Friday, August 1, 2008

How to Save Starbucks, or, "It's the economy, stupid"

Today is the birthday of the first great American novelist, Herman Melville, and in honor of his masterwork, Moby-Dick, I'm going to write about Starbucks. (If you do not, alas, understand the connection, then our public school system has failed you. Click here.)

Starbucks is off 28.2% for the year. Its nearest competitor, McDonald's, has managed to eke out a 1.5% gain for the year, which ain't too bad in this market. Starbucks, for its part, has announced it will close 600 underperforming stores, and the costs associated with that move led to the company's first quarterly loss, posted yesterday. The red ink, which came amid a $200 million increase in revenue, amounted to a nearly invisible $6.7 million -- more symbolic than anything else.

Wall Street's open for business every weekday. It picks up on symbolism and it doesn't take much of it to give investors a reason to sell, especially these days.

There is a very simple reason these shares are down. Management hasn't figured out how to respond to softening consumer demand, and investors have lost faith. Starbucks executed its explosive growth well -- and investors who have held shares for 10 years have done pretty well -- 25% annualized returns. But the company hasn't been able to stay ahead of the day-to-day macromanagement curve.

Now, I'm willing to give credit where it's due. The store closures were a painful defeat, but they were a good move. An executive shakeup that's in the works already may prove worthwhile, too. And efforts to reduce nonstore headcount by 15% is also wise. The jobs section of Starbucks' Web site lists no open executive positions. That's good.

But if this is the entire turnaround plan, Starbucks is screwed. As smart as these moves may be, they can only be considered a good start -- they just don't go far enough.

Since 1998, Starbucks investors have seen per-share earnings and revenue increase an average of 25% a year. To accomplish that this year, Chief Barista Howard Schultz needs to add $2 billion to the top line. So that $200 million revenue bump was really only 40% of what was needed.

Bloomberg says analysts are forecasting per-share earnings of 74 cents. That would be the fourth year in a row earnings growth has slowed and would translate into a more-than-symbolic loss: It would mean earnings declined more than 15%. That's why Starbucks shares are already down more than twice the S&P 500.

Starbucks executives clearly need to do more, because even despite its abysmal performance year-to-date, Starbucks still has a lot of room to fall. Its earnings multiple, at 19, is still higher than McDonald's, which is kicking ass even as Starbucks gets its kicked. I don't think that Schultz is really in touch with what dramatically increased energy and food prices are doing to consumers discretionary spending. He says the store experience is paramount and he won't compete on price.

Here's what he said in a conference call yesterday after one analyst asked about some kind of value or combo pricing:

"We have no intention of doing things that would dilute the integrity of the premium position that Starbucks occupies, and what I mean by that specifically is we are not going to go down the fast food lane and do things that are what I believe not in the interest of, long-term interest of the value of the brand and the experience. We’ve been testing a number of initiatives in many markets over the last I’d say two months or so, and some of those initiatives are proving to be interesting. We’re gaining as much insight as possible but you are not going to see us bundle product in a way that would be consistent with fast food."

This will be Starbucks downfall. If Schultz can’t grasp that high prices are in no way part of the vital Starbucks experience, then he needs to step aside and let someone else save the company. A chief executive, trial lawyer or general must know that all options are always on the table.

If customers are coming in because of high price, you can't just wait until they can afford to come back in on their own, because they'll either find someplace else to get a similar experience, or they'll realized they can live without you. Those sorts of problems can impact annual revenue, not just quarterly results.

Here's my take on righting the Pequod:

Refine the mission.
The Pledge of Allegiance has 31 words. Starbucks mission statement has 109. Customers aren't brought up until the sixth sentence. Profitability is the last thing mentioned. The current mission is all about playing nice and making great coffee. Well, bullshit. To quote Bob Sugar, "This ain't sho' friends, this is show business." The new mission should be three words: Sell more coffee. Everything else will take care of itself. It's already part of the corporate culture anyway.

Cut costs.
McDonald's and Tim Horton's operating margins are 24% and 20%. Starbucks is 10%, half what it ought to be. Reducing headcount and closing stores will help a lot here, but I say turn up the thermostat two degrees and cut part-timer's benefits if that's what it takes to turn a bigger profit. Again, everything has to be on the table.

Announce a buyback.
Starbucks shares are a bargain! Well, maybe not. But putting your money where your mouth is can make people believe that. Starbucks could tighten its cash conversion cycle and use come of the $280 million in cash it has on hand to buy back shares. Wall Street tends to like this, and in the long term it can do a lot to boost earnings. SBUX has 700 million shares out. It could buy back 1% of those with no sweat.

Focus on revenue.
This is the most important, and it means cutting prices. Then, advertise it with no fine print. Then consumers think: "Whoa! You're cutting the price a buck? Hey, that's a good value! I get the Starbucks experience for a reduced price? You know, I haven't been there in a while -- a little short on folding money there days -- maybe I should drop in. Everyone else is raising prices."

Coffee is a volume business. I'm no expert in economics, but I'm pretty sure that I'd rather sell 1000 lattes for $3 than sell 200 for $4. Also, if I feel like I'm not getting hosed on the coffee, I'm more likely to buy a slice of that lemon pound cake.

If Starbucks really, really can't stomach an actual price cut, then it should use its rechargeable Starbucks cards to create some sort of value. Buy a $100 card, get $125 worth of credit, that sort of thing. These cards are very popular. And -- to be fair -- Schultz did hint about this in the conference call.

Starbucks needs a major shift in managment thinking to focus less on experience and more on revenue. Revenue is the rising tide that will lift all boats. If people aren't coming the the store because the prices are too high, then experience isn't just moot, it's nonexistant.

Mr. Starbuck questions the captain's judgment in Moby-Dick. It's time for Starbucks' board to do the same with its captain. Admittedly he has made some good steps. But I fear Schultz thinks he has had the entire vision. Until price is no longer sacrosanct, he hasn't.

And Schultz shouldn't be so quick to disparage fast-food. Their stocks are doing better, their sales are higher, their earnings are stronger and, in the case of McDonald's, they're taking your market share. Oh, and how are they doing it? Offering the McDonald's experience, or some such pretentious bilge? No. Turns out they're selling premium coffee at a reduced price point. Pretty smart. Take a lesson.

1 comment:

Mike Walden said...

Your blog has become a part of my daily reading routine. Keep up the great work!