Stick to What You Know Starbucks

By Chad Henage - October 15, 2012 | Tickers: DNKN, GMCR, PNRA, SBUX | 0 Comments

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One thing that should worry investors is when a company tries to expand a concept that originally was meant to be complementary to their primary product. When most customers think of Starbucks (NASDAQ: SBUX), the first thing that comes to mind is specialty coffee drinks prepared at a Starbucks location. There are two recent moves that the company made that don't necessarily fit with this high margin business. Among the euphoria of investors over recently improved results, some might not realize that the company is setting itself up for more difficult earnings comparisons ahead.

Verismo and What it Might Mean for Starbucks Margins:

With the introduction of the company's Verismo machine, many investors believe that Starbucks will gain market share in the single serve beverage category, at the expense of Green Mountain Coffee Roasters (NASDAQ: GMCR). However, there's something else that this introduction does for Starbucks. Potential customers could be driven away from its highly profitable locations. Green Mountain doesn't have to worry about protecting its coffee shops because it doesn't have any. Instead the company is perfectly comfortable letting customers brew their own flavors at home. Consider this: Last year Green Mountain's gross margin was just over 34%. By comparison, Starbucks' gross margin was nearly 58%. Given that Verismo is priced similarly to existing high-end Keurig brewers, it's almost certain that the company is breaking even on the unit itself. In theory, Starbucks could make up the difference on the sale of the pods used in this machine. However, investors need to realize there's a huge difference in size between Green Mountain and Starbucks. Last year, Green Mountain produced $2.6 billion in sales, versus almost $12 billion at Starbucks. The point is, if the company breaks even on the machine, Starbucks will need to sell a lot of pods at higher prices than traditional K-Cups in order to maintain its much higher margins.

It Needs to Stay All About the Beverages:

Another recent announcement that concerns me is Starbucks' expansion of La Boulange. While there's certainly nothing wrong with the company expanding its baked goods offerings, this can't be a primary focus for the company either. In a recent article, Starbucks announced its intention to eventually expand distribution of La Boulange cooked bakery items nationally. While at first this would seem to make sense, it places Starbucks in more direct competition with both Dunkin' Brands (NASDAQ: DNKN) and Panera Bread (NASDAQ: PNRA). This would seem to be the wrong strategy for the company as even high-end baked goods carry a lower margin than the company's beverage lineup. In order for Starbucks to meet or exceed analysts expectations, the company can't afford significant margin contraction. Considering that Panera is expected to grow earnings at nearly the same rate as Starbucks, there doesn't appear to be a huge boost to be gained by taking on this formidable bakery competitor. Where Dunkin' Brands is concerned, they are actually expecting lower growth in earnings and slower revenue growth than Starbucks. Dunkin' Brands has been expanding its food menu, and because almost all of the company's stores are franchised, their gross margin is protected. Panera seems to be a more fair comparison as to the effect more food sales could have on Starbucks. In the last year, Panera's gross margin was just 24.06%. This is less than half the gross margin analysts expect for Starbucks going forward. It seems like expanding the company's food offerings can only create negative gross margin pressure as well.

Conclusion

Starbucks' investors might not want to hear this, but even beating revenue expectations with better sales won't necessarily mean better earnings. Both Panera Bread and Green Mountain are expected to see higher revenue growth next year than Starbucks. Both of these companies have much lower margins than Starbucks and need this higher growth to meet analyst earnings expectations. If Starbucks insists on going after lower margin markets such as single serve and food offerings, this will create margin pressure that only significant new sales could offset. Take a look at a few scenarios Starbucks might see depending on how Verismo and the La Boulange expansion are received. The first line is what analysts expect for next year, the remaining lines show different amounts of revenue from these new initiatives at different levels of gross margin compression:

(each scenario assumes flat expense growth over 2012 full year, and 760 mil. outstanding shares) 

As you can see, in the best case scenario the company beats analysts' revenue expectations by $2 billion (a 13%+ difference) and manages to keep their gross margin unchanged. Earnings would clearly be significantly higher. This seems highly unlikely. Starbucks would have to make almost as much off Verismo in its first year as Green Mountain made all of last year and with no margin compression at all. Since margins will be pressured by the startup of Verismo and the roll-out of La Boulange, what happens if gross margins slip to 45% or 40%? You can see the results in the last two lines of the table, and it's not pretty. The bottom line is, Starbucks needs to stick to what it knows. Analysts are already calling for almost 8% gross margin compression from 2011 to 2012. As you can see from above, if the Verismo machine or La Boulange offerings really take off, the company's gross margin has to be maintained or investors are going to be disappointed. I like the company and their potential growth, but they need to stick to what they know. These new offerings might be very successful, but at what expense to the company's earnings?

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