Hang on to your coffee cups, because I'm about to get bearish on Starbucks (NASDAQ:SBUX). My outlook is based on expensive prices -- for both the shares and the products -- as well as growth initiatives that may falter, and the company's performance, which may well be a harbinger of things to come.
Not such a hot performance
Sure, Starbucks has been a great-performing company and stock. But how long can the growth continue, and at what cost?
In its latest quarter, total revenues rose 20.1% from the prior year, and much of that growth came from opening new stores. Same-store sales, meanwhile, rose by a respectable, but not very frothy, 4%. But while earnings rose 16.7% despite a lower share count, higher expenses, including commodity costs, weighed on the bottom line. The favorable figures are nothing to sneeze at, but they are lower than what the company has experienced in the past. Management is aware of the situation and has lowered its growth expectations to 18% for the top line (from 20%), and 20%-22% for earnings (from 25%).
Although revenues rose, expenses rose even more. Higher commodity prices, particularly dairy costs, were partly to blame. Those costs may eventually go down. But other factors, such as higher rents and a shift to higher-cost products, are more difficult to control in the future. In the end, Starbucks may be stuck with a higher cost structure. With 85% of its top line coming from company-owned stores, it bears the brunt of the damage.
You may wonder how it plans on dealing with this situation. If you guessed "by raising prices," you win a prize -- although almost certainly not a free cup of coffee. Yes, consumers will ultimately have to dig even deeper for that morning jolt of already overpriced coffee. That 4% comps figure, by the way, came almost entirely from higher prices. The company experienced just a 1% increase in customer traffic.
Trying to maintain fast growth also costs money. While Starbucks generated more than $1 billion in cash flow from operations, it spent more than $825 million on capital expenditures and acquisitions.
Growth? From where?
The company has a nice niche -- selling premium coffee. But Starbucks has always been about more than just coffee. It has also been about selling a lifestyle. People go in, spend an exorbitant amount of money for whatever funny name the company has slapped on the java, sit down with their cups, and open up their laptops. This is why I get a little uneasy hearing the CEO mentioning expansion opportunities in terms of traditional coffeehouses.
Speaking of lifestyle, Starbucks has increased the development of its drive-through retail stores and had 1,600 of them at the end of fiscal 2006. This seems like a waste of time, money, and effort. If the company wants to sell a lifestyle of sitting and either working or just relaxing in its stores, then developing more drive-throughs seems counterproductive. If Starbucks is just to be grabbed on the run, any number of restaurants already do that for a lot less money -- Dunkin Donuts, McDonald's (NYSE:MCD), and Tim Hortons (NYSE:THI) are just a few that come to mind. This is probably a good time to point out that in blind taste tests, McDonald's coffee was favored over Starbucks'.
The CEO also says his company accounts for less than 10% of the total consumption of coffee beans in North America, and less than 1% internationally. But that statement strikes me as a bit disingenuous. Starbucks isn't competing with Folgers or Maxwell House. Its target audience is well-to-do professionals. There's nothing wrong with that, but it limits growth opportunities, and it's certainly not representative of the overall coffee market. Stores should ideally be located in metropolitan areas and suburbs, but in reality, the location can't be just any suburb. Based on the prices Starbucks charges, it has to be in well-to-do neighborhoods; otherwise, it's tough to separate those dollars from customers' wallets.
Starbucks already has more than 10,000 stores open in the United States. Given its limits to geographic expansion, how long will it be before the country becomes saturated? I know the saying -- "You haven't arrived until there's a Starbucks." But it doesn't make sense if there's more than one coffeehouse in each town.
This is why international expansion will become a greater focus. There are 557 new locations this year in foreign countries, for a total of about 4,100. You may think an ample opportunity lies here for Starbucks. But will a $4 latte fly in, say, Europe? This is one area where success domestically may not necessarily translate internationally.
A final stick
Despite falling almost 21% year-to-date, the stock still trades at a high trailing price-to-earnings ratio of 35. It still trades like a lofty growth stock while the company is increasingly pressured by higher costs and slowing growth. When the market fully comes to realize that's what's going on, look for the stock to drop further. If you still want to shell out some hard-earned money for Starbucks, stick to an overpriced cup of coffee.
Wait! You're not done with this duel. Go back and read the other arguments, and then vote for a winner.
Starbucks is a Motley Fool Stock Advisor selection. See what other market-beating recommendations Tom and David Gardner are brewing up by taking Stock Advisor for a free, 30-day trial run.
Fool contributor Larry Rothman is happy to receive feedback, and he promises to read it when he's not being wrestled by his three children. Feel free to email him at [email protected]. He doesn't have any positions in the companies mentioned. The Fool has a disclosure policy.
