More Worries Concerning Starbucks' Growth Prospects

Thursday's Wall Street Journal featured a front page piece about Starbucks.

The article focused on Starbucks' growth prospects. Some passages from the piece stated,

"More broadly, Starbucks's recent attempts at expanding its brand have had mixed results. While its strategy to sell music has been a hit with customers -- baristas recently gave customers free songs from iTunes with their coffee -- the films it has promoted in stores have had only minimal box-office success. Some analysts say the chain has fallen behind on creating enticing new beverages and its breakfast sandwiches have created little excitement.

Chairman Howard Schultz has said that, throughout the company's history, outsiders have questioned the company's growth potential, and that he's always proved them wrong.

What has investors worried is that for the past two quarters the growth in transactions per store in the U.S. has been flat after climbing for several years. Same-store sales, which measures sales in locations open at least a year, have hovered in the mid single-digit range, after years of growing at a high single-digit or double-digit rate each quarter.

Much of that may not be Starbucks's fault. Pressures on consumer spending haven't made it any easier for Starbucks to increase sales, particularly because Starbucks's customer base has gradually broadened to include Americans with lower average incomes, a group more likely to cut back. This summer, a spike in dairy costs caused the company to implement its second price increase in less than a year. And competition has intensified: McDonald's Corp. has bolstered its coffee offerings and plans to add lattes and cappuccinos to thousands of U.S. stores next year.

At Starbucks's annual meeting in March, Mr. Schultz told how, when the company went public in 1992, an analyst wrote a report doubting the company's prospects.

"The analyst headline, which was picked up by a newspaper, said, 'This dog won't hunt,' " he told the audience. In those 15 years, Starbucks market capitalization went from $250 million to $24 billion. "I had it in my desk drawer for many, many years," he said. " 'This dog won't hunt.' ""

To me, the most telling sentences are those in the fourth paragraph which I have quoted from the article. The company, in order to sustain growth over the past few years, headed down market. Now, those less-wealthy customers are being more affected by recent economic events, including prices of gasoline and food, while even Starbucks' ingredients' price rises are driving them to increase prices, too.

Lastly, McDonalds and Dunkin Donuts, both of whom no doubt count the newer Starbucks customers as their targets, as well, have taken aim at the Seattle coffee giant. All of this is right out of Joseph Schumpeter's theory of creative destruction. Starbucks' own success has brought it into tertiary markets, drawn competition, and simply pushed its business model to the brink.

Then, after Starbucks' announced earnings on Thursday, after the Journal article ran, Friday's Journal noted,

"Shares of Starbucks were down 7.5% in premarket action, after the company said traffic in its stores fell for the first time since the company started keeping this figure. Also, the coffee shop giant reduced its earnings and same-store-sales-growth estimates for the coming year, despite a 35% increase in profit for the third quarter. The stock was one of the most actively traded in premarket action, according to Nasdaq, trailing just the Nasdaq-100 and S&P 500 tracking ETFs."

I guess this would seem to begin to confirm that Schumpeterian dynamics are, at last, at work at Starbucks. Same-store sales is no longer growing. Eventually, despite Schultz's ire at the early, wrong prediction that Starbucks wouldn't grow and prosper, it had to eventually hit a wall. And now it seems it has.

The nearby Yahoo-sourced stock price chart for Starbucks and the S&P500 for the past five years confirms that the company's total return has not consistently outpaced the index. Now, its return has almost fallen to the level of the index.

Music and films might provide some small added growth, but coffee is still the company's main product line. If their music and films flopped, but their coffee remained strong (pun intended), they'd probably remain in good shape, if not enjoying robust growth. But if their music and film sales shot up, while their coffee business sagged, they'd be finished.

At least they are only suffering a lack of growth in the coffee business, rather than outright declines. Their recent quarterly sales growth figure was 22%. However, as the dynamics of that growth shifts to new outlets, from older ones, everyone realizes that their core markets must be fairly saturated now. And new growth will be more expensive, infrastructure-related.

In the end, Schumpeterian dynamics catches up to every business that I've ever studied. Every one of them. It's usually the hubris of the CEOs which keeps companies from acknowledging this fact. And Schultz's stubbornness in the face of the quantitative evidence suggests that maybe, now, he is in that situation.

The company's stock price shows that investors, however, are more sanguine. This stock price chart, covering Starbucks and the S&P500 Index since 1992, show a clear plateau in total return performance over the past two years.

The company has had a tremendous run of building shareholder value at a pace which outstripped the S&P500 index for years. But 15 years is a long time, and that era is now over.