SBUX - ever passionate and overly convincing

On its 4Q08 earnings call, SBUX management made a comment regarding early fiscal 2009, “Over the past few weeks, signs of improving comps have appeared episodically, though it is too early to call a trend particularly with the important holiday period still in front of us. That said, October did not show further deterioration to comps or traffic, a possible indicator that Q4 may have represented a bottom coming out milestone for our company.”

Unfortunately, SBUX had to take back those comments at its analyst conference today because the company has since experienced a further deterioration in its U.S. same stores growth in November. For the first 9 weeks of Q1, U.S. comparable sales are down 9% relative to the 8% decline in Q4. On a 2-year average basis this represents a significant sequential decline to down 5% in Q1 from down 2% in Q4. Additionally, the U.K. continues to worsen as well. Management did not provide specific Q1 EPS guidance except to say that it expects to fall short of current Q1 consensus EPS estimates of $0.22. The company attributed its expected earnings shortfall to the significant investment incurred in the quarter for its leadership conference, to the fact that it is lapping its most difficult comparison in Q1, and of course, to its deteriorating comparable sales trends, the future of which management has little visibility. So, the main takeaway from today’s meeting is that Starbucks has not yet found a bottom.

The only piece of new good news that emerged from the conference stems from the company’s expectation to generate $400 million in cost savings in FY09, up from SBUX’s initial guidance of $200-$210 million. On an EPS basis, this translates into about $0.36 of costs cut out of the P&L relative to the company’s prior forecast of $0.17-$18. Importantly, management highlighted that these savings are engineered to be ongoing and not just a FY09 benefit. The projected savings will come from four sources. SBUX expects to cut $150 million out of its $2.5 billion annual labor expense (For reference, this was the first time the company ever provided the investment community with its total annual cost of labor). An additional $50 million of savings will come out of its waste expense, or what SBUX calls its “cost of quality,” $150 million from procurement and $50 million from manufacturing/logistics. In aggregate, the company expects to cut $200 million of costs at the store level (labor and waste) and $200 million of costs out of its supply chain (procurement and manufacturing/logistics).

Due to these aggressive cost saving initiatives, management stated that even if same-store sales declined 7% for the year, it would still expect FY09 EPS to exceed FY08’s reported $0.71. However, management was quick to point out that it is not providing guidance but instead providing parameters around how to think about the impact of its expected $400 million in costs savings. The savings will provide more leverage to the P&L and offset some same-store sales weakness. Although I would agree that this is a positive development as it relates to improving margins, I don’t think the stock will really rebound until same-store sales growth returns.

From my math, it appears that the company plans on flowing the entire amount of its cost savings to the bottom line. The motivation for doing this most likely stems from the fact that SBUX wants to offset its top-line weakness and grow earnings. I would argue, however, that in this challenging and competitive environment that it would be more prudent for the company to reinvest some of these savings in the brand as the long-term success of the brand would benefit more from increased national advertising. Going forward, Starbucks will require a larger share of voice in order to combat the Dunkin’ Donuts and McDonald’s of the world, each of which will be spending a significant amount of money promoting its respective brand.

Outside of its not investing enough in advertising, I think SBUX is finally properly managing for the long-term. The company will continue to experience near-term pressure from same-store sales weakness, similar to other retailers and restaurants alike, but at some point SBUX will benefit from its renewed focus on operations within its four walls. Slowed unit growth, the closure of over 600 underperforming units in the U.S., reduced capital spending and a more efficient cost structure will all lead to improved store unit economics and inevitably, to stronger returns. At the risk of sounding like the ever passionate and overly convincing Howard Schultz did during his closing comments today, I would agree that two years from today we will be talking about where the stock was and the significant returns that have been made.



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