Thursday, June 21, 2007

Starbucks' Earnings Warning: Outrageous

I have been saying this since February and if I was a shareholder, I would be asking management why they took so long to admit this to you, rather than reaffirming guidance as recently as May. None of these issue are new, unless they were hoping they would just go away. Incredible.

Shares of Starbucks (SBUX) imploded to a near two year low this morning after CFO Michael Casey, said meeting the top end of its 2007 profit target will be "very challenging." The company had set a range of earnings of 87 cents to 89 cents a share for the year but Casey, speaking to a conference in Chicago, cited "rising dairy costs and soft transaction growth" as factors that are weighing on the bottom line. Shares were down about 3% at $26.49 in morning action.

In May, when Starbucks was still blowing smoke up your, well you know where, I was saying "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.

Then, when management continued the deception with their 2% milk move in "response to our customers requests", I opined:

"This is all about price and Starbucks doing anything it can to reduce rising costs in the face of stagnant store traffic. According the USDA, 2% milk averages 8 cents a gallon less than whole milk and when you buy almost 300 million gallons a year, 8 cents a gallon adds up real quick. Starbucks can try to gloss over this by saying they are "listening to our customers" but the cold hard reality is they have been making drinks this way for almost two decades now and no one has complained. If they really were listening, they would have eliminated all milk with growth hormones from the stores, but that would be expensive and negatively effect profits. The tell tale sign here is that they are cutting costs, not raising prices like they have in the past. This is perhaps the most public recognition that even they feel they are at the top of the price range and going higher here will cause even more defections to McDonald's (MCD) than they have already suffered."

So now the truth finally comes out today and shareholders, down over 20% since January and believing in management are getting killed again today. Shareholders should be outraged and it is not because milk prices or coffee prices are going up, they have no control over that.

They should be outraged because management apparently still believes in the face of all empirical evidence that they exist in an business category of one. When CEO Jim Donald says "we do not really consider our competition" despite stagnant store comps, there is a serious problem. This is painfully obvious when you consider this store growth stagnation directly coincides with product (coffee) improvements at these non-existent competitors.

Shareholders should be outraged because for almost 7 months now management has been in denial about their business and if you believed them, you have lost a boatload of money.

There are two options here for Starbucks and neither one is good. Either they do not know what is happening out there, or they did and lied about it. When some guy in Massachusetts is more honest with you about a company he has no financial interest in than the people you entrust to run it, there is a serious problem.


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