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BILL ACKMAN, WITH 41% OF ASSETS IN QSR, CMG AND SBUX COMBINED, IS STILL NOT WELL POSITIONED

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BILL ACKMAN, WITH 41% OF ASSETS IN QSR, CMG & SBUX COMBINED, IS STILL NOT WELL POSITIONED

We wrote an article on October 11th, discussing the three major positions in Bill Ackman’s Pershing Square Capital portfolio, within our knowledge base, that comprise a massive 41% of his $8.3 billion portfolio.

At the close of business, October 11th, Restaurant Brands (QSR) was $56.26, Chipotle (CMG) was $434.06, and Starbucks (SBUX) was $54.87. Our conclusion on October 11th was that he should switch his QSR immediately into McDonald’s (then at $163.98), sell his CMG to take advantage of the huge move since new management has been installed, and hold his SBUX (which has moved up nicely).

We have no reason to think that he has made any moves in the last several weeks, but Restaurant Brands, McDonald’s and Chipotle have all reported third quarter results. Starbucks reports tonight.

From the close of business October 11th to last night’s closing price, Restaurant Brands, at 53.06 was down 5.7%, or $85M on the $1.5B position. McDonald’s, at $178.42 was up 8.8%, so would have made Ackman’s Pershing Square Capital a profit of $132M. Chipotle closed at $465 so Ackman would have foregone a profit of 7.1% or $63M on his $900M investment.

Our advice, less than three weeks ago, to Ackman can definitely be considered “theoretical” in terms of the practical ability to switch $1.5B positions instantly, or sell $900M worth of Chipotle on the spur of the moment, and Ackman’s positions are established on the basis of long term prospects. Acknowledging that three weeks doesn’t “make a season” or prove a thesis, Ackman’s portfolio would be ($132M+85M-$63M) a cool $154M better off, or 4.5% of the $3.4B in these three positions, especially costly when all hedge fund managers are fighting for every basis point in a difficult market environment.

Our points here are (1) too many multi-billion hedge funds, and other institutions are playing hunches rather than making well informed long term judgements. This is a function of not enough really attractive reward/risk investment propositions when trillions of dollars of capital are competing to generate “alpha” after nine years of a bull market (2) there is too much emphasis on short term performance, trying to “game” the monthly comps for example,  rather than evaluate long term strategic positioning (3) in too many cases, the self confidence of multi-billion dollar money managers is unjustified. They are very smart, hard working, in many cases have become very rich (which breeds inflated egos), and can’t be expected to know as much they should about every industry. Rather than make Bill Ackman an undeserved particular example: Eddie Lampert, still a billionaire, had no chance whatsoever to turn around Sears based on his strategies, and there were lots of highly experienced retailers that could have told him so. It has taken ten years to play out, but it was clear to many of us years ago that the brilliant and successful Lampert was wasting enormous time and money on Sears.

If we were speaking with Ackman today, we would suggest that it’s not too late to adjust the portfolio. The last three weeks are history.  Let’s see what happens over the longer term.

Roger Lipton

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DOMINO’S REPORTS, EARNINGS BEAT, COMPS BARELY LIGHT, STOCK (DPZ) DOWN 5%, OUR TAKE…….

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DOMINO’S REPORTS, EARNINGS BEAT, COMPS A LITTLE LIGHT, STOCK (DPZ) DOWN 5%, OUR TAKE…….

We recently (10/5) published our updated writeup on Domino’s, a fully copy of which is provided below. Our conclusion, with the most pertinent bullet points BOLDED, was as follows:

“We have no quarrel with the consensus that Domino’s is writing the book in the pizza delivery business, and there is no apparent reason that they will lose market share to Pizza Hut or Papa John’s. We can’t help but point out, however, that the recent rate of increase in Operating Earnings (rather than the more dramatic recent EPS growth), at roughly a “mid-teen” rate, should probably be the expectation. This still admirable growth rate would be driven by a 6-8% (more likely to be closer to 6 than 8 in the near term) rate of net new stores, a mid-single-digit comp (against very tough comparisons), a bit of SG&A leverage and/or fewer shares outstanding. This year’s tax impact won’t be duplicated. Relative to the share repurchases, if we were on the Board we would not be enthusiastic about (according to Bloomberg) share repurchases at 34x ’18 earnings, 24x trailing EBITDA, 33x trailing Cash Flow and 45.3x trailing Fee Cash Flow. Even when borrowing at still low interest rates, the EPS accretion at this valuation is modest. The regular dividend, yielding 0.7% currently, has been increased each year, but perhaps shareholders would better appreciate another special dividend (last paid in 2012 at $3.00 per share), or a substantial increase in the regular dividend, rather than spending hundreds of millions to buy back stock.

We wouldn’t want to be short this fine company’s stock, and DPZ has been a fantastic holding over the last decade, but we have a feeling that “the easy money has been made”.

With that background, recent developments by way of the third quarter results were as follows:

The Q3 earnings “beat” of $1.95 vs. Street expectations of $1.75 was driven by fewer shares outstanding (43.0M vs. 47.7M) and a low tax rate. The company continued its aggressive repurchase program by spending $109.1M in Q3 at an average of $274/share and an additional $10.0M in just the first 11 days of October at $273/share. The tax rate in Q3 was only 15.3% vs. 33.3% in ’17. Income from operations was up 13.1% in Q3, up 13.3% for the nine months, so the gain has been narrowing.

Same store sales were up 6.3% domestically, barely below the expectation of 6.5%. International comps were up a more modest 3.3%. Net new units were up 232 globally, 173 internationally and 59 in the US. This was just above the 217 net new units in Q3’17, 164 internationally and 53 domestic, so the trailing twelve month continues to be right at the 6% level versus the base, at the low end of the 6-8% range over 3-5 years to which the company has guided. It is a strong commentary on the health of the system that only 21 stores (out of over 15,000) have closed in the last twelve months, 19 internationally and 2 domestically.

