Starbucks Reinventing Itself, But Will Rise Again

Starbucks (SBUX) reported fourth quarter earnings after the close on Monday. Analysts had been expecting profit of 13 cents per share on revenues of $2.58 billion. Well, the results were a disappointment to most as the company earned only 1 cent per share after restructuring charges (store closures, etc), when excluding those charges the coffee retailer would have earned more like $.10 a share. Revenue did rise 3% from a year ago, but the input costs of coffee and dairy products squeezed the bottom line. Perhaps most troubling was the fact that same store sales were off by more than 8 percent.

Starbucks has been fighting an uphill battle for more than a year now, as their coffee is a discretionary luxury to most consumers. As the housing and credit troubles have been absorbed by the public, mocha lattes have often been replaced by the cheaper if less decadent homemade brew. The consumer spending environment continued to deteriorate throughout 2008, and by mid-summer Starbucks knew that it had to do something. So, management moved to close 600 underperforming stores and shed a fair portion of their workforce. This was a necessary contraction of their least profitable locations. In the good ole days, Starbucks had grown its business so rapidly that it seemed to make sense to open one on every street corner, every grocery store, every airport terminal, etc. But somewhere along the way, it became less of a gourmet coffee experience than a coffee version of fast food (generally stand alone Starbucks even have a drive-thru.)

Starbucks Chart

Since the closure of those 600 stores there has been a corporate identity crisis of sorts. Starbucks needs to get back to its core competency, which I think is more than good coffee, it is being a community meeting place, a study hall, and a place to catch up with a friend. There employees were competent and friendly, all of which added to the feeling of being a valued customer. Starbucks grew too fast to maintain strict business standards, especially at grocery store and airport Starbucks which were employed by the grocer or the airport and not by Starbucks. Starbucks has attempted more than a few initiatives to get the besieged coffee house back on track. They took strides to make their coffee more affordable offering “treat receipt” promotions and offering frequent purchasing cards. The unveiled their Pike’s Roast blend of coffee, and began to offer smoothies. There was mandatory employee retraining, and the list goes on and on. Clearly this is a time of restructuring for Starbucks and their management.

Furthermore, Starbucks is facing increased competition from Dunkin Donuts and McDonald’s (MCD). This has had the effect of more competitors’ slicing up a shrinking coffee “pie”. However, while we realize that these cheaper alternatives are stealing sales from Starbucks, it remains to be seen if people will still “trade down” when the economy rebounds. Also, Starbucks would benefit from offering a more extensive (or at least improved) food menu, people are hungry in the morning and Starbucks often loses these customers to said competitors.

Well, as you can see from our ratings chart, we have been bullish on Starbucks for well over a year now. While, it pains us to see our performance get crushed on a particular security, the old saying remains true, “if you liked them at $25, you’ll love them under $10!” Seriously, Starbucks is undoubtedly cheap right now, and growth prospects in China and India remain compelling. We calculated the range of price-to-cash flow and price-to-sales in which Starbucks has normally traded over the last 10 years. For price-to-sales that historically normal range is 1.86x to 3.13x, but price-to-sales is currently less than half of the low end of the range at .69x. Similarly, price-to-cash flow is currently 6.1x which is less than half of the low end of the historically normal range of 14.5x to 24.5x. So, there is no other way to describe this stock other than “deep value”, and if you have a long time horizon it is very likely that Starbucks will begin to creep up closer to its normal valuation ranges as economic conditions improve. The company is trying to find its footing during a tough period, but management will manage and earnings will begin to grow when restructuring is in the rear view.

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

We utilize this straightforward approach to value over 5500 securities, with key emphasis given to the study of individual securities' price-to-sales, price-to-cash earnings and other historical valuation ranges. Our long term value investing methodology is powered by the teachings of Ben Graham and it has proven to be very adept at identifying stock prices that are out of line with fundamental factors.

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