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Everyday hundreds of millions of people around the world wake up and drink a cup or two of coffee in the morning. It’s a habit for some and will remain that way forever. Starbucks is a brand that has relevance in our society and can satisfy the habits of millions. How many times have someone said to you let’s meet at Starbucks and get a cup of coffee? It happened to me yesterday! At Research Edge we think the timing is great to start a consumer fund with a 3-5 year investment horizon. There are some incredible opportunities given the debacle in consumer names. Starbucks would be one of the names we would put in that portfolio. Don’t misunderstand my positive tone has nothing to do the quality of the quarter to be reported on November 10th. A lot has changed since the last time the company gave guidance to the street.
  • Starbucks still faces significant headwinds as it adjusts to the global consumer macro issues. Since the company last gave guidance for 2009, consumer sentiment is falling and spending has slowed. The company current expectations are for same-store sales to grow 2-3% for fiscal 2009, with no pricing. This appears to be aggressive given the current trends in consumer spending. Every company is facing theses issues and Starbucks is better positioned than most to deal with them. To the degree that smaller competitors can’t survive, Starbucks’ opportunities grow.
  • In the short run, two big negative commodity factors have swung positive for the company. Over the past couple of weeks, we have posted extensively on the decline in both milk and coffee prices. While they will not provide any significant benefit to the company in its fiscal fourth quarter reported on November 10, lower commodity prices will have a positive impact in the first quarter of fiscal 2009 (higher dairy costs resulted in a negative $0.02 impact to EPS in fiscal 1Q08).
  • Another short term issue includes consumer demand at the company’s core U.S. store base. Last week, CEO Howard Schultz made the following comments to reporters at a company leadership conference in New Orleans; "The downturn continued in the fourth quarter, and we did see a slight improvement in the first weeks of Q1 ... which might suggest that Starbucks may have hit bottom in terms of negative transactions in our fourth quarter.” If I had 3-5 year investment horizon, SBUX would be on the top 10 list of consumer stocks to buy….. But, why did Howard need to be this vocal about business trends? I don’t see any upside at this point...
  • I believe Howard is also seeing the benefits of the company’s efforts to slow store growth and close underperforming stores. The shrinking of the U.S. asset base (closing stores and rationalizing the U.S. infrastructure) will eliminate cannibalization and close underperforming stores, which will help to improve same-store sales trends.
  • For most consumer companies there is not much that can be done to offset the macro environment. Therefore given today's turbulent investment environment, cash and the redeployment of cash flows will be a critical factor in determining future levels of valuation and, therefore, stock price performance. A cash flow sustainability analysis suggests that managing cash flow properly will allow any given company to outperform its peer group over a sustainable period of time. A key component to sustainable, consistent growth and a premium valuation is the proper balance between cash reinvested into the business and cash returned to shareholders. We all know that Starbucks had tipped the scales too far in favor of growth. What is not clear is how the capital allocation decisions made in fiscal 2008 will impact 2009. Our model suggests one outcome, but the reality of the reported numbers will not be evident for 3-6 months. Over the next two years SBUX will likely generate about $1.2 billion in free cash flow, but this number could move higher because I think FY09 capital spending still has the potential to come down further. To date, management has not spoken about what they intend to do with this cash. In all likelihood the company will pay a dividend for the first time in the company’s history. The divided could be anything from $0.15 to $0.25 per share. At the high end it would provide shareholders 2% yield, helping to put a floor on the stock.
  • Lastly, the investment community is so sure that MCD will put SBUX out of business, or at least significantly erode the profitability of SBUX’s business model. I’m confident that the MCD coffee program is not working – there is clear evidence that MCD is way behind on its store conversion schedule and they are still tinkering with the recipe. SBUX is the cheapest global restaurant company I follow (6.5x NTM EV/EBITDA) with great cash flows and global opportunities, but patience pays.