It was interesting to us that the comp increases, both domestically and internationally were driven by transaction growth, as well as ticket growth in the US. The Piece of the Pie loyalty program was called out as a meaningful contributor to the traffic gains. It may be an important insight, provided by management in the course of the conference call that “it is transaction count growth over time that correlates not only with sales growth, but with profit growth……our Piece of the Pie rewards program….the foundation was built on driving frequency…points are earned based on the number of purchases as opposed to the amount of dollars spent”. While there are lots of contributing factors to transaction growth, or lack thereof, we can’t help but contrast the consistent growth in comps at DPZ with the now acknowledged traffic slowdown at Starbucks since they changed their loyalty program a couple of years ago to reward dollars spent rather than transactions. Seems worth thinking about.

Otherwise, there were few surprises. Higher labor expenses continue to be a burden, and the commodity basket has been up 3-4% year to date. No guidance relative to future commodity cost was given.  There is continuing capital spending to support supply chain distribution. The Hotspot initiative is promising, with more than 200,000 locations in the US, but no operating details were given. The bulk of the conference call was dedicated to a reiteration of the long term goals, described in our full writeup from 10/5 provided below.

Conclusion: Post Q3’18 Report

Very much the same as provided a couple of weeks ago, and reprinted above. The company is doing well, and there is no reason that they can’t continue their leadership position for the foreseeable future. However, in terms of the DPZ, the stock, there is no particular material positive catalyst on the horizon that would cause a “re-rating” on the upside. We think there could be at least modest risk from this price level, in the short run, from industry -wide concerns, a general market downturn, or a modest slowdown within the operating results at DPZ.

DOMINO’S PIZZA – Updated Write-Up And Conclusion

October 5, 2018

CONCLUSION:

We have no quarrel with the consensus that Domino’s is writing the book in the pizza delivery business, and there is no apparent reason that they will lose market share to Pizza Hut or Papa John’s. We can’t help but point out, however, that the recent rate of increase in Operating Earnings (rather than the more dramatic recent EPS growth), at roughly a “mid-teen” rate, should probably be the expectation. This still admirable growth rate would be driven by a 6-8% (more likely to be closer to 6 than 8 in the near term) rate of net new stores, a mid-single-digit comp (against very tough comparisons), a bit of SG&A leverage and/or fewer shares outstanding. This year’s tax impact won’t be duplicated. Relative to the share repurchases, if we were on the Board we would not be enthusiastic about (according to Bloomberg) share repurchases at 34x ’18 earnings, 24x trailing EBITDA, 33x trailing Cash Flow and 45.3x trailing Fee Cash Flow. Even when borrowing at still low interest rates, the EPS accretion at this valuation is modest. The regular dividend, yielding 0.7% currently, has been increased each year, but perhaps shareholders would better appreciate another special dividend (last paid in 2012 at $3.00 per share), or a substantial increase in the regular dividend, rather than spending hundreds of millions to buy back stock.

We wouldn’t want to be short this fine company’s stock, and DPZ has been a fantastic holding over the last decade, but we have a feeling that “the easy money has been made”.

COMPANY OVERVIEW (2018 10-K; Analyst Day Slides January 2018)

Domino’s, with more than 14,856 locations in over 85 countries around the world, is the largest pizza company in the world based on global retail sales. Founded in 1960, Domino’s roots are in pizza delivery; however, in recent years a significant amount of sales have come from carryout. On average, Domino’s sells more than 2.5 million pizzas each day.

Domino’s business model is simple – they handcraft and serve quality food at a competitive price with easy ordering access and efficient service enhanced by their technological innovations.

Domino’s generates revenue and earnings by charging royalties and fees to their franchisees. The Company also generates revenue by selling food equipment and supplies to franchisees, primarily in the U.S. and Canada, and by operating a number of Company owned stores. In Domino’s international markets, they generally grant master franchises for a geographic area. These master franchises are charged with developing their geographical area and they may profit by sub-franchising and selling food and equipment to these sub-franchisees as well as by running their own stores.

Domino’s business model yields strong returns for their franchise owners and Company owned stores. Historically, Domino’s has returned cash to their shareholders through dividend payments and share repurchases.

Domino’s pioneered the pizza delivery business and has become one of the most widely recognized consumer brands in the world. Since 1998 the Company has been structured with a leveraged balance sheet and has completed a number of recapitalization events. The Company’s most recent recapitalization transaction (in 2017) primarily consisted of the issuance of $1.9 billion of fixed and floating rate notes and the repurchase and retirement of $910.2 million of previously outstanding fixed rate notes. Following this recapitalization, the Company has $3.15 billion in total debt. Excess proceeds were primarily used to repurchase shares of common stock.

LONG-TERM BUSINESS STRATEGY (2018 10-K)

Begun in 2009, Domino’s first priority was to reinvent their core pizza, and they relaunched the brand by introducing a new recipe for their signature product. Next, they improved existing products and/or introduced new items that complimented changes to the core pizza.

Secondly, in 2013 they launched the program to reimage the stores to be more attractive for carryout customers – creating the “Pizza Theater” design which allowed customers to see the process of pizza making. Market studies and current sales trends (from NPD/Crest) had revealed the take-out business was much bigger than delivery. In 2017, delivery business equaled slightly over 1 billion occasions whereas carryout was over 2.5 billion occasions. Since Domino’s carryout focus was launched in QTR-1 2011, Domino’s share of carryout has risen from 7.5% to 14.4%. Carryout necessitates Domino’s to be closer to the customers, therefore, the Pizza Theater helped address this but what was also needed was more locations to make carryout more convenient. In their 2018 Investor Day Presentation, Domino’s management discussed this plan in some detail. It is called Fortressed Markets and is based on realigning the franchise system with programs that encourage strong franchisees that wanted to grow multiple opportunities, both to open new locations and to buy out weaker franchisees in their market areas. Since 2016, Domino’s U.S. franchise base count has moved from 1,300 to 800. This new alignment continues to drive growth with those franchisees who share the Corporate vision. Another component of the Fortressed Market program has franchisees investing heavily by splitting their markets into smaller delivery/carryout areas. According to Domino’s Internal Data (Analyst Day slides) the majority of a location’s carryout business is within 6 minutes of the store. Seattle, WA was one of the first markets to engage in Fortressed Marketing and saw AWGS increase from $20.7K to $26.3K over a 3-quarter period in 2017.

