SBUX – WHEN IS ENOUGH ENOUGH?

It was a little over a year ago that SBUX first announced Howard Schultz’s return to the CEO position and the company’s new transformation agenda, including slowing the pace of U.S. growth and closing underperforming store units, to renew its focus on store-level unit economics. There was much anticipation for the 1Q08 earnings call that followed shortly after that initial announcement to learn the magnitude of the changes. On that 1Q08 call, SBUX reduced its 2008 U.S. new unit opening targets and announced the closure of 100 underperforming stores. Additionally, the company said that it would open less than 1000 stores in the U.S. in 2009.

Here we are one year later and SBUX has since increased those 100 expected closures to 961 with 800 in the U.S. (384 of which are already closed) and 161 internationally (including the 61 stores that have already closed in Australia). Regarding new unit growth, SBUX now expects a decline in net new stores in the U.S. in 2009 following all of the expected closures. Unfortunately, these significant downward revisions to store growth and store closures did not come at once. Instead, we have had to agonize through these additional cuts each quarter since the transformation agenda was announced. I thought SBUX’s initial announcement last January was reactionary as comparable sales trends had already started to decelerate and yesterday’s revisions are once again reactionary. That being said, no one expected this quarter to be good. We did not need CEO Howard Schultz to remind us that unemployment, jobless claims and the number of housing foreclosures have increased while consumer confidence has fallen to an all-time low to know that.

Even if the announced changes continue to be reactionary, they are the right moves for the company going forward, and they prove that CEO Howard Schultz is willing to make the difficult and necessary decisions to improve SBUX’s profitability. The fact that Mr. Schultz said he has a “Plan to Win” (MCD called its 2003 turnaround plan the “Plan to Win”) and that SBUX is going to begin offering some type of value breakfast combo meals at a national price point in March show that he no longer thinks SBUX is immune to the issues facing his competitors.

And, these store closures, slowed unit growth, headcount reductions and increased focus on managing costs are already yielding results. Although same-store sales declined 9% on a consolidated basis (-10% in the U.S. and -3% internationally), the company’s EBIT margins improved on a sequential basis to 8.3% in 1Q09 (excluding restructuring and impairment charges) from 4.5% in 4Q08. Although margins declined nearly 380 bps YOY, an 8.3% margin is not a bad number for a restaurant company in today’s environment. Yesterday’s, we also learned that the company is expecting to yield an additional $100 million in fiscal 2009 cost savings, primarily from additional reductions in non-store positions and store closures, bringing the total expected savings in fiscal 2009 to $500 million. Margins should improve throughout the year as the company’s savings are expected to ramp up in each subsequent quarter from $75 million in 1Q, to $100 million in 2Q, to $150 million in 3Q and $175 million in 4Q. The comparisons get significantly easier as we trend through the year as well.

Predicting when SBUX’s top-line results will improve is much more difficult. These comparisons also get easier but easy comparisons no longer seem to matter when it comes to same-store sales growth in this environment. In the short-term, investor sentiment will be influenced by SBUX’s top-line results, but the company is now well-positioned for the long-term and is managing the aspects of its business it can control. We have already seen an improvement in margins and the company’s current cost initiatives are expected to lead to increased savings in 2010 and beyond. It should also not go unnoticed that even with comparable sales down 9%, SBUX generated over $100 million in free cash flow in the quarter, which on an annualized basis is a 6% cash flow yield, also not a bad number in today’s environment.

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