5 Reasons Starbucks Has Me Jittery

By Jason Hall - September 19, 2012 | Tickers: DNKN, GMCR, JMBA, PNRA, SBUX | 0 Comments

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I am a Starbucks (NASDAQ: SBUX) fanatic.  I love their core business, execution, and management.  They work closely with suppliers to practice Ethical Sourcing, pay employees a living wage, offer solid benefits (including 401(K) with employer match), all because it's the right thing to do.  There are very few businesses that are as ethical in their practices.  This is my second-largest stock holding - that alone should say enough.  

I have decided to revisit many of my core stock holdings based on something that I discussed in this post a couple of weeks ago- the failure of most investors to evaluate a company's past and apply history to possible future results.  Combine that with my strong emotional attachment to this investment, and the results can be disastrous.  There have been thousands of pages written on the destructive power of emotion on investing. 

As I started looking closer at Starbucks, I observed four things happening that, each taken on its own, wouldn't be worth discussing.  Yet as they are all happening simultaneously, it has given me pause, especially when I look back over just a handful of years.  Factor in a challenge that all businesses deal with, and there are five things that may cost Starbucks investors a lot of money. 

But as I said, we need to look backward before we look forward. 

It’s easy to forget that this is a company just a few years removed from almost burying itself via an overly aggressive expansion plan.  Remember the article in The Onion about a new Starbucks opening in the bathroom at Starbucks?  Remember this letter that Howard Schultz wrote to then-CEO Jim Donald in early 2007?  From the opening paragraph: 

“…we have had to make a series of decisions that, in retrospect, have led to the watering down of the Starbucks experience, and, what some might call the commoditization of our brand..”

Since that time, Starbucks has undergone a renaissance, refocusing on its core brand and a more targeted expansion under Schultz, who resumed command of the company about a year after the famous letter quoted above.  Let’s take a peek at how Starbucks fared from the beginning of 2007, a year before Schultz took command, until the end of 2009, nearly two years after re-assuming control:

SBUX Revenue TTM data by YCharts

The return of Schultz couldn’t have occurred at a worse time (or a better time, if one considers the long-term implications) as the U.S. economy was plunged into the deepest recession in nearly 80 years.  While the momentum from the  over-expansion under Donald carried revenues higher into 2008, net income plunged sharply as per-store sales growth declined by 3% in FY2008, and 6% in FY2009. This dragged net income down sharply, as fixed costs weighed heavily on the bottom line.

By the end of FY2009, Starbucks had managed to reduce operating costs by over $500 million through a combination of closing under-performing locations and enhancing other operational efficiencies.  The only major new product innovation was VIA Ready Brew, Starbucks’ foray into the $20+ billion global instant-coffee market, as the focus on strengthening the core brand was first and foremost on Schultz's agenda.   The bottom line is that the refocusing of the core business paid strong returns, especially on the bottom line:

SBUX Revenue TTM data by YCharts

Through the end of FY2011, Starbucks increased revenues by 28% over the prior 18 months and grew income by an amazing 81.9%.  This moved the share price from $23.05 on January 4, 2010, to over $50 per share in recent weeks, more than doubling investors’ money and beating the S&P 500 by more than 80% over the same period.  Schultz has clearly put Starbucks back on the growth track, as the store count has grown to more than 17,000 locations globally, well on the way to reaching 40,000 locations. 

So what’s got you so jumpy?

Simply put, Schultz himself may now be making decisions that could lead to - as he accused former CEO Donald in that letter- the “watering down” of the Starbucks brand.  From the FY2011 Annual Report:

“Among our most exciting moves in 2011 was our November entrance into the $1.6 billion super-premium juice segment through the acquisition of Evolution Fresh, Inc., which also represents our intentions to more fully enter the $50 billion Health and Wellness sector.”

Health and Wellness?  That's pretty far outside of the core brand, no?

From the LA Times:

“Starbucks said it would bring booze to four to six new or remodeled stores in the region by the end of this year and planned to do the same to a small group of locations in Atlanta and Chicago. In addition, patrons could order "premium food" such as savory snacks, small plates and hot flatbreads.”

The article continues, with quotes from Starbucks patrons:

“If I wanted a beer, I'd go to a bar,’ said Doug Tanaka, 48, a police officer who lives in Valencia. ‘I bring my grandkids in here. I don't want to have to deal with a drunk if I'm having coffee.’”

Talk about watering down the brand - how about pickling it?  I wish I could say there wasn’t more, but there is.  From a June 4, 2012 press release: 

“ ’The acquisition of La Boulange® bakery will help us to expand day-parts, drive customer loyalty and ultimately grow the overall business through differentiated brand experiences and multiple channels,’ said Cliff Burrows, president, Starbucks Americas, who will oversee the integration and expansion of La Boulange®.”

This, from the same company that said in 2008 it would stop serving warm egg and cheese breakfast sandwiches, because, as Schultz put it, they “fight with the coffee aroma in stores.”  Now he says, from the press release, “…we will be able to say we are bakers too.” 