Thirdly, priority was an aggressive investment in technology (which began in 2010) to be the leader in making connections with consumers through technology that exceeded their expectations. This became an aggressive investment in building digital platforms and eventually data analytics in-house. In 2016 Domino’s developed its own digital platform to manage internal operations and customer-facing actions all with the goal to simplify ordering and payment processing and enable order tracking on virtually any communication device. The system is called GOLO (Global Online Ordering). Together with a sophisticated loyalty program (launched in 2016), the platform provides a rich source of data for its robust marketing initiatives.

While Domino’s continues to innovate around the brand’s interactive experience with consumers, nothing has been, or presumably will be, embraced or created that can disrupt operations. Domino’s has preserved the integrity of their brand with an emphasis on continuity relative to their heritage.

SOURCES OF REVENUE (2018 10-K):

As of its 2018 10-K Report, Domino’s operated and franchised 14,856 units globally generating more than $10,638 billion, making them the second largest pizza chain (after Pizza Hut) in sales and the number one pizza delivery company. Approximately one-half of the global sales are generated by 5,587 domestic stores (5,195 franchise and 392 Company). The remainder is produced by 9,269 franchised stores in over 80 markets around the world. Additionally, $1.7 billion is generated from Domino’s supply chain.

Domino’s revenue is generated from multiple sources: domestic franchise fees (5.5% of franchisee sales), international master franchise fees (3.0%), domestic and GOLO digital fees, and supply chain and Company-owned store segment.

UNIT LEVEL ECONOMICS (2018 10-K; 2018 Analyst Day Slides)

From the FDD and the above sources, we estimate AUV’s of Company units are slightly over $1.2M (or about $837/sq. ft. assuming the average store size of 1,500 sq. ft.) and domestic franchised units AUV’s are about $1.0M. Disclosed average store level EBIDTA of domestic franchisees is about $136K – up from $61K in 2009 or a store level margin of 13.6%. (These figures are presumably net of royalty fees and advertising fund contributions.) The cash investment for leasehold improvements, furniture, fixtures, equipment, signage for a new store (provided from Domino’s FDD) is about $410K. Accordingly, the $136K store level EBITDA would represent a store level cash on cash return of 33.1% for a domestic franchised unit.

The supply chain provides pricing and distribution scale and consistent uniform quality ingredients to participants. It operates 18 regional dough manufacturing and food supply chain centers in the U.S. It also operates centers in Canada and leases a fleet of more than 500 tractors & trailers.

SHAREHOLDER RETURN (2018 10-K):

Domino’s 1, 3 and 5-year stock performance has been 24.4%, 147.3% (35.2% CAGR) and 440.9% (40.1% CAGR) respectively. Including reinvestment of dividends, total return for the same periods have been 25.3%, 153.0% (36.2% CAGR) and 457.4% (41.0% CAGR).

RECENT DEVELOPMENTS (PER Q2 EARNINGS REPORT AND CONFERENCE CALL)

Domino’s continued its outstanding performance in Q2, with domestic same store sales up 6.9%, international up 4.0%. It was the 98th consecutive quarter of int’l SSS growth, only the 29th domestically. Diluted EPS was up 34.8% on a GAAP basis and 39.4% “adjusted”. Impressive as the performance is, it should be noted that Income from operations (pretax) was up a more modest (and sustainable) 11.5%, with the higher percentage increases driven by 12.5% fewer shares outstanding and a tax rate of 15.1% versus 25.7% a year earlier. There were 156 net new stores added to the system, 113 internationally and 43 domestically.

The second quarter was highlighted by the innovate launch, late in Q2, of over 200,000 Domino’s Hotspots in the US. Financially speaking, the April recapitalization included $825 million borrowed, of which $490 million paid off previously issued notes. Also in Q2, 905,556 shares were repurchased for $219M and $0.55 per share was paid in dividends.  Remaining share purchase authorization amounted to $429.9M at the end of Q2. The operating numbers above are fairly consistent with the previous quarter, though lower, and the six month increase in operating income was 13.4%.

The Conference Call provided some additional operating details.

US franchisees’ SSS were up 7%, with company stores up 5.1%. The company continues to spend a substantial sum in technology related capital spending, now expected to be $115-120M in ’18, up from a previous estimate of $90-100M.  Supply chain investment is being accelerated, including additional distribution centers in the US, to support the double digit gross sales growth. Carryout business is viewed as a separate occasion from delivery, largely incremental, and advertising is targeted accordingly. Points of distribution, including Hotspots are also being designed with that in mind. The impact of Hotspots was not clear as of the end of Q2, including the incremental effect, but should be more apparent by the end of Q3. Management is guiding to 3-6% long term SSS growth internationally, slowing a bit from the more rapid growth recently.

On a trailing twelve month basis, 905 total net new stores were added, most of them internationally, as has been the case in recent years.  There was a modest slowdown in the rate of international openings in the first half of ‘18, but that is expected to be temporary, a consolidation of sorts after opening over 1,900 net new int’l stores in 2016-2017. The estimate continues to be 6-8% annual net new units on a global basis. The 905 net new stores opened (almost exactly 6% of the 15,122 base), of which 651 were international, including only 113 in Q2, so the Q2 pace is clearly below that.

CONCLUSION: Provided at the beginning of this article.

 

 

 

 

 

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

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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.

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STARBUCKS – Great company, still, but stock will continue to underperform

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STARBUCKS (SBUX) – Great company still, but operating earnings are flat, and stock is expensive. Always has been expensive, but growth in earnings and cash flow is not what it was.

Introduction:

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.

Most Recent Results Support Conclusion

The following is a very brief summary. See our full writeup,

STARBUCKS

for more detail.

