"Altruistica": Seeking a return to full financial disclosure and regulatory oversight. A financial market analysis blog for "entertainment purposes" only by an experienced CFA seeking new hedge fund engagements for investment writing and analysis. The author has experience investing internationally, running a hedge fund, making angel investments, and helping launch five startup companies. Investors should do their own due diligence.

21 November 2006

SBUX- Brother, Can You Spare $3.75?- September 2006

Is a morning coffee or two addictive? Is it the fuel for a nation of two-income households? When is enough, ENOUGH?? How about 12,000 stores (8500 in the U.S.) in 37 countries? How about 800,000 stores EVERYWHERE? (SBUX wants 30K stores total with half in the U.S. by 2010). How about the 40 multiple valuation of the ubiquitous seller of this libation, Starbucks (SBUX:Nasdaq), which recently posted just 5% same store sales growth? Well, one of America’s favorite growth stories may well be stumbling. SBUX shares are a short or attractive put candidate over $34. Someone go tell perma-java bull Jim Cramer to chill and have an iced latte…

Cramer: “This is a company that can do the impossible. SBUX can charge you $5 for a cup of coffee and get away with it. Why? Because they offer an ambiance. It is yuppie heaven. SBUX is done growing in the U.S., but their China-based growth is just beginning. SBUX intends to have 20% of its sales from China in two years.”

Jim Cramer, “Mad Money”, May 15, 2006

SBUX is a well-known and generously-valued consumer marketing success story with 15 years of 5% or greater same store comparisons until July this year. SBUX’s long term goals are to achieve 20% annual sales and 20%-25% annual EPS growth. Its “folklore” is continuously trumpeted by billionaire founder, Howard Schultz, although Schultz, CEO Mike Casey and three other officers have been selling their stock aggressively this year (nearly $100m so far). And this week, SBUX was sued for anti- competitive and predatory sales practices such as competitor intimidation and customer poaching (i.e. by providing free coffee in front of other vendors’ establishments). Filed in U.S. District Court, the class-action lawsuit alleges that Starbucks has exploited its monopoly power in the specialty coffee retail market to stifle competition through a series of predatory practices including exclusive lease agreements, "cluster bombing" of stores and offering to buy out competitors at below-market prices and threatening to open nearby stores if the offer is rejected. "It is clear to us that Starbucks' game plan is to completely dominate a market by forcing out competition, something they've done quite well in the Seattle area," the plaintiff’s lawyer Steve Berman added. "We also believe that this scorched-earth approach is happening in many other major markets across the U.S."

With an estimated 73% of the specialty coffee market, SBUX has market power and is soon raising prices. Starting on Oct. 3, the prices on lattes, cappuccinos, drip coffee, and other drinks will go up 5 cents at company-operated stores in North America. Starbucks is also jacking up the price of its coffee beans by roughly 50 cents per pound, or an average of 3.9%. This is the first price hike on drinks in two years, and the first on beans since 1997. SBUX claims the higher prices are intended to offset higher labor (especially health care) and fuel costs. But another set of class action suits relate to legal battles with Starbucks union members in New York and California. The labor problems have led to Labor Department rulings in favor of the unions and negative press. As an example, a Starbucks (SBUX) manager says the company forced him to work off the clock and has filed a federal lawsuit on behalf of thousands of managers who worked in California stores over the past four years. A previous lawsuit classified managers as exempt from overtime, which why managers are paid an hourly wage.

This price increase may be an effort to get same store sales comparisons back over 5% since comps began missing some analyst expectations in April and fell below 5% in July. Another SBUX response has been to increase U.S. planned store openings from 1000 to 1500 to 1800 this year (versus a 500/year historical average), a move which will expand capex, hurt margins, and possibly cannibalize existing outlets. Moreover, this panic expansion plan will not hurt new premium coffee pushers including McDonald’s (MCD: NYSE), Dunkin' Donuts, Green Mountain Coffee Roasters (GMCR: Nasdaq) and Caribou (CBOU:Nasdaq). About two thirds (about 750-1100) will be drive through, which kills the movie, book, CD and ticket impulse, in-store purchases. Strong, well blended coffee at 50% discounts to SBUX prices may just resonate with some customers facing a sharp increase in mortgage payments starting this fall when nearly 40% of all mortgages reset to higher interest rates. Roughly $500 billion of these adjustable rate mortgages (ARMs) are due to be reset by the end of 2006, with another $1.5 trillion resetting in 2007. According to the Wall Street Journal in August, consumers are cutting back on high-priced coffee, fashion accessories, clothing, and other luxury items. Late summer, SBUX, Whole Foods (WFMI), Williams-Sonoma (WSM) - and boat maker Brunswick Corp (BC) and Panera Bread Co (PNRA) missed their comps targets. Low-income households are more likely to shop at dollar stores, but households earning $75,000 a year are also changing their habits

