Starbucks Meeting May Soothe Investors

By Angela Moore,
MarketWatch
Mar 16, 2007

NEW YORK (MarketWatch) -- Starbucks Corp. will be hosting its shareholder meeting next week, and industry watchers will be looking for reassurance that the coffee-shop operator's growth plans are on track.

Starbucks' annual meetings are usually staid affairs, but after a few bumpy weeks recently, an uneventful meeting could help quell investor concerns.

"Typically, the shareholders' meeting is not that much of an event from a Wall Street perspective; [executives] talk about the things they've accomplished," Friedman Billings Ramsey analyst Ashley Woodruff told MarketWatch on Friday. "What makes it different this year is that there's fear that they might slow their growth rate. People are looking for them to reiterate earnings per-share guidance and long-term growth targets."

Seattle-based Starbucks (SBUX : Starbucks Corp SBUX 30.58, +0.99, +3.3%) has been grappling with two lackluster quarters; competition in the coffee category from rivals; a trademark disagreement with Ethiopia; and a leaked memo from its Chairman Howard Schultz raising concerns about the company's swift growth rate, commoditization of the brand and a "watering-down of the Starbucks experience."

As of Thursday's close, shares are down more than 12% since the company last reported earnings, and have slipped more than 23% since hitting a 52-week high back in November. Shares traded up 3.3% at $30.57 on Friday afternoon.

Woodruff, for one, doesn't expect any material changes to the growth plan or other targets, and thinks the overreaction in the shares represents a buying opportunity. In a Friday note to clients, she reiterated her outperform rating.

Goldman Sachs also gave Starbucks a vote of confidence on Friday, adding it to the "Americas conviction buy list."

"Recent market turbulence compounded by concerns over brand erosion and earnings quality have created a compelling buying opportunity in Starbucks shares -- a high-quality company that offers tremendous long-term growth prospects," analyst Steven Kron wrote in a note to clients.

Remember the memo

Last month, a leaked memo sent on Valentine's Day to top company executives by Schultz questioned some of the decisions Starbucks had made -- such as using automatic espresso machines, stocking prebagged coffee and noncoffee merchandise and streamlining store design -- have taken some of the "romance" and "theater" from the brand.

"While the current state of affairs for the most part is self-induced, that has lead to competitors of all kinds, small and large coffee companies, fast-food operators and mom and pops to position themselves in a way that creates awareness, trial and loyalty of people who previously have been Starbucks customers," Schultz wrote. "This must be eradicated."

The Starbucks chairman has been the engine for much of the company's growth, and took responsibility for many of the changes he criticized. Starbucks started with one store in Seattle and now has more than 12,000 outlets.

In October, the company raised its long-term store opening goal to 40,000 from 30,000 and said that it plans to have a presence in more than 40 countries by the end of 2007.

"I'd certainly like to hear more from the board and management team on some of the concerns expressed in that memo, specifically what action they're going to take to address these issues," Morningstar analyst John Owens told MarketWatch. "By sending out that memo to his executive team as they begin planning for 2008, Howard [Schultz] wants to make certain they're not complacent."

The leaked memo hit as rivals have been ramping up their coffee offerings. Dunkin' Donuts is working to beef up its coffee beverages and fast-food giant McDonald's Corp. (MCD : McDonald's Corporation Insider MCD43.48, +0.01, +0.0%) has been seeing success with its premium coffee. In fact, a taste test by Consumer Reports magazine showed McDonald's beating out Starbucks in a drip-coffee comparison.

To be sure, Starbucks is still the dominant coffeehouse chain in the fast-growing specialty coffee category. Its nearest direct rival, Caribou Coffee Company Inc. (CBOU : caribou coffee inc com CBOU7.00, +0.04, +0.6%) has only about U.S. 500 locations, compared to Starbucks' 9,400 U.S. stores, with about 1,700 more U.S. openings expected this year.

While the threat from fast-food restaurants is real, the companies aren't sharing many customers, at least right now. But McDonald's wants to broaden its customer base to include people who go to Starbucks today, which is why they're planning to roll out competing beverages. By the same token, Starbucks wants to grow to 20,000 U.S. stores so they have to broaden their customer base as well.

This underscores one of the key themes in Schultz's memo, and the importance of Starbucks' continuing to raise the bar.

"Starbucks makes money charging a premium for coffee. The premium is derived from the strength of the brand," Owens said. "The brand is extremely strong. It'll continue to be strong because of actions the board takes as a steward of the brand."

The company has been building its business beyond coffee and beverages to merchandise including such items as mugs, books, prepared food, and music that have lower margins than coffee, but also have lower labor costs.

The pace of same-store sales has slowed recently, and the company has outlined initiatives and invested in equipment and labor-saving devices to relieve store congestion. It is also adding more food options, entertainment and drive-through windows.

Margins have also been under pressure, and analysts expect that wage increases for its employees will crimp profits in the short term. Coffee, food and dairy costs are also rising.

Trademark woes

Starbucks has struggled with accusations by Ethiopia that Starbucks was blocking the country's attempt to trademark its coffee beans.

Ethiopia is seeking to trademark the names of its most famous coffee regions -- Sidamo, Harar and Yirgacheffe -- which appear on the packaging of Starbucks and other coffee roasters.

The country, one of the poorest in the world, is trying to get better prices for farmers and gain more control over the distribution and promotion of its coffee, a key export.

Starbucks gets about 2% of its coffee from Ethiopia.

"I'm surprised it's gone on as long as it has," Woodruff said. "They buy very little coffee from Ethiopia. It's gotten a lot of media and management attention, [but] I think they'll resolve it soon."
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Angela Moore is MarketWatch's consumer editor based in New York.