Fiscal Year ending 9/30/17 included consolidated net revenues up 7% (adjusted for the extra week in ’16), global comp sales up 3%, GAAP operating income down 0.9%, non-GAAP operating income up 7.8%. GAAP EPS grew 3.7% while non-GAAP EPS (which the Company and analyts prefer to use) grew 11.4% to $2.06 per share. Without reviewing all the multi-year trends, the growth in revenues has slowed 17% in fiscal 2015 to 11% in 2016, and of course much higher rates of growth prior to 2015. It is worth noting that China/Asia Pacific has built revenues at a 42% rate over the last three years (vs 9% in the Americas) and will continue to grow rapidly, but represents only about 14-15% of total revenues. With ’17 completed, management provided long term financial targets which included annual comp growth of 3-5%, annual net revenue growth in high single digits, annual EPS growth of 12% or greater.

After the first quarter, ending 12/31/17, was reported, showing consolidated revenue growth of 6%, consolidated same store sales growth of 2% (flat traffic),  GAAP operating Income down 1%, and GAAP Operating Margin down 140 bp to 18.4%, the Company updated their fiscal ’18 guidance. They continue to expect 3-5% global comp growth, near the low end of the range and, and (with Q1 at 2%), obviously back loaded. Consolidated revenue growth will be in the high single digits (they say “consistent with long term guidance”). The HSD works out to 7-9% because they say that the 9-11% total expectation includes 2% from the acquisition of East China and other streamlining activities. Non-GAAP EPS is expected to be $2.48 to $2.53, vs. $2.06, which includes the effect of lower taxes (we estimate $0.25-$0.30) and stock buybacks. Subtracting $0.29 of tax effect from $$2.51 (the midpoints) leaves $2.22 vs $2.06 (up 7.7%), a large portion of which would be due to fewer shares outstanding. Suffice to say, therefore, that pretax earnings, and EBITDA, growth, will be modest, at best, and the most recent guidance, in total, implies short term growth at the low end of long term targets.

Previously:

We have written a number of articles describing Starbucks over the last two years, describing the high valuation of the stock and the changing fundamentals, not all of which are necessarily positive.

Late in calendar ’15, we wrote “At 33x estimated forward earnings…… I view SBUX as priced close to perfection. As great as the year (’15)  was, as great as a 9% same store sales comp in Q4 was, a slight slowing, which the company is indicating for the first quarter, and inevitable at some point anyway undermines new buying enthusiasm. Guidance has not been boosted, which is normally necessary for an upside run from this kind of valuation. Having said all that, strange things can happen in this market. My fundamental view is that the stock is “efficiently valued”, not a bargain…

On November 1, 2016, we wrote: “My observation, as a Starbucks customer and corporate fan, is that business is, if anything, slower than in the past. Nothing I hear or see indicates that the quarter ending 9/30 (’15) will encompass a positive Q3 surprise, or increased guidance going forward. The unforgiving environment can affect even a “best of breed” (by far) operator such as Starbucks. Almost any chart analyst would view the situation negatively, foreseeing a price breakdown. Combined with my fundamental view, I see no reason to be a hero here.”

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.

MILLENIALS, 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 as described above who says 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.

Lastly, on January 4, 2018, we wrote:

This is a very big ship, forced to navigate a continuing turbulent, competitive consumer spending environment. Growth in sales and earnings has slowed, and we doubt that EPS growth can be re-ignited, in large part due to the law of large numbers. To some extent, SBUX has become a “cash cow”, very profitable, generating still very high returns on capital, even if the base is growing more slowly. The shareholder base is transitioning to include long term value, and dividend, oriented, investors. In fact, SBUX has been in a trading range from the mid-50s to the low 60s over the last two years, with the stock’s valuation mirroring the slowdown in earnings (and EPS) growth. The corporate initiatives described below, further described by management on their conference call, are all necessary for further progress. Collectively, they can maintain corporate progress, and even move the growth rate by a few points, but we suspect that the days of high single digit comps (in the US) and 20% or better EPS gains are in the rear view mirror. There are now a large number of operational moving parts, not all of which will proceed smoothly. Furthermore, the business model is evolving, with possible unintended consequences, as discussed in our report of 8/22/17. Earnings reports in 2018, as predicted by management, will be muddied by one time transactions, so “adjusted earnings” will be a feature of their reports. Analysts and investors may not care much, if the current forgiving stock market environment continues, but tolerance for lots of adjustments will not be as high if the general market runs out of steam. A revised food menu is in the works but, even if food sales increase, non-coffee margins are lower, so earnings may not “leverage”. Starbucks is a great company, and will remain so, admirable in many ways, a great brand building example. The Company is one thing, the stock another. Investors can, and will, decide for themselves, what valuation is appropriate.

Roger Lipton

 

 

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STARBUCKS

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Conclusion:

This is a very big ship, forced to navigate a continuing turbulent, competitive consumer spending environment. Growth in sales and earnings has slowed, and we doubt that EPS growth can be re-ignited, in large part due to the law of large numbers. To some extent, SBUX has become a “cash cow”, very profitable, generating still very high returns on capital, even if the base is growing more slowly. The shareholder base is transitioning to include long term value, and dividend, oriented, investors. In fact, SBUX has been in a trading range from the mid-50s to the low 60s over the last two years, with the stock’s valuation mirroring the slowdown in earnings (and EPS) growth. The corporate initiatives described below, further described by management on their conference call, are all necessary for further progress. Collectively, they can maintain corporate progress, and even move the growth rate by a few points, but we suspect that the days of high single digit comps (in the US) and 20% or better EPS gains are in the rear view mirror. There are now a large number of operational moving parts, not all of which will proceed smoothly. Furthermore, the business model is evolving, with possible unintended consequences, as discussed in our report of 8/22/17. Earnings reports in 2018, as predicted by management, will be muddied by one time transactions, so “adjusted earnings” will be a feature of their reports. Analysts and investors may not care much, if the current forgiving stock market environment continues, but tolerance for lots of adjustments will not be as high if the general market runs out of steam. A revised food menu is in the works but, even if food sales increase, non-coffee margins are lower, so earnings may not “leverage”. Starbucks is a great company, and will remain so, admirable in many ways, a great brand building example. The Company is one thing, the stock another. Investors can, and will, decide for themselves, what valuation is appropriate.

COMPANY OVERVIEW (2017 10-K):

Starbucks is the premier roaster, marketer and retailer of specialty coffee in the world, operating and licensing over 27,339 locations in 75 countries. They employ over 300,000 employees generating $22,386 billion in sales.