So, on August 3rd, SBUX plummeted 12% on the report of July comps of 4%, well below the 6.4% gain analysts expected and the smallest increase in five years, providing “a sign that the coffee giant may be vulnerable to pressures on consumer spending, like other retailers,” according to the Wall Street Journal. SBUX earlier increased its share buyback program by up to 25M additional shares, in addition to the 3.4M shares that remained available for repurchase under a previous authorization. Oddly, Cramer’s touting and a Wall Street Journal article just before SBUX’s Q3 report hyped it as a “consumer staples stock” Hello? Specialty coffee and frozen drinks at ANY retail outlet are a luxury and a discretionary purchase. Meanwhile, diversification efforts into new drinks (Ethos Water with Pepsico), breakfast foods (Kellogg), movies (Lionsgate Films), books (Mitch Albom) and couponing have been bungled, maybe highlighting the value of ex-marketing head Greg Maffei (who quit SBUX in March 2006). To “outsource” Maffei, Starbucks hired the William Morris Agency during spring to find more movies (2-3 annually) and book projects (at least one) to market.

Meanwhile, analysts pray for a new ‘killer frap’ or frappuccino to save the comps. And for every failed new drink concoction such as Chantico, SBUX was pushing non-coffee drinks such as Banana Cream, Banana Caramel, and green tea Frappuccino drinks this past summer. But SBUX has started making non-caffeinated fraps available to children, despite its claims it would NOT market to children. Shades of Google’s PR claim of “Do No Evil”? Now the legendary “ambiance” of its stores is being killed by a push to build drive-thru stores (currently 1,300 of 8,500 stores) in high density areas like California with the next push in New York to attack Dunkin’ Dounts there. But McDonald’s (MCD:NYSE) franchises launched a premium coffee under the name Newman's Own early in 2006 ahead of parent company MCD’s own launch of a premium coffee nationally in March. The coffee is enabling MCD franchises compete with SBUX, Dunkin' Donuts and Burger King, which launched its own premium coffee, BK Joe this past summer. Canada’s Tim Horton’s has also entered the fray.

SBUX is trying to prevent customers from defecting from long lines during the summer when it suffered from failed promotions and labor-intensive fraps that hurt margins .But new ventures seem ill-advised or tantamount to brand stretching or “cheapening.” The deal with Yahoo Personals gets you a $10 gift card in exchange for disclosing your identity and getting spammed with the closest SBUX store to use that gift card. Customers have complained about the taste and pricing of “Grani”, a new “on the go” breakfast item joint ventured by SBUX with Kellogg’s (K:NYSE) Meanwhile, the $150m in incremental sales goal has quietly been dumped even though 600 U.S. stores are slated to have “breakfast warming ovens” by fiscal year end. In addition, under the promotional deal for the flop film "Akeelah and the Bee," SBUX agreed to promote the movie, sell DVDs of the movie and CDs of its soundtrack, in exchange for an undisclosed share of the movie's box office proceeds. This fall, Starbucks is also planning to sell other DVDs and books alongside the CDs is sells. :

Of course, the SBUX “holy grail” is international expansion, increasing its existing 3,500 stores to 15K by 2010. Recent pushes into China, India, Brazil (with Cafes Sereia do Brasil Participacoes S.A) and France. Operating profit margins for the international division over the past four quarters averaged 9.1%, compared with negative margins in fiscal 2003. But new expansion in France and China is moving to second and third tier cities, some where cultural resistance may prevail. However, internationally savvy Coca-Cola (KO) is getting into the coffee business, setting up mini-cafes in retail stores, offices, fast-food outlets and movie theaters that will brew espresso drinks in 30 seconds for under $3."We're not going to be in the real estate business - we're going to sell brewed coffee and teas wherever Coke is sold," said Udaiyan Jatar, head of Coke's coffee project

Part of the SBUX appeal as a short is the lack of negative opinions on the stock with sponsorship and coverage coming from Goldman Sachs, JP Morgan, CIBC, UBS, Think Equity and new summer coverage from Deutsche Bank. The firm anticipates the international operating margin is going to continue to benefit from increased scale, maybe at a slower pace in 2006, as the Company invests substantially in China in expectation of robust growth. FY06 (Sep) EPS may reach $0.75 when Q4 is reported October 5 and $0.90 in FY07. But with the U.S. middle income consumer retrenching and the Chinese yuan appreciating (finally) against the dollar, SBUX looks vulnerable during a period of heavy overseas capital commitments.


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