In an excerpt from an Institutional Call earlier this week, Restaurant Sector Head Howard Penney fields a question concerning a bubble in low quality small cap U.S. stocks. As competiion heats up in the space CHUY’s odds of beating the larger more well known names in the space appear slim. The restaurants team recently turned bearish on CHUY, adding it to the Best Ideas list as a short.
Takeaway: Hedgeye managing director Howard Penney added SBUX to the Hedgeye Best Ideas list as a short on September 11.
Editor's note: This note by Hedgeye managing director Howard Penney adding Starbucks (SBUX) to the Hedgeye Best Ideas list as a short was originally published September 11, 2014 at 16:49. The world’s biggest coffee-shop chain posted quarterly revenue after the close yesterday that missed estimates sending shares lower approximately -3% today.
We are adding SBUX to the Hedgeye Best Ideas list as a short.
We are hosting a Black Book call next Thursday, September 18, 2014 at 11am EST to run through our thesis and field questions. We will send out dial-in information and materials for the call next week.
SBUX: The Seven-Year Itch
It’s been seven years since Howard Schultz penned his now famous memo to management and employees, outlining where the company had gone wrong and what it needed to do to get back on track. It has also been six years since I turned positive on Starbucks – but nothing lasts forever.
McDonald’s went on an eight-year corporate revival before it lost its luster and we fear Starbucks is nearing the end as well. In this presentation, we will outline a number of concerns we have with the company leading us to believe that the street is overly optimistic about its future prospects.
I recently read that Harvard Business School Professor and Historian Nancy Koehn has studied Starbucks and its leader, Howard Schultz, for nearly 20 years. She recently released a new HBS Case Study, “Starbucks Coffee Company: Transformation and Renewal,” which traces “the dramatic arc of the company’s past seven-plus years – a period that saw Starbucks teeter on the brink of insolvency, dig deep to renew its sense of purpose and direction, and launch itself in new, untested arenas that define the company as it exists today.”
While all of this may be true, I too have been following Howard Schultz and Starbucks for over 20 years. Unlike Ms. Koehn, however, I did not go to Harvard and I am not a HBS Professor. But I did release a Hedgeye Black Book in early 2009 detailing why I believed Starbucks was a great company and the stock was a great buy.
Today, while Starbucks is still a great company with a strong management team, the stock is far less attractive. More specifically, and perhaps to the heart of the topic, I believe the company’s domestic business is maturing and management is rapidly attempting to stem this decline by deviating from its core. Let us not forget that sentiment is near an all-time high. To me, this HBS Case is simply another example of a Starbucks “top.”
Our call on SBUX will focus on:
- Menu trends suggest increased complexity and slower throughput
- Decelerating same-store sales and traffic
- Rapid diversification away from the core business
- Proprietary Hedgeye survey confirming new menu initiatives are not resonating with consumers
- Significant and sustainable increase in coffee costs
- Peak margins
- Street optimism and overconfidence
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Takeaway: The beat and raise thesis is very much intact. Look for a REIT story to emerge next year.
This management team feels good and sounds confident - and our Q4 forecast is above consensus.
Chris Nassetta, CEO
- Pleased with growth and results, above high end
- Macro set up feels great
- Transient: rev +8% in Q3
- Group >9% systemwide, volume driven - positive on group business system wide up mid to high single digits for next four quarters
- Group rebounding and positively impacting mix
- Canopy by Hilton - game changer, appeals to wider audience, not limited to luxury segment. Lifestyle, light, organic feel while reflecting neighborhood location. 11 signed deals in key urban markets, another 15 in discussions. Third party capital will drive unit development.
- Curio - discussion on >90 properties. Plans to open 5 hotels, 3,200 rooms by year end. Currently three assets open.
- China - will leverage new partnership, licensing agreement for Hampton brand. 400 hotels target. Will allow for acceleration of brand development and penetration across China.
- Waldorf Astoria - on track to close as announced. WIll likekind exchange proceeds and well along this process.
HSD = high single digits
MSD = mid single digits
- U.S.: positive outlook and muted supply growth = Q4 HSD RevPAR
- America ex US: Q4 HSD RevPAR
- Europe Western & Southern strong, Eastern weighted down by Q4 MSD RevPAR
- MEA: Recovering - Egypt strong easy comps, Saudi Q4 MSD RevPAR
- Asia/Pac: consistent, Japan strong but tempered, China steady, India stronger, Thailand a drag Q4 MSD RevPAR
- 2015: Feel great about fundamentals
Kevin Jacobs, CFO
- M&F Fees: new unit and top line driven
- IMFs: increased participation rate and IMFs outside, 75% non-US
- $5 million base to incentive fee reclassification
- IMF outlook now 13% to 15%
- Timeshare: new and first project in Maui, will begin sales in 2016, YoY increase of inventory 58%
- Washington DC uptick in leisure and co meetings
- Prepayment Guidance: Full Year expect to pay $900M- $1B by year end
Q: Waldorf Astoria 1031 like-kind exchange - types of properties?
- All domestic U.S. assets, institutional grade, best urban/resort, singles/portfolios, UUP and Luxury, mixture of HLT brands and also not branded. More details 60-90 days
Q: Waldorf like-kind disciplined on valuation?
