Coffee, Cows & Corn All Hurting Starbucks

Starbucks recently met its expected earnings number of 19 cents per share, representing 18% earnings growth. Great, right? But does that make it worth paying 36 times earnings? I'd say no.

Let's look closer. In the first quarter of 2007, Starbucks (SBUX) bought back $50 million worth of stock. In the second quarter, that number exploded to $513 million, or 17.1 million shares. This represented 2.1% of diluted outstanding shares and was the reason Starbucks met expectations. After all the negative publicity recently, a miss would have led to a share sell-off and more stories about the "end of the line" for Starbucks.

While I applaud share buybacks as a way to enhance shareholder value, Starbucks cannot continue to spend $500 million a quarter to reach earnings estimates. One also has to consider that Starbucks' margins will be under pressure from higher costs, and that store traffic growth is anemic.

Domestic same-store sales transaction growth was a paltry 1%, leading me to wonder when CEO James Donald will finally admit McDonald's (MCD) coffee offerings are affecting sales. He never had to address the issue, as not a single analyst's question on the earnings call broached the subject.

After the earnings announcement, in an interview on CNBC, Donald said "we do not really consider or discuss our competition." He'd better start. They are stealing his business. Attracting only 1% more people per quarter will not fuel the long-term growth rate of 21.9% that analysts expect.

Another problem for Starbucks is ethanol--hardly what investors might expect to trip up the coffee company.

This year, the U.S. ethanol industry will produce over 5 billion gallons and use more than 1.5 billion bushels of corn, pushing prices near $4 a bushel. Dairy farmers are seeing the cost of feed jump and are finally able to pass that on to consumers. After years of flooding international markets with surplus milk products, the European Union, under heavy pressure from within, has curtailed its $59 billion annual subsidy system, at least where dairy is concerned. Combine that with drought conditions in New Zealand and Australia, two big milk-exporting countries, and it makes for tight supplies worldwide--and higher demand for U.S. product. Milk farmers, who collected 12.3% less for their milk in 2006, are fully intent on making that up this year.

"The price this year is not just going to beat the record by a few cents. It's going to knock it out of the park," Michael Suever, senior vice president for milk procurement at Chelsea, Mass.-based HP Hood, told the Boston Globe in April. Prices for raw milk are expected to rise at least 25% this year.

Starbucks, which uses an estimated 93 million gallons of milk a year, is looking at a $279 million milk bill in 2007. While it may not seem a lot to a billion-dollar company, it does equate to 36 cents a share, an increase of about 9 cents, or about 10.3% of profits, over 2006. This does not include the price increase to be incurred from changing the percentage of hormone-free milk from 27% to 37%. Starbucks does charge 50 cents more at some locations for this milk, so it must cost considerably more, no? When you are guiding 83 to 87 cents a share and 18% growth, the 10% of that in milk costs is huge.

We need to now look at biodiesel. Currently, Brazil is famous for two things: coffee and ethanol. Its national ethanol program has allowed it to become independent of imported oil, and now it's turning its sights on biodiesel. Researchers have found an economically viable way to turn coffee beans into biodiesel. The oil-extraction from coffee bean rate, now at 92% to 94%, means the project will begin next year, and this year's harvest will be affected, as coffee bean supplies are built up in anticipation. The project will enable coffee producers to produce enough biodiesel to power all their farm and agricultural equipment.

Why does this matter to Starbucks? Brazil is the world's largest coffee producer and exporter, and this study contends that up to a fifth of coffee production will be used to produce biodiesel.

Let's go back to Econ 101: When you constrict the supply of an item and have constant or increasing demand, price must increase. Starbucks, which already gets $5 for a cup of coffee, will feel the pinch. How much are people going to be willing to pay for a cup of coffee? Like all products, raising prices depresses demand. In the case of Starbucks, I think the effect of price on demand is more dramatic than commonly thought, as quality coffee can now be had at McDonald's for a fraction of Starbucks' prices. All coffee producers and sellers will be affected by the price increase, but when you are at the top of the price ladder and have painfully slow growth that is already a result of those lower McDonald's (MCD) prices, that pain may be more immediate and severe.

When you add the Brazil situation to the recently announce Ethiopia settlement that now has Starbucks paying additional royalties for coffee from that country, Starbucks is now facing an onslaught of input price increases with not much wiggle room on the revenue side. When consumers are looking at $4 a gallon for gas, will they cut back on the $5 latte and go for the $3 one at McDonald's? I bet they will.