And to paraphrase the immortal Steve Jobs, one more thing:  Starbucks Refreshers.  From the press release:

“…a global breakthrough beverage innovation that delivers a distinctly new take on thirst-quenching refreshment while providing a natural boost of energy from green coffee extract and real fruit juice. Customers can enjoy Starbucks Refreshers™ beverages in Very Berry Hibiscus and Cool Lime flavors…”

Okay, so there's a lot of new stuff happening.  What's so bad about diversifying?

Let's go back to 2007.  Remember that letter Schultz wrote?  Another quote:

“Many of these decisions were probably right at the time, and on their own merit would not have created the dilution of the experience; but in this case, the sum is much greater and, unfortunately, much more damaging than the individual pieces.”

It brings another quote to mind.  Something about “the sins of the father.”

There you have it.  Booze, flowery cold drinks, and the acquisition of two very outside-of-the-coffee-cup businesses.  That's four things that, when tied together, look like a very different business than what I signed up for.  In all of the noise above, there is one new happening that is actually directly tied to the coffee brand: Verismo, Starbucks’ home espresso brewing system.  Even that gives me pause, with all the rest. 

In a vaccuum, maybe I'm overanalyzing this.  But in the real world there's a fifth reason that cannot be ignored, and with Starbucks doing so many things to expand, can they really execute?  As taken from Google's "Ten things we know to be true," it's best to do one thing really, really well.  And getting into all of these other ancillary things may just limit Starbucks' ability to focus on what will be the challenge to make any of these new ideas off the ground:  

Competition, the "Fifth Elephant"

So it would seem that in one fell swoop, Starbucks has decided to take on Jamba Juice (NASDAQ: JMBA), Green Mountain Coffee Roasters’ (NASDAQ: GMCR) Keurig home coffee brewer, and Panera Bread (NASDAQ: PNRA).  Not to mention every corner bar in America, all while trying to fend off Dunkin’ Donuts’ (NASDAQ: DNKN) expansion.  What’s next?  Ice cream? All joking aside, these are serious competitors.  Let’s take a moment and analyze what Starbucks is challenging with its new targets for growth.

Starbucks claims that the Verismo is not a competitor to the Keurig, as it is a high-pressure espresso maker, where the Keurig is a low-pressure system that just makes brewed coffee (and apparently lemonade and iced-tea now, as well). Yet I think that the reality is clear:  These units will compete head-to-head for many consumers who will chose one over the other -- and with Starbucks’ coffee is available in the K-cup for the Keurig. This is the one current initiative that I see bringing clear value to the coffee brand, and the real loser could be Green Mountain Coffee.  That is, if all of the other initiatives don't pull Starbucks' eye off the ball.  

From Dunkin’ Donuts’ FY2011 Annual Report:

“In early 2012, our coffee was named #1 in coffee customer loyalty for the 6^th consecutive year by the Brand Keys Customer Loyalty Index.” 

Just a few pages further down:

“…we plan to more than double the Dunkin’ Donuts footprint in the U.S. to more than 15,000 locations…”

Dunkin’ Donuts’ aggressive growth, matched with its inexpensive iced- and hot-coffee beverages, could be a real challenger for Starbucks expansion plans moving forward, especially as cost-conscious consumers continue to feel the squeeze of a stagnant economy. 

Panera Bread is well known for the quality of their sandwiches and baked goods.  If Starbucks has plans to expand La Boulange into a more full-service experience, the competition would be stiff, with more than 1,500 Panera locations and aggressive growth plans.  I am merely speculating, but the fact that Starbucks has made a significant investment into this new business could foreshadow expansion of this kind.  And that’s a very different business than selling espresso drinks -- and well outside of the core brand. 

The Innovation Fresh acquisition could very well take Starbucks down the path to compete head-to-head with Jamba Juice.  And while Jamba Juice has struggled in the past, the most recent two years have shown a company that is revitalized, expanding, and increasing same-store sales figures for more than 7 quarters in a row.  Factor in privately-held Robeks and Smoothie King, as well as numerous regional players, and this is a cut-throat business. 

Tie in Starbucks Refreshers and the testing of wine & beer in select markets, and it seems that the company is just looking for ways to expand to more customers than just coffee drinkers, and offer alternatives even to those that do.  That in and of itself isn’t necessarily a bad thing, but there's just so many things.  

Run!  Get out before the Deworsification gets you! 
Okay, I admit I may be acting a little bit melodramatic, but there is a lot of change happening right now at Starbucks, and if Jim Donald were still running the company, I would not be a shareholder.  Frankly, there aren't many business leaders that I would trust to manage through this much change, and never an outsider. 

But Howard Schultz is a different leader, and if I could use one word to describe him, it’s “focused.”  So while on the surface it looks like Starbucks is engaging in a massive re-invention of the brand, that’s not what I really think is happening.  The company is smartly testing different ideas such as beer and wine in specific stores and markets, and will roll out the juice & bakery businesses in a way that brings value to the brand without overwhelming it with lots of noise and confusion about what Starbucks is all about. 

I plan to hold my shares, confident that Schultz is going to keep a smart, focused approach to implementing these new brands into the Starbucks family. But with that said, I intend to watch closely as Innovation Fresh and La Boulange are integrated and expanded, and if for one minute it looks like Schultz has forgotten to take the medicine he served Jim Donald, I'm outta here. 

And I may just have a beer the next time I’m at Starbucks.  If they ever announce which stores will be serving, that is…

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