Something Good Is Brewing at Starbucks

STARBUCKS SPARKED A premium-coffee revolution, which now threatens to devour the world's largest coffee-house chain. With Dunkin' Donuts, McDonald's (MCD), the local deli and even Target (TGT) getting in on the act — and that's just a partial list — Seattle-based Starbucks (SBUX) has found itself saddled with rising costs, declining revenue, a sinking stock price and customer fatigue. The crisis has returned founder and Chairman Howard Schultz to his role as CEO, with an imperative to "significantly differentiate" Starbucks from a whole latte competition.

Schultz, 55, is answering customers' calls for healthier dining options with a revamped menu that includes oatmeal and fruit smoothies. He's taken steps to enhance the "coffee experience" at Starbucks cafes, while promoting the company's social-action endeavors at home and abroad. And he's cutting stores and costs in the U.S. while stepping up international expansion. "We have the resources and the tools to execute on a well-thought-out plan," Schultz told Barron's in a recent interview.

So far, Wall Street isn't even nibbling on the story, especially now that a sour economy threatens to make a Caramel Macchiato a capital expense. Starbucks shares have plummeted more than 60%, to a recent 15, from a peak of 40 in November 2006, and show little sign of regaining their buzz.

Yet, investors may be too dismissive of Schultz and his company, especially in view of Starbucks' history of innovation and growth. A year from now consumers may be feeling richer, and Starbucks will be running smarter. The combination could help lift the shares by as much as 20% to 30%.

"There's a lot more upside than downside" to the stock, says Scott Chapman, a partner and portfolio manager at Lateef Investment Management in Greenbrae, Calif., which started buying Starbucks shares a few months ago. Chapman thinks the company will benefit from the recent decline in oil and gasoline prices, among other things.

Starbucks' income from operations shot up 18% in the fiscal year ended September 2007, to $1 billion, or 87 cents a share. In fiscal '08, however, the company's good fortune reversed. Analysts estimate income from operations fell 18%, to $866 million, or 75 cents a share, on revenue of $10.5 billion, though net income will be substantially lower, reflecting the impact of charges taken to close stores and lay off workers.

In fiscal '09, which is about to begin, the charges will continue, though the Street forecasts income from operations will rebound to 89 cents a share, just shy of management's estimated range of 90 cents to a dollar. Based on '09 forecasts, the shares sell for 16.7 times earnings.

Schultz & Co. thinks Starbucks' earnings could climb to $1.10 to $1.20 a share in fiscal 2010, and to $1.35 to $1.50 in 2011. Using the midpoint of those ranges, management expects profit growth of 20% to 27% in each of the next three years.

If Starbucks earns 95 cents a share this year — again, the midpoint of management's range — and can increase earnings by 20% in fiscal '10 and '11, it would earn $1.37, Lateef's Chapman notes. Applying a price/earnings multiple of 17 — a modest discount to the company's growth rate — would yield a stock price of 23 a share, 50% above today's price, he says.

It is unusual that a company undergoing dramatic change and facing such strong economic headwinds would issue specific financial targets. That could mean Schultz sees a lot of low-hanging fruit ripe for the picking, given Starbucks' pell-mell expansion since it came public in 1992. That year the company had 127 stores. Today it has 16,548, and is a seemingly ubiquitous presence in many cities.

"We felt it was important to provide shareholders with as much transparency as we had," Schultz says of the company's earnings guidance. Citing the quiet period before its next earnings release, scheduled for Nov. 10, he declined to comment on whether the turmoil in the financial markets would force management to revise its earnings targets.

Analysts like Colin Guheen at Cowen & Co. have been less reticent. Guheen cut his fourth-quarter earnings estimate last week by three cents, to 13 cents a share, and lowered his fiscal '09 forecast to 87 cents from 90 cents, blaming higher costs tied to the turnaround.

Starbucks opened its first store, in Seattle's Pike Place Market, in 1971. But it became a national phenomenon only after Schultz acquired the company's assets and set out to transform America's coffee-house culture along the European model. Transform it he did, dotting the landscape with Starbucks cafes that sold richly flavored java and coffee-based drinks, many at rich folks' prices. Revenue soared, along with the company's shares, which split 2-for-1 five times in the past 15 years.

The magic ended in fiscal '08 for a panoply of reasons, including Starbucks' poor real-estate decisions and a surge of imitators who successfully improved their coffee offerings. Starbucks' revenue likely grew 11% in the past 12 months, versus 21% in fiscal '07, and is expected to increase just 4% this year. Sales at U.S. stores open more than a year, which grew between 3% and 11% from fiscal 2005 through fiscal '07, now are falling 6% to 7% a quarter, according to JPMorgan.

At the same time, costs have expanded and profit margins have shrunk. Retail-store operating expenses as a percentage of retail revenue are thought to have jumped to 43% in fiscal '08, up three percentage points from the prior year. Operating margins hit a low of 16% in the latest quarter — attractive by some standards, but not those of Starbucks, which boasted margins as high as 22% at the start of fiscal 2007.

The source of the problem is Starbucks' U.S. stores, which account for almost 80% of revenue. In the latest reported quarter, U.S. retail revenue grew 6%, to $1.9 billion, but operating margins shrank to 8.6% from 13.8% a year earlier.