Fool on Call: Starbucks a Star No More?

Over the past few months, Starbucks' (Nasdaq: SBUX  ) investors have become pretty indecisive on the company's future growth potential. With the stock down 25% so far this year, there's a lot of concern whether the company can continue to operate at the high growth rates it has shown in the past. After listening to management's latest quarterly conference call, the Starbucks question didn't become any clearer, as it provided reasons for both optimism and concern.

The potential
Starbucks founder and chairman Howard Schultz, responding to one analyst's query in the Q&A period, made the most bullish statement of the whole call: "I think what I would like to just try to explain is, the coffee category, the specialty coffee category, despite the growth of Starbucks and others, is still in its infant stages, and as we've talked in previous years, we have less than 10% share of total coffee consumption in North America [and] less than 1% internationally."

So, even though there are already 14,396 Starbucks stores operating in 42 countries, from this perspective, the company's potential remains largely untapped. To go after the rest of the market, Starbucks will use a multipronged growth strategy that includes steady domestic expansion by adding 1,700 stores a year, accelerated retail growth in international markets, and continued development of its premium-goods offerings. There are already more than 4,000 international locations, and management believes it will grow this number to at least five times its current size. In addition, it has already begun creating strategic alliances by teaming up with Hershey (NYSE: HSY  ) to introduce Starbucks-branded premium chocolates. All of these initiatives combined are expected to lead to Starbucks' doubling the size of its overall business "over the next four to five years," according to CEO Jim Donald.

The problem
A problem that potential investors face with this stock is that it has been traditionally priced as a growth story. While the company is still growing, it appears that this growth may be decelerating. In the latest call, management projected top-line growth of 18% and bottom-line growth of 20% to 22%. These are very respectable figures, but they are lower than what the same management was calling for just a year ago when predicting 20% on the top and 25% on the bottom.

Coupled with this situation is the recent escalation in commodity prices, particularly in dairy, that is placing a strain on the company's profitability metrics. If you're a Starbucks regular, I'm sure you've noticed the company's attempt at offsetting these costs by raising prices by an average of $0.09. A concern here is what kind of impact higher menu prices will have on customer traffic. As it is, traffic grew less than 1%, resulting in a meager 4% comps. So how will this same metric fare in the next quarter when factoring in the new higher prices?

Even CEO Jim Donald is uncertain of how customers will respond: "We're not expecting a significant traffic decline with the coming price increase, but we recognize that it's the first time we've taken two price increases as close together as these two and just want to acknowledge that it might have a short-term negative impact on traffic."

Decelerating growth and weakening margins is rarely a recipe for a winning investment, and unfortunately, that's exactly what Starbucks investors are facing at this time.

The debate rages on
Last week, my colleague Alyce Lomax gave Starbucks a cautious nod of approval, stating, "I think it's a good time to consider Starbucks, but as always, investors should weigh all of the elements with a critical eye." At the same time, another colleague, Nathan Parmelee, offered a much more optimistic view of Starbucks' prospects: "I fully expect that Starbucks will once again get the formula right and start kicking butt."

The Motley Fool CAPS community has a lot of mixed feelings on Starbucks as well, as it rates three out of five stars. Here is a taste of what many players are saying:

Starting with the bears:                       

  • Gryfonclaw keeps it short and sweet: "Overvalued. Plus, I hate tip jars."
  • JungJung points to high-priced products as a problem: "Down on $4/cup Latte Venti!"
  • And Abitarecatania sees increased competition as a serious threat and asks rhetorically, "How hard is it to make good coffee? Not hard, and everyone is going to try ... McDonald's (NYSE: MCD  ) , 7-Eleven, Caribou Coffee (Nasdaq: CBOU  ) , etc. ..."

And from the bullish camp ...

  • Abbcmoney likes its store growth: "Starbucks stores are popping up everywhere. ... More stores means more profits ..."
  • Tarfu773 highlights Starbucks' partnerships as a source for optimism: "Exclusive rights in the Barnes & Noble (NYSE: BKS  ) cafe was a great idea, as was installing them in Target (NYSE: TGT  ) to give tired soccer moms a place for a Venti Soy Latte."
  • BadManNo1 points to the company's historical success, which might suggest more good to come: "A winner since it went public in 1992."

I have yet to give my official call on Starbucks under my own CAPS profile, but if I were to make a pick today, I would likely lean toward a thumbs-down. While I am not convinced that over the next one to three years, Starbucks will significantly underperform against the market, I am equally unconvinced that the underlying stock will be a market-beater over that time frame. In a nutshell, I see an average investment over the short term as the stock continues to digest both a pricey valuation along with weakening growth and rising costs.

Does that mean investors should steer clear of Starbucks altogether? Nope. There is an air of uncertainty surrounding this company right now, and enough uncertainty can provide just the opportunity for the savvy investor.

Starbucks is a Motley Fool Stock Advisor selection. Take a free 30-day trial of any of our newsletter services today.

Fool contributor Jeremy MacNealy, under the username jmacn22, is currently ranked 938 out of more than 60,000 CAPS participants. He has no financial interest in any company mentioned. The Motley Fool has a disclosure policy.


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