Grounds for Concern at Starbucks

MAY 3, 2011   THE WALL STREET JOURNAL

By JOHN JANNARONE

The consumer recovery is still sleepy, but many investors are using Starbucks to power through.

After suffering a backlash from overexpansion last decade, the Seattle coffee chain's stock is within a whisker of an all-time high, trading at 25 times consensus earnings for the September fiscal year. One reason for the recent rally was Starbucks's move to regain control of products such as coffee beans sold outside its cafes, a venture previously managed by Kraft Foods. And a deal with Green Mountain Coffee Roasters will give Starbucks exposure to single-serve K-cups, by far the fastest-growing segment of the U.S. coffee market.

But even with those new growth sources, investors need to count on stability at the company's U.S. retail stores, which account for about 70% of revenue. Benchmark coffee prices have more than doubled in the past year, yet the company last week said it was "extremely cautious" about price increases in cafes. That contrasts with its approach to bagged coffee sold in U.S. grocers, where it announced in March a 12% price increase.

Certainly, coffee inflation is less threatening to Starbucks at its cafes. Morgan Stanley's John Glass estimates raw coffee costs reflect just 7% of the sale price of a typical drink, compared with a far higher percentage for bagged coffee. But a few percentage points of cost inflation could still eat into margins.

Indeed, Starbucks said on last week's investor call that customers have been sensitive to the total check size when visiting cafes, especially given broad commodity inflation. David Palmer of UBS points out that some fast-food chains have encountered similar issues when consumers balked at rising prices for "value" combination meals and instead chose cheaper items individually.

And some Starbucks customers may be especially sensitive to price changes. According to a Morgan Stanley study of people who drink coffee at least once a week, the average Starbucks customer earns more than $75,000 a year, but some 17% earn less than $30,000.

That means cafe sales growth will depend heavily on attracting traffic, which can be challenging. Starbucks has tried to draw customers into its cafes with new products such as food and brewing equipment, but coffee is still the key. Beverages have accounted for about 75% of sales at company-owned stores for the past three fiscal years.

Starbucks was wise to seek growth in consumer products and single-serve coffee. Given the power of the Starbucks brand, both businesses have enormous potential. Meanwhile, prospects for healthy store additions overseas are another sweetener. But the dominance of the domestic cafe business means Starbucks is still a bet on surging commodities not squeezing its customers—or its own margins.

Write to John Jannarone at john.jannarone@wsj.com