STARBUCKS (SBUX) – IT’S NOT JUST ABOUT HOWARD SCHULTZ LEAVING

Starbucks, and Howard Schultz, are all over the news recently, most notably after the incident in Baltimore that resulted in closure of 8,000 stores for an afternoon, and the founder stepping down after an extraordinary career building one of the most prominent worldwide consumer brands, in our mind “writing the book” in hospitality among QSR operators. Our concerns, and expectations for Starbucks’ future are more long term in nature, than the result of the bias training, or management transition.

We reprint below several of our most recent articles, the most relevant of which was done in March of this year.  As of the moment, I would only add to the discussion below that Howard Schultz’s political leaning will not maximize the appeal of the Starbucks brand, which has already shown less momentum than in the past. I’ve spoken to golfers who won’t play a Trump golf course or stay at a Trump hotel, and consumers who won’t go to Norstrom’s after they took Ivanka  Trump products out of the store. While Howard Schultz makes an articulate argument that a company cannot ignore social issues, there are no doubt a number of coffee drinkers who just want a cup of coffee and a smile and will go elsewhere.

March 12, 2018

We have written a number of  articles over the last two year, with excerpts provided below. We have consistently expressed our admiration for this worldwide brand, at the same time pointing out that the “easy money” has been made. We think it is no accident that the stock has done nothing since late 2015,in a trading range from the low 50s to the low 60s while adjusted EPS increased from $1.58 in the year ending 9/30/2015 to $1.91 in fiscal 2016 and $2.06 in ’17. It is timely to re-examine our thesis, as the stock trades toward the high end of its two year trading range, during which it has underperformed the market, we believe with good reason.

On August 2, 2017, I wrote an article 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.