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    MARKET EDGES

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“Incredible opportunity to bring the artistry of the best French bakery product to the U.S. marketplace in a similar way that Starbucks brought the romance of the Italian espresso bar to many American coffee consumers”

- Howard Schultz on 06/04/12

This bold quote from CEO Howard Schultz was taken from the call Starbucks held following the acquisition of La Boulange.  At the time, the company had big plans to reinvent the food sold in its stores.  If you are long Starbucks today, you believed management when they told you that rolling out food nationwide would actually increase traffic in its stores.  Given that La Boulange is now rolled out system-wide and traffic has decelerated from 5% to 1% last quarter, it’s clear to us that this platform is not driving incremental traffic.

Our short call argues that the proliferation of new menu items is in fact slowing service times and traffic trends.  Management was hard pressed on this issue on the earnings call and was in complete denial about the possibility of a throughput issue.  In fact, they attributed the entire slowdown to the macro environment and a shift in consumer’s shopping patterns.

SBUX: Short Thesis Firmly Intact - 1

After finishing his prepared remarks, CEO Howard Schultz went off script and said, “when I look at the results of this year, the stunning accomplishments on so many levels, and I hear somebody being disappointed with a 5% comp on a base of over 7,500 stores, I’ve just got to ask myself, is there any company in your universe putting up these kinds of numbers?”

The truth is, yes, there are a few companies, but not many.  More importantly, however, is that there are more than a few companies driving greater than 1% traffic growth.  The fact of the matter is, Starbucks is aggressively taking price and while the benefit they are seeing from a mix shift is a short term positive, it is highly unsustainable.

Our Short Thesis Confirmed

Starbucks reported disappointing 4Q14 results after the close yesterday, reporting in-line earnings while missing top-line estimates.  Management also guided down 1Q15 EPS estimates from $0.83 to $0.79-0.81 and FY15 EPS estimates from $3.17 to $3.08-3.13.  Perhaps more telling than the release itself, however, was the subsequent earnings call.

We knew the 4Q14 print was going to be a defining one for Starbucks.  As we pointed out multiple times in our 82-page bearish slide deck in September, the company has been failing to stem recent declines in traffic, particularly in the U.S.  We believe that the nationwide rollout of La Boulange has created menu complexity and, subsequently, increased execution risk within its stores.  We view the continued expansion of the menu (into various dayparts) as an impediment to traffic growth and while comps continue to look healthy, the overwhelmingly majority is being driven by average check growth.  Not only is this unsustainable, but it is precisely what we were looking for to further validate our thesis.

Americas same-store sales growth came in at 5% for the quarter, below estimates of 6%, driven by a 4% increase in average check and 1% increase in traffic.  This marks the fifth consecutive quarter that traffic has decelerated on a sequential basis.  Management aggressively denied any throughput or competitive pressures, instead pinning this continued deceleration on the current macro environment.  We’ve heard enough earnings call already to know that this is a rather lame out.  We clearly believe there is more to the story here and know management will do what is in their power to dispel fears until they no longer can.

In addition to decelerating traffic, another hot topic has been the recent surge in coffee prices.  Management noted that, while coffee provided a 400bps tailwind in FY14, they expect it to have a neutral effect in FY15.  Importantly, they have 2/3 of their coffee needs locked for the full-year and they believe there is nothing that indicates a prolonged shortage in the market.  This stands in stark contrast to our view that we will see two, potentially three, back-to-back shortfalls in the global coffee market.  With the remaining 1/3 still not purchased, this will be something to keep a close on eye moving forward.

The two variables in 2015 continue to be traffic trends and coffee prices.  Starbucks usually hits the numbers, but the truth is the stock is no longer bullet proof.  We got the feeling that sentiment was changing within the analyst community, which would certainly support our case.

In short, our short thesis remains firmly intact.  Please shoot us an email if you’d like to review our slide deck or give us a call if you’d like a more in-depth update to our thesis.  There’s a lot of moving parts, but the very core of our thesis is playing out exactly as expected.  Happy to talk.

Howard Penney

Managing Director

Fred Masotta

Analyst