Friday, March 14, 2008

Well, He’s Back at Starbucks. Now What?

Yes, he’s back at Starbucks.

No, I do not mean Howard Schultz.

I mean Mark. Mark was a hard working, conscientious kid, and he worked at the local Starbucks for years. Mark left for various reasons a year or so ago and I had not seen him since.

Then this morning Mark appeared behind the counter. He’s come back, for various reasons, and it was good to see him. But the most interesting thing about Mark’s return is that he can’t yet make espressos until he’s done his training.

This is a guy who, at the rate of ten lattes, cappuccinos and other, foofier, beverages per shift, probably made at least 10,000 espresso drinks over a period of five years at Starbucks. If that sounds ridiculously high, do the math yourself. In fact it's probably low.

But Mark can’t make a single one until he’s finished his training again.

Now, no fall from grace—among the many that have occurred in Corporate America since the Housing Bubble burst—has been more visible and more welcome in more quarters than Howard Schultz’s Starbucks.

And I’m not sure exactly why—resentment at the fancy prices, resentment at the foofy names for cup sizes and what are essentially chocolate milk shakes, or resentment at the demise of local coffee shops at the hands of a Chain Store from Seattle.

Whatever the reason, now that Wall Street has mostly given up on it and McDonald’s is gloating over the boost to its business from an espresso roll-out of its own, Howard Schultz has returned to Starbucks and made a few changes.

Actually, he’s made a lot of changes—firing executives, firing employees, getting rid of the hot sandwiches that made the place smell like a Subway sandwich shop, and shutting all the stores for three hours for an all-hands training session all around the country.

I had my doubts about that much-hyped “training” session, but hearing Mark talk about his own experience coming back makes me wonder if Howard’s return won’t be a good thing—for the business, if not necessarily for the stock.

Sure, McDonald’s is now out there, along with Dunkin Donuts and Peet’s. And yes, traffic is down and the cost of milk is up and the price of coffee beans is through the roof.

But I recall a conversion I had long ago with John Bryan, who at the time ran Sara Lee, which, back then, was a well-run company.

Bryan had come out of the meat-packing business—an awful, commodity business—and he loved consumer brands. He still couldn’t quite get over the fact that consumers paid more for nothing but a label and the perceived quality behind that label.

And the consumer brand business that intrigued him above all was the tobacco business.

Now, this was in the days before Big Tobacco became a target of the government, and even before the toll of cigarette smoking on public health was as well known and widely accepted. Also, Bryan wasn’t actually looking to buy a tobacco company, what with the liabilities and public censure and all surrounding what was regarded in most quarters as a somewhat dirty business.

But as a business, he mused, it was the best model you could find: not only were cigarettes addictive, he noted, they were brand-addictive.

And coffee is like that, too. Except for the emphysema and lung cancer and all.

Starbucks drinkers drink Starbucks, for the most part. They’re not firing up Maxwell House at home, and they’re probably not altering their morning routine to go through the McDonald’s drive-thru instead of the Starbucks.

The same thing holds true with Dunkin Donuts regulars. And doubly-so with the snootier coffee drinkers who swear by Peet’s and wouldn’t be caught dead with a Starbucks cup in their hands.

So maybe there’s something to this turnaround at Starbucks. Perhaps, if and when the commodity inflation that's hurting margins subsides, and the lending crisis that's hurting store traffic is over, the business will come back.

After all, a non-lethal, brand-addictive product can’t be too bad a business, in the long run.

Jeff Matthews
I Am Not Making This Up

© 2008 Not Making This Up LLC

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.


Phillip Charles said...

Anyone who buys (or holds onto)anything selling at 10x book that isn't returning 90% on equity and is not paying a steady dividend deserves what they get...just my two cents...I still love SBUX coffee, tho!

Peet's, of course, is trading at a much more smug 2x BV with no burdensome debt on their books. Debt is so boorish these days!

Michael said...


Peets has no debt because their roic/wacc is prohibitively low/high...therefore their 2x bv.

Sbux has a bv of 6x (according to thompson) because it has a roic in the mid 20-s range.

As for divs, if roic's are that high, why the heck would sbux bother to return a div to investors...especially in this market? If I'm a shareholder, i don't want a div...i say 'please keep it and reinvest at 20+%' least it won't get wiped out by Hurricane Mozilo.

As for sbux's return of capital via buyback (as opposed to div), it makes imminent sense if the stock's got 20+% of upside in it. That's, of course, a subjective call for both sides of the table...but at least a div is black and white.

Sbux's roic promotes the idea that reinvestment in the business will compound those high returns and eventually reward shareholders (patient ones) down the line when they decide to stop expanding (~75% of OpCF is spent on new stores) and start returning cf with a real conviction.

Of course, in the meantime, sbux has to defend its operating margins if it intends to be that cash cow in the future. But I think Jeff diligently illustrated that sbux fully realizes this.

Phillip Charles said...

Michael, I enjoyed reading your response and found it both thought-provoking and informative. Everything you said is true and valid from an ‘at its peak’ perspective. I simply view an investment’s potential from a different position. I never expect to return 100% in a year, but if I never lose 50%, well, I hope to hang around for awhile.

The 10x BV to which I was referring was when SBUX was at its peak just under two years ago (actually it was closer to 12, but who’s counting?). Yes, with the metrics you accurately noted, maybe some could justify such a high valuation, and with the returns SBUX was realizing there is little justification to start paying a dividend. However, and at the risk of recklessly espousing clichés, no tree grows to the sky. I can not justify something that is selling at such a high valuation, especially in a company that was coming upon noticeable and obvious stall points in its business model. I am not wired to buy downside and anything selling at such valuations and returning only 20-30% roic has limited upside and tremendous downside. In that situation, I would at least want a dividend to create some hope of a price floor. You don’t have to agree with me, but wait long enough and the market will always validate that concept. Anything else is market timing, and good luck with that.

Your evaluation of SBUX was very intelligent and thorough and I hope that this response was a worthy follow-up; I’m often concerned that I oversimplify things.

My Peet’s allusion was a play on Mr. Matthews’ spot-on description of their clientele. The Peet’s that I frequent and enjoy is in Harvard Square, the epicenter of East Coast snootiness, so I couldn’t resist…

sean said...

Just my 2 cents on valuation metrics...

Looking at the book value of Starbucks and comparing it to another consumer goods company is an exercise in futility in my opinion.

What is the asset here? In my very brief analysis, the real asset is a global brand that in many a consumer's noggin stands for 'high quality coffee and drinks' that they can sell for a lot more than 'joe's house of caffeine' because they provide a great experience and product.

The most valuable assets are not, in my opinion, the coffee equipment, leasehold assets, and those barista aprons, all stated at historical cost.

I think book value has its place (but not at Bear Stearns apparently). Book value is worth something at a financial company or something with liquid assets.

But if you try to look at something like starbucks or coca cola and use book as your value compass you might be digging for treasure in circles.

In other unrelated news I thought i would mention that I actually go to Starbucks, Dunkin Donuts, and make generic coffee (although i try to make it starbucks)sometimes in the same week.

Anonymous said...

"Peets has no debt because their roic/wacc is prohibitively low/high...therefore their 2x bv."

Isn't it the other way around? Peets has a low ROIC & WACC because they are unleveraged and have low debt?

Jeff Matthews said...

Peet's has a low ROIC because they're too small to leverage their store base and their investment in roasting capacity.

Their model doesn't support debt. They have cash because they've sold stock.

Starbucks had similarly low ROICs in the early years of its growth.