In addition to selling products under the flagship Starbucks Coffee brand, they sell goods and services under the following brands: Teavana, Tazo, Seattle’s Best Coffee, Evolution Fresh, La Boulange, Ethos and Princi (an Italian bakery concept recently added to their portfolio).

Starbucks purchases and roasts high quality coffees that they sell along with hand crafted coffees, teas and other beverages, and a variety of high quality food items including snack offerings through company owned stores. Starbucks also sells a variety of coffee and tea products and license their trademarks through other channels such as licensed stores, grocery and food service accounts.

Starbucks is considered the main representative of “second move coffee”, initially distinguishing itself from other coffees – serving venues in the U.S. by taste, quality and customer experiences while popularizing darkly roasted coffee.

The first Starbucks opened in Seattle, WA March 1971. Originally the company only sold whole coffee beans and did not brew to sell. In 1987 the original owners sold Starbucks chain to Howard Schultz. It was under Mr. Schultz’s leadership the company developed into today’s concept.

SOURCES OF REVENUE (2017 10-K):

The company operations are organized into four principle segments.

  1. Americas which is inclusive of the U.S., Canada and Latin America;
  2. China / Asia Pacific (CAP);
  3. Europe, Middle East and Africa (EMEA); and
  4. Channel Development which functions primarily as a wholesaler of branded Consumer Packaged Goods (CPG). Such products as single-serve Starbucks Coffee K-Cups, ready to drink bottled coffee, etc. to grocers, warehouse clubs, specialty retailers, convenience stores and U.S. food accounts. The remaining operations are grouped together under the heading – all other segments which include the retail operations of their smaller brands: Teavana, Seattle’s Best Coffee, Evolution Fresh, Reserve Roastery Tasting Rooms.

 *UNIT LEVEL ECONOMICS:

Starbucks utilizes a wide variety of sites, types and sizes to meet its market penetration objectives. Depending on urban vs. suburban location, types and sizes include traditional and nontraditional mall locations, inside big box retailers, college campuses, hospitals, airports, hotels, resorts, etc. A typical Starbucks free standing unit ranges from 1900-2100 square feet.

Starbucks does not franchise; however, it does grant licenses to operate a Starbucks under certain restrictions to select retail or hospitality operators – such as Marriott hotels, Target Retail Stores and airports to name a few. Average costs to open a license location is $315,000.

One of Starbucks essential attributes is its Return On Investment Capital (ROIC) at the store level performance. See table which reflects unit level economics as disclosed by the company for 3 of its principal markets at its 2016 analyst day in December 2016. While the performance of all stores in each country are industry leading, the returns of the stores opened in FY16 are especially impressive as they are even more profitable than their country-wide averages though they have lower or the same AUV’s. It is also notable that in the 2 years since the last investor day, year 1unit level EBITDA margins and cash ROI’s were up 1400 bps and 3300 bps, respectively, in the U.S. and up 900 bps and 1100 bps, respectively in China. In Japan year 1 metrics were down in the two-year period (EBITDA% -200 bps, ROI% – 1700 bps), likely transitional effects resulting from the buyout of the company’s JV partner in Japan. Still, though the Japanese metrics compare unfavorably with their counterparts in the U.S. and China, their unit level economics surpass most peers.

An equally important attribute of the company’s performance (but less quantifiable) is the culture instilled throughout the organization by Howard Schultz.

Starbucks Culture:

  • Employees are partners
  • Commitment to the environment
  • Provide great work environment
  • Create a third place
  • Never compromise the quality of the coffee
  • Complete guest experience: focus on details, people oriented, team gratification, aggressiveness and stability.

Mr. Schultz handed off leadership to Kevin Johnson in April 2017. This is the second time he will have stepped away. The first time (he remained non-executive chairman) it is worth remembering how the “romance and theater” of coffee preparation and service was lost in pursuit of speeding service and increasing efficiency. This led to “watering down the Starbucks experience” and “commoditizing the brand” per the diagnosis of SBUX’s underperformance sent to top management by Howard Schultz in February 2007. It is also worth remembering that the turn around and the renewed growth and margin expansion noted above dates from his return to the CEO role a year later in 2008 with the initiatives summarized in this letter. Clearly, Mr. Schultz has put a great deal of effort in selecting and grooming Kevin Johnson, his new successor, so relinquishing his executive role will hopefully be more successful this time. Mr. Schultz will remain as non-executive chairman and will supervise the development of the Roastery and Reserve concepts. Mr. Johnson first came to SBUX as a board member in 2009 when he was a top executive with Microsoft and later with Jupiter Networks. Mr. Schultz convinced him to join management in 2015 where he became steeped in the operations and led the development of the digital flywheel which Mr. Schultz determined several years ago would be instrumental in the next phase of SBUX’s corporate life.

LONG-TERM BUSINESS STRATEGIES (Biennial Investor Conference 12/7/16):

  • Transforming the Premium Coffee Experience

 Since opening two years ago, the Starbucks Reserve® Roastery in Seattle has become recognized as the most dynamic and immersive coffee forward retail experience in the world, delivering an unprecedented level of premiumization to the coffee category and fueling the next wave of transformation that is elevating the Starbucks Experience globally.

Each Roastery will serve as the foundation for Starbucks Reserve® stores – a new retail format that will integrate the theatre and romance of the Roastery with the unique culinary experience of the company’s new Italian food partner, Princi.

  • Premiumization Strategy to Drive Innovative New Customer Experiences

Starbucks Reserve® Roasteries will serve as an innovation pipeline that will elevate the brand and contribute a “halo” to the entire Starbucks Experience. This includes new product breakthroughs that will contribute to the growth of the company’s ecosystem, segmented strategically across all Starbucks® stores.

Starbucks is simultaneously innovating and expanding its food menu with products customers have been looking for convenient breakfast; the spring launch of a Certified Gluten-Free Breakfast Sandwich; the expansion of the successful Bistro Box platform; as well as a regional rollout of delicious organic soups. Relevant innovation has become fundamental to unlocking the lunch daypart and building on existing breakfast daypart momentum, giving the company the ability to realize additional profitability and incremental sales.

