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I have been a SBUX bull since early 2009 and remain one today.  Yet, unfortunately, I am still not allowed to ask a question on the earnings calls.  I know there are 28 analysts that follow SBUX and there is a limited time on the call to get every question in but I was disappointed when calling in 20 minutes in advance did not yield an opportunity to ask a question.

The IR team did reach out to me and I look forward the conversation, but I must say I was hoping to ask my question in a public forum.  That is not to say that I doubt they would have expertly danced around the issue I planned on bringing up but I was eagerly anticipating the dialogue nonetheless.

Ever the optimist, I was hoping that management might look kindly upon the only sell-side analyst that has been covering the company from day one.  Then working at Morgan Stanley, I titled my initial report “Expensive and Built to Stay That Way”.  Nine months later I got cute and put a sell on the stock due to a rich valuation.  Soon after, I received a call from Howard Schultz and he told me that I did not understand the room the company had to grow.  He invited me out to Seattle to show me what he meant.  After taking him up on his offer and spending a day driving around with him, I walked away having learned a lot.  One week later I changed my rating.  So, my relationship with Starbucks has had its ups and down, but surely longevity counts for something!

As Schultz reminded us on the call yesterday, SBUX has come a long way since its beginnings in 1987. He said, “this week approximately 60 million customers will visit us, and that's just an unbelievable number when you consider where we have come from 1987, 11 stores, 100 employees, and today, 17,000 stores in 55 countries.”

I learned a very important lesson that day early in my career and it still applies today.  Howard Schultz embraced my sell rating as a challenge and, telling me “you don’t get it and let me show you why”, set about changing my mind rather than cutting me off.  I don’t think that Starbucks would cut me off for asking the question I was going to ask yesterday, but I do think that the topic it addresses will be a real concern in the coming 12 or 18 months.   

So, here is the thought process behind my question:

Starbucks has identified the single serve category as being very important to the company future growth.   While I understand the rational for going with Keurig and Green Mountain, I was surprised the company did not want to control the “last mile” into the home.  A number of people from the SEC to forensic accountants and well-known hedge fund managers have expressed serious reservations about the integrity of the company and the viability of the business model. 

Does Starbucks have a contingency plan in case Green Mountain cannot access the financial markets for the needed capital to execute its growth plan and deliver an adequate supply of k-cups?

The lack of the company ability to generate cash has been well documented and screens “UNSUSTAINABLE” in the Hedgeye Sustainability model.  The biggest red flags in the Hedgeye Sustainability model are Asset Turns and CFFO or, more importantly, the proportion of earnings yielding cash. 

Why would Starbucks rely on a supplier where we need to ask the question:  Is the company generating enough cash from its operating activities to continue without accessing new external sources of cash?  What if the capital markets dry up for GMCR?

We define CFFO as cash from operating activities less capital expenditures, less the benefits from the exercise of Employee Stock Options and adjustment for one-time gains/losses or restructuring items.  

Most of the companies we follow generate free-cash flow after significant investment in the growth of the core business, while other smaller, faster growing companies do not generate free-cash flow.  This is not necessarily a negative if the cash burn rate is within the limits of available resources.  To-date, the capital markets have been very generous to GMCR, but what happens when the music stops?    

Importantly, we are looking at the proportion of earnings yielding cash.  If GMCR reports strong revenue growth, good margins, healthy profits but those profits are accompanied by negative cash earnings yield, SBUX must be suspicious, or at least I hope they are. 

Howard Penney

Managing Director

Rory Green