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Are There Grounds for Starbucks' Demise?

Ann Gilpin

Ann Gilpin: Hi, I'm Ann Gilpin. I'm an equity analyst at Morningstar on the consumer team and I'm here today with RJ Hottovy, our Starbucks analyst, to talk about the pros and cons of Starbucks. Thanks for joining me, RJ.

R.J. Hottovy: Thanks for having me.

Gilpin: RJ, Starbucks has been a controversial name. It's been in the news a lot and a lot of people have a very negative view about it. Starbucks has changed a lot over the years, and I think the way it looks right now is it's essentially a fad stock. You've had a lot of growth and that has really halted. There's a lot of competition in the space right now, especially with the recession. Consumers are looking to make their coffee at home. Folgers's sales have been really good, and also you've seen some competitors like McDonald's ramping up their McCafe selection.

Can you talk about what's going on with Starbucks right now and why is it having so many problems?

Hottovy: I think a lot of your concerns are overblown. Honestly, I think Starbucks is a name that's still going to be around 10 years from now, 20 years from now. I think it's got a lot of compelling growth prospects. It's probably not going to reach the growth rates that it had over the past decade. I think that is pretty unrealistic. But I think the company can establish a more modest but still solid growth trend over the next couple year. What I focus on is it has still got a strong brand name, structural advantages in the form of excellent real estate, and just generally a product that people want to pay up for.

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Gilpin: What about what's going on with McDonald's? Their same store sales growth has been pretty healthy, mid-single digit growth, and they're rolling out the McCafe selections and Starbucks isn't growing as much. You said they're not growing as much as they used to. Their there competitors are growing faster, so doesn't that seem to suggest that Starbucks is losing market share?

Hottovy: I think there's some truth to your argument that they are losing market share. Again, the timing of McDonald's rollout was perfect, rolling out a slightly lower-cost product in an environment where consumers aren't willing to pay for a premium brand. Certainly there's going to be a trade down, and they're probably losing a modest amount of market share. At the same time, I look at the products as two different things. At Starbucks you're not just paying for a cup of coffee, you're paying for an in-store experience.

The management team there describes it as a "third place." It's a place outside of the home. It's a place outside of work. It's a third place you can go to for recreation and get some work done. I really think that consumers are willing to pay up for that. I just think there's an audience out there that no matter how cheap or how good the product quality that you see at McDonald's or its competitors, they're still going to go to Starbucks.

Frankly, when was the last time you saw someone at a McDonalds using a laptop getting work done?

Gilpin: Well, that's true. But I think the third place, or this idea of a third place, is really kind of dead, and I think Starbucks has kind of admitted that by their own concession. They're closing a lot of stores, and even CEO Howard Schultz has said that their over-extension and their growth has kind of watered down this third place experience. So I don't think that really holds now.

Hottovy: Yeah, I think that Starbucks is probably guilty of a little bit of over-expansion over the past decade. Certainly going from 1,000 stores in the early '90s to close to 12,000 stores now, a lot of growth there. But at the same time, Starbucks became such a popular brand right away that they were getting great rates from retail landlords. I think, given that, that they had every excuse to grow as fast as they can.

Now I think they're realizing it's probably a bit over expanded. But at the same time, I think that store closings are a prudent move on their part to rationalize their cost structure. I think once they realign the store base, I think they'll be very successful.

And really, I look at the store closings as just a general theme that we're seeing across the board in retail, and I think it will serve them well.

Gilpin: It seems like management is the major problem, even though most retailers today are dealing with this off top-line or maybe trying to reduce their rent expense. Not every retailer is having the same problem with management. Starbucks has had what, three CFO's in 18 months? The eliminated the COO position. Howard Schultz has had his own problems. Don't you think management is a problem here with Starbucks?

Hottovy: It is a concern. Certainly they've had a couple of missteps over the past few years. I think that a lot of the recent negative results that we have seen for the company are partially attributable to that management team. At the same time, I think the management team they have in place right now is a solid team. And really what I think is the highlight is that they really focus on product innovation.

Again, looking at what they have done over the last couple quarters between rolling out a healthier breakfast menu, Vivanno fruit smoothies, and even more recently the instant coffee initiative Via, not all these things are going to work, but at least they're taking the proactive stance and not just sitting back waiting for the recession to take out results here.

I give them credit for trying a lot of new things. And again, ultimately not everything is going to work here. But at the same time, there were a lot of concerns when the company first rolled out cold drinks and Frappuccinos. And again, that has become one of the most successful things for the business.

Gilpin: Well I think there are a lot of headwinds that they still have to deal with, even if the economic environment stabilizes. And I think it's pretty clear that there is a wide range of outcomes for the future of Starbucks.

Hottovy: It's a high uncertainty name for us and it's a name that we would wait for a bigger pullback in the stock price to be a better opportunity for a buy here. Our fair value on the stock is $15, which is pretty close to where the stock is trading right now. But again, it is a name I still think has some long-term growth potential.