Monday, July 30, 2007

Starbucks at $22? Maybe lower....

I got a great question to my recent Starbucks (SBUX) post last week.

Here is the question: Matthew asked, "Earlier you wrote that SBUX is a matter of price for you, and you mentioned the $22 level as the highest you'd pay. Does this news make your price go lower? Or were you already discounting the fact that having screwed up already, they're likely to screw up some more?"

This got me to thinking, is my $22 target actually too high? To date, none of the moves Starbucks had made since the beginning of the year have worked and I strongly feel the recent price increase will backfire on them in a major way. The bottom line for them is store traffic and that is falling fast. I cannot think of a retail situation in the past in which raising prices increased foot traffic to a location.

$22 may end up being just a way point downward from here. I know Starbucks fans out there are coughing up their latte's but they did the same thing early this year when the stock was trading north of $35 and I said it was just way overpriced. If anything, things have only deteriorated for the company since then and I cannot see any light at the end of the tunnel right now. Costs are rising and look to stay there, the competition is getting more fierce, people are becoming very price conscious and the lack of convenience Starbucks offers is becoming a larger issue now that the competition offers a quality substitute with the convenience. All these add up to more headwinds to earnings going forward.

What should Starbucks do? Much like many people feel Citigroup (C) shares would jump if CEO Chuck Prince was let go, I would expect the same from Starbucks shares should CEO Jim Donald be ask to seek "other opportunities". Founder Howard Schultz's support of the CEO is noble but it is a bit like standing next to the captain of the Titanic and telling him "things will be ok".

They are not and do not look to get better any time soon.

Supporters will point to the recent announcement with Hershey (HSY) as proof the company is moving in the right direction. But, my opinion is that this is just another move further in the wrong direction. They only industry that is seeing prices skyrocket and industry fundamentals deteriorating faster is the chocolate business. They have gotten so bad that makers have petitioned the FDA to let them call a substantially cheaper substance called "mocklet" chocolate. Does this means we will be buying a "double mocklet latte"?

They will then point to the "overseas" expansion but to date is has been a bit of a mess. Plans into India were shelved this week and their entry into China's "Forbidden City" was a unmitigated disaster and a huge PR flop for the company. We need to scale back our expectations here. Just because they are huge in the US does not mean a billion tea drinking Chinese will run to them. Just ask WalMart (WMT) about expansion in other countries, it is not alway just a matter of "if you build it, they will come".

Now, stop frothing and relax, Starbucks is not going under nor will it become irrelevant, nor am I saying "it sucks". I actually think it is a great company but even great companies go astray and make moves (or have CEO's) that hurt performance. That being said, earnings growth is going to slow dramatically and paying 35 times that slowing growth, well, will be a losing game.

Starbucks reports earnings Wednesday, August 1st. Want a prediction? They will miss, or, if they hit, it will be due to some creative number crunching (nothing illegal, or another huge unsustainable share repurchase like in Q1)If they meet expectations and that is a major "if" I would expect them to guide earnings lower or at the very bottom of estimates for the rest of the year. Now for those of us who do not own shares, a miss and a decimation of shares into the high teens might just be the catalyst to get changes made that turn this thing around.

The earnings call will be infinitely more important than the numbers they release in telling us plans or at least the though process they have. A word of caution, Starbucks has not been very forthcoming or honest with shareholders up to this point so to expect much may leave you disappointed. Stay tuned..

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