  • Extending the Digital Flywheel

Starbucks offers the largest and most robust mobile ecosystem of any retailer in the world, with more than 12 million Starbucks Rewards™ members (up 18 percent year on year). Today, Starbucks will unveil an innovative conversational ordering system, My Starbucks® Barista, powered by groundbreaking Artificial Intelligence (AI) for the Starbucks® Mobile App.

Starbucks digital flywheel has also continued to gain momentum with the launch of true one-to-one personalization. While still early in the evolution of this service, Starbucks hyper-personalized email reward offerings – with more than 400,000 variations – have more than doubled customer response rates over previous segmented email campaigns, translating into increased customer engagement and, importantly, accelerated spend. Starbucks has delivered personalized offers to customers directly on the front screen of the mobile app. By early 2017.

  • Unlocking High-Value Opportunities in China

Customers in China have continued to embrace the Starbucks brand, with some of the company’s most innovative, efficient and profitable stores producing record revenue and strong same-store sales growth in FY16. Starbucks newest class of stores in China are delivering the highest AUVs, ROI and profitability of any store class in the company’s 17-year history in the market. Starbucks now operates approximately 2,500 stores in 118 cities in China and employs more than 30,000 partners (employees), opening over a store a day – a growth rate that will continue to accelerate well into the future.

  • Expanding Global Leadership Position in At-Home Coffee and Ready-to-Drink

Over the next five years, Starbucks expects its Channel Development segment, which includes its Consumer Packaged Goods (CPG) portfolio, Branded Solutions (licensed stores and foodservice), and Ready-to-Drink (RTD) segments, will generate an incremental $1 billion in revenue, grow operating income by 75 percent, and double its RTD business outside of the U.S. The company is the industry leader in premium single serve, premium packaged roast and ground coffee, and Ready-to-Drink products, and is well positioned to grow its share of these markets both in the U.S. and globally. The company’s more than 20-year partnership with PepsiCo to create the North America Coffee Partnership (NACP) is a more than $2 billion business and has approximately 97 percent share of the RTD coffee category. The NACP continues to bring to the market highly relevant, new and innovative coffee and energy products to meet the needs of customers looking for premium, on-the-go coffee offerings.

  • Creating Long-Term Opportunities for Partners

From being among the first to offer comprehensive health benefits and equity in the form of stock for partners who work 20 hours or more a week, to providing them with the opportunity for full tuition reimbursement for a bachelor’s degree from Arizona State University through the innovative Starbucks College Achievement Plan, Starbucks has continued to invest in and innovate around the partner experience while balancing the needs of its customers, shareholders and the marketplace. Starbucks has now matched $78 million in 401K savings in the U.S. with a total fund balance of $1.3 billion as of FY16. The company also recently announced it will add an enhancement to the program in 2017.

Starbucks is finding that these incremental investments in both wages and benefits have helped support and elevate its partners, attract and retain the best talent, provide measured improvement in service to customers and deliver outsized returns to shareholders.

  • Shareholder Returns

Starbucks has returned $10 billion of cash to shareholders in the last five years, through dividends and share repurchase. $15 billion more is scheduled over the next three years, indicated to be modestly front loaded to early 2018 . The dividend was recently increased 20% to $0.30 quarterly, so the stock now yields a little over 2%. As noted above, the stock has been in a relatively narrow trading range in the last two years. It is worth noting that Starbucks also invested, in 2016, for operating “partners”, $322 million in healthcare and other benefits, $15M in the Starbucks College Achievement Plan, and $221.6 million in Bean Stock. No doubt, these benefits have been an important contributor to the Starbucks operating “culture”, the best we have ever seen for a food service company of this size.

Source = Starbucks Annual Meeting March 2017

Recent Developments, Per Q4’17 Press Release, Per Q4 Conf. Call Transcript

https://s22.q4cdn.com/869488222/files/doc_financials/quarterly/2017/Q4-FY17-Earnings-Release-Final.pdf

https://s22.q4cdn.com/869488222/files/doc_financials/quarterly/2017/transcripts/SBUX_Q4-2017-Earnings-Call-Transcript.pdf

The fourth quarter was relatively strong, especially in terms of sales, for SBUX, especially considering the challenges within the restaurant landscape. As Indicated above, US comp sales were up 2%, with a 1% increase in traffic, excluding the impact of Hurricanes Harvey and Irma. Comp sales in China were especially impressive, up 8% with transactions up 7%.

Q4’17 had 12 weeks, versus 13 in Q4’16, obviously affecting the YTY earnings comparisons. GAAP results were also affected materially by  “strategic actions….as it focuses on accelerating growth in high-returning businesses and streamlining its operations”. From a revenue standpoint, the consolidated flat revenues would have been 8% higher with the extra week, as indicated in the Q4 release. Be that as it may, Q4 GAAP operating income was down 16.7%, and non-GAAP operating income was up 2.8%. GAAP operating margin declined 360 bp to 17.9%, non-GAAP operating margin declined 90 bp to 20.0%. GAAP EPS was flat at $0.54, non-GAAP EPS grew 10.0% to $0.55 per share.

More details are available within the Q4 release, but it seems noteworthy to us that while consolidated operating margin was down 360 bp, this consisted of a decline of 470 bp in the Americas segment, a decline of 410 bp in the EMEA segment, offset only nominally by 80 bp of improvement in Channel Development and 60 bp improvement in China/Asia. “All Other Segments”, including Teavana stores, Seattle’s Best, and Starbucks’ Reserve lost $46.1M vs. a $10.1M loss QTQ, primarily due to closing Teavana retail stores.

Other Q4 highlights included 603 new store openings globally, Starbucks Rewards’ growth up 11% to 13.3M active members in the US, representing 36% of US sales, and Mobile Order & Pay reaching 10% of US transactions. Long term financial targets were provided, with global comp sales of 3-5%, annual consolidated revenue growth in high single digits, annual EPS growth of 12% or better, and annual ROIC of at least 25%. The dividend was increased by 20% to $0.30 quarterly, 15.1M shares were bought back, and a new commitment was announced to “return $15B to shareholders” over the next 3 years through dividends and share repurchases.

