SBUX is once again now a Best Idea SHORT.
SBUX is a company in the midst of a major transition and the operating results are beginning to reflect that transition.
The central thesis for our SHORT on SBUX can be seen in the Black Book we did back in April. The core theses still hold true and we could be one quarter away from the company scaling back on one if its key growth initiatives – FOOD. Importantly, did Starbuck’s CEO, Howard Schultz, set the company up for an enormous disappointment in 4Q16? Why did the CEO make bold predictions on the 3Q16 earnings call? Is Kevin Johnson the right man for the job as COO? We believe the CEO’s bold statement on the 3Q16 earnings call might cost the company a few multiple points following the 4Q16 earnings call.
THE 4Q16 SET UP
We have enormous respect for Howard Schultz, but he may have promised more than the company can deliver. Here is what he said on the 3Q16 earnings call:
“I want to address right out of the gate the two questions you are likely asking yourselves: does a 4% positive same-store sales comp from our US business in Q3 signify or even suggest a turning point in Starbucks' long-term growth trajectory and does this comp figure in any way relate to the success and value of our Starbucks Rewards loyalty program?”
Then he went on to say:
“On today's call we will demonstrate with clarity and specificity why our US comps in Q3 were an anomaly and that we have clear line of sight to returning our business to historic levels of comp growth, which has been at or above 5% for the past 25 consecutive quarters.”
Currently, the street estimate for the Starbucks Americas same-store sales is 5.1%, confirming the bullish bias management has instilled in the street models. This represents a 60bps acceleration in sales quarter-to-quarter. With the sell-side having an 83% buy rating, they have to be bullish. We see same-store sales for the Americas coming in around 3-4%.
Howard Schultz has promised the sun the moon and the stars and the consensus is falling into line. Will the company deliver, but more importantly what happens if they miss for the second quarter in a row?
SUMMARY OF THE 3Q16 ISSUES IMPACTING THE AMERICAS
In 3Q16, the company made a strategic shift in their loyalty program from a frequency-based to a spend-based model. The company has made it clear that they will not see a shift in usage under the new program. What if the “spend based model” causes a secular shift in consumer behavior and thus permanently impacted guest frequency? According to management, the new loyalty model was intended to have the immediate benefit of eliminating a major in-store operating issue, order splitting. By reducing order splitting the impact will result in shorter lines, increased speed of service, and reduced line attrition. At the same time, the company’s roll out of mobile order and pay was designed to also increase speed of service and reduce line attrition. Taken together, both initiatives should have a significant impact on improving traffic, especially in 4Q16.
On the earnings call the CEO explained that the company “underestimated the interdependence of Starbucks Rewards and Frappuccino Happy Hour” and how the two programs was competing for customer and partner mind share. How the programs are interconnected and work together was never fully explained, but it appears the street has just accepted this as the truth. The core operational issues in 3Q16 caused a 1% decline in blender drinks due to the competing programs.
The CEO also admitted that the 3Q16 performance in the USA was impacted by the macro trends affecting overall consumer spending. What was not discussed on the call is what part of the Starbucks business is vulnerable to macro pressures. Is it just a general slowdown or is the company seeing sales soften in the more discretionary and afternoon daypart. This would better explain the decline in the blender sales, rather than operational issues. If the latter is having a bigger impact, it is going to make a 4Q16 sales recover harder to achieve.
On top of this we have the emerging issues of slowing food sales. Slowing food sales was part of our original short thesis. In Q3, food sales only grew 10% (was 16% in 2Q16) and contributed 1% to the comp versus a 2% contribution in 3Q15. Over the next two quarters (4Q16 and 1Q17) SBUX is up against challenging food comps of 3% for both quarters.
One of the areas that we believe the macro issues are impacting spending in the SBUX business model will be incremental spending on the food offering. Overall, the Starbucks food offering is very expensive and the quality of the product is not comparable with competition at similar price points.
THOUGHTS ON MANAGEMENT TRANSITION
Given the operational challenges SBUX encountered in 3Q16, it’s important to revisit the time line of events that lead to Kevin Johnston becoming COO of the company. The timing of the appointment of the new COO was a complete surprise and the choice of Kevin Johnson was an even bigger surprise to the street.
SBUX RECENT EVENTS
- 12/4/14 – Analyst meeting in Seattle (Food is one of the key drives of future growth and COO Troy Alstead was the clear #2)
- 1/8/15 – Troy Alstead takes unexpected unpaid “coffee break” from SBUX
- 1/22/15 – Kevin Johnson named COO (CEO of Juniper Networks; 5 year SBUX Board member)
- 3/1/15 – Kevin Johnson officially takes over as COO
- 3/10/15 – Troy Alstead announces he not returning to SBUX (23 years at SBUX CFO, COO)
- 2/21/16 – SBUX announces changes to it Loyalty program
- 7/11/16 – Baristas get a 5% raise or more
- 7/21/16 – 5 quarters after Kevin Johnson take over as COO SBUX posts the biggest same-store sales miss in five years
- 7/26/16 – Howard Schultz stepping back from day to day operations
- 9/13/16 - Starbucks has announced it's going into content production (Howard Schultz –Producer)
It’s clear that Howard Schultz is ready to move on from running Starbucks Corp. While it’s easy to understand why he may want to move on, it’s also not that unusual. When Bill Gates, founder of Microsoft, another Seattle company, moved on from his company, that transition did not go well. With Howard officially stepping back from Starbucks, so far the Starbucks transition is not off to a great start. Starbucks, COO Kevin Johnson, has no retail experience and his only experience with Starbucks was as a board member for five years.
Now five quarters after taking over the COO role, the company is experiencing its first significant operational challenge in eight years. We see the change in the loyalty program as the first big operational initiative under the new COO Kevin Johnson, and his boss thnks the 3Q16 issues will be a one quarter blip. The 4Q16 earniings call will be very interesting if the Americas does not post same-store sales of better than 5.1%.
This is also on the heels of the company announcing a significant increase in labor costs following significant pressure from Starbucks partners. If the current operational issues persist, and or new ones crop up, many on the street will begin to ask serious questions about the CEO stepping away from the business and the qualifications of Kevin Johnson.
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