tom Stone’s call on the market direction - he is usually right, and his prediction for continued downward pressure in general makes me want to avoid something like SBUX that has little going for it… but that ultimately comes back to feeling the valuation is still too open-ended to get a concrete feel of margin of safety. I’d be perfectly willing to buy something with “nothing” going for it, if I felt there was a sufficient discount - but the valuation is telling me we aren’t there yet.
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November 17th, 2007 at 1:26 pm
The CEO noticed one major flaw back in early 2007 and I couldn’t agree more just by being an observant customer. The liquidfied product delivery by farming out to secondary markets under the same name has resulted in poor quality, poor customer service and a serious watering down of the ambiance of the core starbucks experience. All of this causes a breakdown of the company culture especially when you have a Starbucks within a large grocery chain store across the parking lot of a “real” Starbucks. Who’s idea was this; more inportantly, why was it allowed to continue across the country for soo long causing in my best estimate an irreversible trend of collateral damage.
November 18th, 2007 at 4:24 am
“As someone who is perfectly content with a $2 Dunkin Donuts coffee, I don’t quite understand the Starbucks phenomenon, but nonetheless… other people apparently do, and are willing to pay up for it.”
It is difficult to find exact numbers for the current price of a “regular” (filtered coffee) coffee at Dunkin Donuts and Starbucks.
However, according to this March 2007 report the average price for a medium cup of joe from Starbucks was $1.55 while the same cup from DD averaged $1.65.
(http://www.consumerreports.org/cro/food/beverages/coffee-tea/coffee-taste-test-3-07/overview/0307_coffee_ov_1.htm)
My point is that the price differentiation between Starbucks and Dunkin Donuts for a regular coffee is actually quite small (Starbucks is sometimes the cheaper of the two). This may or may not be a problem for Starbucks, given that its most profitable drinks are the tripple shot, caramel infused, white chocolate raspberry moch lattes-with soy milk. It could be the intentional result of branding strategy or an indirect occurence due to the coffee culture that emerged from the Starbuck’s “phenonenom”.
As a consumer I choose to go to Starbucks because of the atmosphere, the relative consistency, and the strong coffee. However, if it actually cost me $4.00 to get a large cup of coffee I would be giving the Coffee Bean & Tea Leaf and Dunkin Donuts a second look. I am sure many other Starbuck’s customers would take a similar stand if this were to occur.
I only raise this point because of an article that ran in the Boston Globe approximately one year ago regarding the price of coffee at (McDonald’s, Dunkin Donuts and Starbucks) due to McDonald’s move into the gourmet coffee market. At that point in time the price of a large DD coffee was approximately $0.05 higher than a similar coffee at Starbucks.
January 10th, 2008 at 10:05 am
Schultz’s concern about the loss of the soul is real. I have walked into a number of Starbucks since the changeover to automated machines and the experience is substantially worse. The “Barista” used to have to actually “brew” the espresso, which introduced some slight variability and technique. Then also there were the sounds and smells of the process enriching the experience and making me feel that I was getting something more for the premium dollars that I was spending there. Now, anyone can be a Barista. Just push a button and serve it up! You almost sense the old New York City “attitude” when they do their tasks….”wahdayouwant!”
Until they tear out the automation and go back to their personalized roots, Starbucks is on a long term decline and I would expect the investment value to decline to a “commodity” investment having nothing special to offer. Too bad.
November 3rd, 2008 at 5:22 pm
excellent evaluation of the current market model. I personally do go to starbucks, even as a student, not necessarily for their coffee, which is usually too bitter or too loaded with sugar which is used to HIDE the bitterness, but because there is literally one on every major road around my college. The convenience and longer night hours encourage me to go there rather than to a ma and pa shop that probably serves better coffee. Brand loyalty is definitely strong in my opinion, but i see more of a loyalty to the atmosphere than the actual product. We shall see how the holiday sales turn out for this year, but i don’t see starbucks necessarily disappearing as much as I see it downsizing and revamping it’s product placement.