Further highlights of the year and quarter were discussed on the call. 550 new stores were added in fiscal ’17, bringing the total there to nearly 3,000 locations, heading for 10,000 within 10 years. Starbucks Rewards and Mobile Order & Pay platforms continue to be enhanced, drawing more revenues per customer and more participants. New financial products will be offered, in partnership with Chase bank, using Starbucks “currency” at other retailers. (A lot better than Bitcoin, in our opinion, though harder to launder a lot of money one cup of coffee at a time. Starbucks Roastery is a continued focus, and a new Princi Italian Bakery has opened within the Seattle location.

Management pointed out on the conference call that GAAP EPS growth will be above 40% in 2018, with over $0.50 of the gain from the purchase of ownership interest in East China and the sale of TAZO. These transactions, as well as the exit from Teavana stores, licensing Taiwan and Singapore, will affect non-GAAP EPS modestly, if at all (“flat to slightly accretive”) in 2018, then become more meaningfully accretive to EPS growth in late fiscal 2018 and into 2019. It was also indicated that the 12-13% non-GAAP EPS growth will be “back loaded” in fiscal 2018, aided by stock buybacks as well as operational improvements.

There are numerous ongoing growth opportunities for this premier worldwide consumer brand, many of them discussed on the conference call, and we encourage our readers who are interested to read the entire transcript. For our purposes, most of the “needle moving” initiatives have  been discussed above.

Conclusion: Stated at the Beginning of this Corporate Writeup

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SHAKE “SHOCK” (SHAK) – VIDEO FROM 3RD DAY OF NEW LOCATION – KIOSK ORDER & PAY – NO CASHIERS

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SHAKE SHACK “EVOLVES” TO ELIMINATE CASHIERS -PROGRESSIVE TO BE SURE, UNINTENDED CONSEQUENCES WILL TAKE A WHILE TO EVALUATE

Danny Meyer, founder of Shake Shack, is no longer actively involved  in management of this leader within the “fine” casual dining industry.  His cultural influence is no doubt being maintained as one of the restaurant industry’s most progressive voices.

Shake Shack, no doubt anticipating the inevitable material rise in the cost of labor, has just opened a unit at Astor Place in Manhattan which has no cashiers.  You can’t accuse Shake Shack, no doubt channeling its founder, Danny Meyer, of lagging the crowd in terms of anticipating changes within the hospitality industry. Combined with mobile order and pay, about 10 POS “kiosks” allow customers to place orders as well as pay. Cash is not accepted. We took a twenty five second video at 1:00pm today (link below), the third day of operations, panning the store interior. On the viewer’s right is the array of ordering stations. SHAK management is not naive about the need to explain the new system and provide customers as much “training” as necessary, so several employees are circulating among the customers, helping where necessary (including myself). I found the system fairly easy to navigate, and used the chip on my card to pay. The customer then moves to the center of the store, and waits in front of the pass through section where names are called out. Mobile orders presumably are handled over the same counter. There is a drink and condiment station, left of center, where customers can set themselves up as they wait for their orders. There is a modest amount of seating as the camera pans to the left, indicating that the Company feels that most orders will be taken off premises.  I will briefly discuss my reaction after you have viewed the video below:

https://www.dropbox.com/s/r83syu3fhcv79q7/SHAKE%20SHACK%20KIOSK%20ORDER%20%26%20PAY%20-%20NO%20CASHIERS%20-%20VIDEO.mp4?dl=0

The business model is “a-changin”. Danny Meyer literally wrote the book in dining hospitality, “Setting The Table”.  His fine dining restaurants have distinguished themselves from this standpoint and he is appropriately viewed as one of the long time greats in the industry. At Union Square Hospitality Corporation, his elimination of tipping two years ago was his effort to equalize compensation between the back of the house and front, and this (I call it “unresolved”) experiment has continued to this day. USHC, however, is privately held, and the operating margins (which we suspect have suffered) don’t come under the  line by line scrutiny of analysts and investors. Shake Shack (SHAK), publicly held, must bow to the needs, and demands of the publicly held constituents. Growth rates, and operating margins, have to be maintained or valuation will suffer. We can’t prove it, obviously, but SHAK (if still private) might not be moving quite so aggressively in eliminating cashiers (which includes a significant personal “touch”) and going to a production based model.

FROM THE CUSTOMER’S STANDPOINT: SHAK will not lose its cult-like status any time soon. We don’t expect volumes to suffer substantially with this new approach, however: at the end of the day, it’s (mostly) a burger, fries, and shakes, preferred by many, but not by all. Lot’s of Californians  think In and Out is the ultimate, some prefer the fresh cut fries at Five Guys, and the burgers at Schnipper’s here in NYC are pretty good if there is not a Shake Shack nearby. I believe that what has distinguished Shake Shack, as much as anything else, as been the hospitality quotient. Their staff has been a cut above the big three burger chains, just as been the case at Starbucks. Credit the influence of founders, Howard Shultz and Danny Meyer. Cutting to the chase: the absence of cashiers is not going to gain customers, and could cost some.

FROM THE EMPLOYEES’ STANDPOINT: Shake Shack is no doubt going to try to maintain the hospitality experience, as best they can, but eliminating cashiers is not an upgrade. There are lots of young people who correctly view a job at SHAK (or Starbucks) as a stepping stone in the retail/hospitality industry. They get an on-the-job education and get paid (modestly) at the same time. I’ve written about the Starbucks barista who told me “working at Starbucks makes me a better person” and I suspect that there are more than a few Shake Shack crew who feel that way as well. The new business model increases the value of “production” rather than customer contact, so it is going to be a lot less satisfying for that young person who really loves to interact with people, but is now just pumping out product.

Bottom Line: No Cash, and No Cashiers, may be progressive, even necessary, but will likely have unintended consequences, for  employees, customers & shareholders.

 

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SIMON V. STARBUCKS – BIG BOY COURT CASE – WARMS MY HEART!

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SIMON V. STARBUCKS  – BIG BOY COURT CASE!!