- Unique given history, cash buyer, have period of time to identify 2x potential properties (fill funnel) then evaluate quality, pricing, terms. Sold Waldorf at 32x, buy closer to current multiple
Q: Waldorf - disruption from renovations with new owner?
- Entered process of sharing prior renovations with Angbang, reviewing all construction alternatives, then will layout plans for next renovations
Q: Development pipeline outside the U.S. - China challenges?
- Healthy growth in all regions of the world, working with JV partners, over 70 of 150 hotels in pipeline under construction. Complexion of China is changing
Q: Net rooms growth - split segments & geographic?
- 55/45% Intl/U.S.
- 55/45% Mgmt/Franchise
Q: IMF growth in 2015?
- Doing well YTD in 2014, not giving 2015 guidance but trending higher
Q: Limited service vs. full-service growth?
- More balanced 2014 growth - both transient and group remain strong, group business continues to pick up momentum which will drive upscale and upper upscale growth
Q: Development trends?
- Mix U.S. with existing developers = 75% existing owners
- Development community feeling better, economic growth in the U.S. and European developers getting more optimistic; Americas ex. US optimistic; Asia/Pac good optimism. World is more upbeat
Q: Incentive Fees - more paying in U.S.?
- More int'l fees - 75% international and components of growth 65% of growth was int'l, participation moving up by 10%. About 65% from same store (int'l) and 35% from new units (almost all int'l)
- Bulk are int'l and linear equation - not sit behind owners pref's, as markets recover and grow, fees will increase
- Adding more int'l units with such contracts
Q: Occupancy vs. ADR growth?
- Pleased with occupancy gains, would have expected more ADR growth in 2014, but while driving rate, getting smarter about revenue management and means still have lots more runway in this cycle. Much better at driving occupancy on Friday and Saturday evenings. Looking toward 2015, will definitely see much more rate than occupancy. 2014 likely 55/45 occupancy rate
Q: Discussions with rating agencies, how balance investment grade with capital return strategy?
- Still believe 3x to 4x is proper leverage "over" the cycle. Won't over cook beyond 3x
Q: Willing sellers of big box hotels - continue to own Big 8?
- Likely hold on to the Big 8, need to maximize value, still value. Waldorf was unique given value realization of terms
- Best value equation today is to keep assets together/Big 8 together
Q: Timeshare six years of inventory - any concern?
- More inventory than competitors but feel good about opportunity, capital light, sustainable, correct amount of inventory is four to six years.
Q: United Nations inquiry into Waldorf Sale?
- HLT went to U.S. Government, held discussions, confident will close in time disclosed.
Q: Canopy - initial properties conversions or new builds?
- Mix of both - as well as adaptive reuse
- of the first 11 - majority are new build, nothing specific
Q: Exchange - seeding brands and included growth?
- Yes, seed any of UUP or Luxury brands to increase distribution of brands
- Not included in NUG - net unit growth
Q: Blackstone assets - able to be sold without brand?
- Some of BX's assets are in Hilton like-kind exchange funnel
Q: RevPAR 2015: US vs Intl?
- US: Higher End
- ROW: mid range
- blended to 5% to 7%
We got the consumption river card for 3Q alongside yesterday’s advance GDP release, but we received the detail data for household spending and income for September this morning.
In short, both the income and spending data were weaker sequentially to close out 3Q but, as has been the case in recent months, the under-the-hood dynamics remain modestly better than the headline as salary & wage growth remains strong and a rising savings rate constrains the upside in consumption growth.
SPENDING: Total Spending declined -0.2% in Sept after a strong August (+0.5% Mom) with the year-over-year and 2Y both decelerating. The story was similar across all categories as spending across Services/Durables/NonDurables all decelerated on a MoM/1Y/2Y.
Services buttressed the decline in overall goods spending and the notable retreat in durables spending, particularly. We’ll have to wait to see if the pullback in higher ticket discretionary spending is more than transient and whether it flows through in the form of a discrete moderation in consumer (revolving) credit growth which has inflected alongside the acceleration in durables consumption.
INCOME: Aggregate Personal and Disposable Income growth decelerated sequentially as did aggregate Salary & Wage growth. However, private sector wage growth continues to run at ~ +6% YoY and total salary and wage growth (i.e. private + gov’t) is running at >5% - both of which are at their best levels since the pre-recession period.
Its worth re-highlighting that income distribution data is positively skewed and the aggregate figures may (to some extent) belie the reality of the median consumer - who remains very much income constrained given the collective impact of a multi-year run of negative real income growth and all-time highs in major cost of living buckets.
SAVINGS: The Personal Savings rate ticked up to 5.6% from 5.4% prior and is now back to highest level in 2 years. The rising savings is an obvious MT/LT positive but continues to constrain spending in the immediate term. The ongoing increase in the savings rate likely represents some combination of distributional effects (ie. inequality effects as more of aggregate income goes to higher income households with lower marginal propensities to consume) and the rise in Durables consumption with households increasing savings to offset the associated financing burden.
OVERALL: September saw a modest deceleration off peak improvement on the income side while consumption growth continues to oscillate above & below middling as the savings rate continues its northward march. More broadly, and from a rate of change perspective, the balance of domestic macro data has been slowing into 4Q.
Christian B. Drake
“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.
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.