minemero
Howard Schultz has built one of the great retail brands of modern business history and the story is far from over. Having covered the restaurant industry for forty years and written many times about Starbucks (NASDAQ:SBUX) on my website, where I cover every publicly held restaurant company, I’ve had a front row seat. Previewing my conclusion here: the brand is great, the future is bright, but not nearly the rocket ship it used to be. It’s about the “law of large numbers” and new “complications.”
Looking back five years, on August 2, 2017, I wrote:
describing the changing business model at Starbucks, including the possibility of unintended consequences.
“THE TIMES THEY ARE A’CHANGIN’
‘BARRON’S MAGAZINE this morning has a front cover entitled THE FUTURE OF COFFEE (AND RETAIL). The subtitle reads ‘Starbucks has succeeded where Silicon Valley hasn’t: changing the way consumers pay. The behavioral shift holds big promise for the coffee giant and its stock’.
‘Not exactly, in my opinion. It is not just about ‘the law of large numbers’, and the difficulty of satisfying investors by building on profit margins that are well above peers. The business model has changed, and the question becomes whether the new model will match the original. It’s well known that a new loyalty program bothered some customers and also that an increasing number of customers are ordering and paying online, often in advance of entering the store. In the most recent quarter, 30% of US transactions were paid using the smartphone app, up from 25% a year earlier and 20% two years ago. More important, to my view, is that 9% of US orders were ordered and paid for in advance. The company has been discussing the store level congestion for several quarters now, as mobile orders slow down service for customers going through the line. Perhaps it’s just me, but I am put off somewhat when the line at the register (where I like the human contact) is short, but I have to wait while eight or ten orders are pumped out ahead of my own.
“MILLENNIALS, WHO ARE THE SPENDERS, DON’T VALUE HUMAN CONTACT (AS MUCH)
“It’s not so long ago that pundits dismissed the internet as a retail venue. The public was not expected to give out their credit card information, and certainly was not going to buy ‘touchy, feely’ products like apparel or shoes through online channels. The public is not only ordering ‘everything’ through Amazon and others, but relationships are maintained through Facebook and other social channels. As a corollary, customers are increasingly seeking ‘experiential’ retail situations, rather than visit the malls, with their undifferentiated stores and restaurants, most often staffed with poorly trained employees.
“WHAT’S IT ALL MEAN TO EMPLOYEES, AND CUSTOMERS?
“Relative to Starbucks, their leadership with mobile order and pay, increasingly in advance of the store visit, may well be appropriate and necessary, but the business model has changed. It’s become a production challenge, not a relationship driven enterprise. The employed ‘people person’ who was the star of the previous model, is not going to be as easily satisfied, because most of the employees, for most of their time, are busy pumping out product. It’s going to be harder to find someone such as the barista at ‘my’ Starbucks who told me that Starbucks ‘is making me a better person’. From the customer side, there are 27,000 stores already existing that are already tightly configured and can’t be reconfigured too much to handle a lot more production. From a customer standpoint, some, like myself (perhaps in the minority these days), who value the human contact, may decide that the local independent shop, or even the home or office kitchen, can provide an adequate cup of coffee at a competitive price without the ‘tumult’.
“CONCLUSION
“I remember when Howard Schultz said that food will never be a material part of Starbucks’ sales. Today, it represents 30% of revenues. Schultz originally envisioned his coffee shops as a “third place”, to hang out other than home or office. That’s a little hard today, in a small busy shop, but we can call this an “unintended consequence” of building one of the still growing premier worldwide brands. Comps and traffic have slowed in recent years, due to the “law of large numbers”, the natural limitations of small stores that were not originally built to handle today’s volumes, and the evolving environment that every successful retailer must adjust to. Starbucks is one of the most successful retailers ever created, and we don’t doubt that they will continue to succeed in a major way. We caution however, that the rate of progress demonstrated in the past, already slowing, will be increasingly difficult to replicate. The business model has evolved. Starbucks was a retail “disrupter” but their previous approach may not be quite as successful. Accordingly, valuation parameters that have applied to SBUX equity in the past may not apply in the future. The stock chart that has languished over the last couple of years may well be reflecting the most likely future business model; still good, just not quite as great.”
Grading my analysis of August, 2017: Seeking Alpha’s financial summary shows that Starbucks’ operating income increased from $3,896M in ’17 to $4,444M in ’22, up 14%, while revenues increased 50%. The previous five years’ operating income had been up 97% on a similar revenue increase of 50%. That time I proved to be right, for whatever combination of reasons.
Where Do We Go From Here?
In the last five years, Howard Schultz has left, come back again (to correct all the problems I pointed out in my article, and then some), and is in the process of transitioning away to allow new top executives to establish themselves. However, the job of maintaining and building upon an extraordinary operating culture does not get any easier. Labor unions are closing in. The situation in China, our most dangerous socio-economic-military adversary, now with 6,000 locations, does not support a premium stock valuation. Operating costs, in addition to labor shortages and volatile food cost, utilities, insurance, trash collection only go one way, which squeezes margins until menu prices can catch up. Positive transaction counts, YTY, have been hard to come by, no doubt because consumer discretionary spending power is challenged and likely to remain so. The difficulty in generating a positive transaction count is not a knock on management, of whom we think very highly.
Management at their recent Investor Day, laid out a long-term plan that will generate 10-12% of annual revenue growth, U.S. comp sales of 7-9% and expansion of operating margins that will expand EPS Growth by 15-20% annually. Street estimates for Y/E 9/30/23 range from $3.27 to $3.62, vs. $2.96 for ’22). My expectation is that there is more likelihood being at the low end of those ranges, or worse, than at the top of the range, or better. At $102, SBUX is trading at 28x the $3.62 high end of next twelve-month EPS estimates, which we consider a full valuation. At $102, SBUX is trading at 31x the $3.27 low end of the coming EPS range, certainly fully priced versus a year that will proved to be only 10% higher than in fiscal ’22. Our website, which covers every publicly held restaurant company, within the Corporate Description section tells us that the Enterprise Value of SBUX, at today’s price, is trading about 22x trailing twelve month EBITDA, confirming our “full valued” thesis.
Roger Lipton
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