THE DISPUTE

On August 21st, Simon Property Group filed a lawsuit that challenged Starbucks’ decision to close 78 Teavana stores that are located in Simon malls. Starbucks announced recently their intention to close all 379 Teavana locations within the next year.

We have not seen the terms of the leases, but no doubt they are iron clad in terms of Starbucks rental obligations, no doubt at top dollar rents, with productive locations within Simon developments. I have not read anywhere that Starbucks does not intend to honor their rental obligations, including rents and common area charges. They will no doubt pay out hundreds of millions of dollars in the process of closing 379 stores. Fortunately, with quarterly cash flow from operations of $1 billion, and growing, they can afford mistakes of this magnitude, and Simon will get their rent due, early in fact.

Simon’s suit contends that Starbucks would be “shirking its contractual obligations at the expense of Simon’s shopping centers.” Apparently, in an effort to broaden the lease terms dealing with “covenant to operate”, Simon says Starbucks must keep the stores open for the term of the lease whether they are making money or not. It wouldn’t “look good”, would be damaging to the mall, Simon implies, if a fairly prominent store location is vacant. Simon seems to forget that, once notified that the store is closing and the rental obligation is paid out (which there is every expectation that Starbucks will do), the space can be rented again, actually improving the overall return on Simon capital investment. The new tenant can’t do much less business than Teavana is doing (or Starbucks wouldn’t be leaving), so traffic will improve from the current disappointing situation. Simon, however, will try to argue that the Teavana store was an “attraction” for mall shoppers, so Simon is damaged when that traffic pattern is disturbed. I wonder if Simon gave Starbucks a rent concession because of that traffic building appeal which both parties expected would be a benefit to all tenants and the success of the mall. I’ve been part of lease negotiations with major mall developers and have found that it tends to be a one way street.  It is no doubt different for Starbucks than for Joey’s Pizza (generically speaking) because Starbucks’ lease is “bankable” and Starbucks can get the good location it wants, still though at top dollar rent. Poor Joey will only get a good location, also of course at top dollar, if he takes two bad ones elsewhere. Put the three locations together and Joey will barely break even. The mall developers seem almost uncanny in their ability to understand these economics, exactly what rent will allow the tenant to work almost entirely for the landlord.

UNFORESEEN CONSEQUENCES

Sometimes bad stuff happens, even with the best of intentions. An architect has an omission in his building plans, changes have to be made on the fly, the end user pays, there is no recourse to the architect. A mall tenant signs a lease, takes occupancy on time, but the mall doesn’t get completed and/or fully occupied for many months, perhaps never. Does the tenant get a concession from Simon (in this case)? Not likely. The hamburger QSR chain signs a top dollar lease in the food court, and is (by the terms of the lease) the “exclusive” hamburger provider, but Nathan’s Famous Hot Dog’s moves in (for example), also has a pretty good hamburger. Does the mall operator do anything about it? Not likely? The retail tenant on 2nd Avenue in New York City signs a twenty year lease (at top dollar), and the City spends 10 years building the new subway line, with traffic disruption bankrupting retailers. Bad luck. A snowstorm of historic proportions puts mall traffic at a standstill on the weekend before Christmas when retailers make their profit for the year. Simon gets their rent; the retail operator has coal in its stocking.

CONCLUSION

Simon Properties, and other major mall developers, have had their day in the sun for forty years. It’s been “their way or the highway”.

To Starbucks I say: You gave it your best shot, you are paying the price. Move on.

To Simon Properties I say: GROW UP!!

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STARBUCKS – WHY IS STOCK LAGGING? – THE TIMES THEY ARE A’CHANGING

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STARBUCKS – STOCK UNDERPERFORMING – WHAT’S GOING ON?

The stock charts, shown below, of the largest capitalization restaurant stocks raise serious questions about Starbucks fundamental prospects. Charts and fundamentals don’t always go hand in hand, especially over the short term, but longer term the stock price and the company’s performance converge.  Starbucks has been one of the great stock market winners of all times since going public in 1992, up well over 100x over 25 years. However, all good things come to an end at some point, at least level out in this case, and over the last two years Starbucks’ stock has substanially lagged the general market and its large cap restaurant industry peers.

IT’S A ‘BUM RAP”, STARBUCKS DOES NOT SELL “$5.00 CUPS OF COFFEE”

It’s a “bum rap”. The media, and the skeptics like to point to the folly of customers paying $5.00 for a cup of coffee. However, we priced (before tax) Starbucks, Dunkin’, and Horton’s in Detroit (to avoid NYC prices) this morning. Starbucks’ 12 oz.“tall” coffee is $2.20, Dunkin Donuts 10 oz. “small” is $1.75, and Horton’s 10 oz. “small” is $1.58. Per oz., Starbucks costs $.183, Dunkin’ is $.175 and Horton’s is $.158. If you want a latte’, the gap is wider ($.312 per oz. at Starbucks, $.253 at Dunkin’, and a materially cheaper $.222 at Horton’s). A latte’ costs more at Starbucks, but Dunkin’ and Horton’s don’t even offer the Soy Latte’ that I order. I can’t vouch for the “quality” of latte’ at Dunkin’ or Horton’s. You can judge for yourself whether the service component, or the type of coffee, is worth the price premium at SBUX but, in any event, it is not a “$5.00 cup of coffee”, and Starbucks’ prices are not grossly higher than the competition.

THE STARBUCKS DIFFERENCE

In my opinion, what has distinguished Starbucks over the years has been the corporate “culture”, which they have incredibly duplicated in 27,000 stores worldwide. Their employees, selected, trained, and motivated to an unmatched degree in food service, look you in the eye, remember your name and drink if you are anything close to a regular customer, and become part of your daily social life. A couple of years ago, about the time that Chipotle ran into trouble, I asked a SBUX employee if he knew anything about Chipotle. This young man, perhaps 18 or 19 years old, told me he used to work at Chipotle, then gestured kind of frenetically with his hands saying: “at Chipotle it was all about speed. Starbucks makes me a better person”. That’s what Starbucks has been all about, creating a uniquely welcoming retail environment that produces “better persons” of their employees.

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.

MILLENIALS, 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 as described above who says 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.

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