Starbucks Bear's Den
by Rick Munarriz ([email protected])

Pardon my bout with nostalgia this week. This Duel takes me back to when I was a knee high, gathered 'round the living room television set watching Battlestar Galactica with the family. It's Starbuck, in outer space. Of course, the only difference between the flying ace Starbuck then and the space shot valuation of Starbucks today is that the earlier version was science fiction.

Today, even after recent weakness, shares of Starbucks are strung out in a caffeinated bliss and it's all real. With the company expecting to earn between $0.89 to $0.94 a share this year, and the stock perched at $43 recently, is a company showing slowing growth really worth almost 50 times earnings? Two weeks ago in his "Fool on the Hill" column Dale Wettlaufer broke down the numbers and predicted that it was bound to tumble. As luck would have it, I see this only as the beginning.

I won't deny the genius of CEO Howard Schultz. I think the company's savvy business practice of collecting the overpriced ransom before they hand over the mind-awakening drug is nothing short of masterful. It just wouldn't work the other way around.

One also has to consider that commodity-based companies, even those that sugarcoat that fact with hardwood floors and fancy storefronts, are victims of their own growth. While I don't think Starbucks will alter worldwide coffee bean prices, in theory any growing chain is also expanding the demand for the commodity it sells. By nurturing the addiction it is swelling demand beyond its own shops. Can supply keep up? If not, are patrons willing to pay more for what they are already overpaying for?

The sad truth is that while we may never tire of the basic two-bit cup of black coffee, we will eventually tire of the expensive coffee bar fluff. It's a cyclical curse of our fickle culture. Or has it already run its course? Starbucks has grown by icing down the hot java with Frappuccino and branded ice cream at the retail supermarket level. Seeing as Bill didn't think much of Dreyer's <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DRYR)") else Response.Write("(Nasdaq: DRYR)") end if %> in last month's Planet Hollywood <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PHL)") else Response.Write("(NYSE: PHL)") end if %> Duel, I didn't think he would be two-faced to the point of praising the initial success of Starbucks and Dreyer's teaming up. Either way, that's pretty much as far as you can milk the quality name of Starbucks. Sure, new coffee variations and Tiazzi may replace sales of older products, but the elasticity of this rubber band has been stretched far enough.

Good show, but now that the product lines are peaking the competition is coming from unlikely sources. Just last month 7-Eleven of all places began rolling out its own Coffee Coolers. I don't pretend to think that a convenience store with a "No Loitering" sign out front can compete with the costly digs of a coffeehouse that doesn't need to wrap purchases in brown paper bags. But with java Slurpees now sold everywhere else, 24 hours a day, it has to stun any kind of pricing flexibility Starbucks may have had on a once unique product. If the average Starbucks junkie who makes 18 monthly visits substitutes just one of those trips with a half-priced competitor, it matters. Starbucks is also being threatened by another fierce competitor: itself. Moving to sell its roasted brew at the retail level, at a fraction of the in-store take, is a percolated disaster in the making.

Last year, with the advent of Frappuccino, same-store sales were robust, growing in double-digits. Earlier this year, same-store sales slowed to single-digit growth and were shrinking. In June, we saw just 4% growth, then last month only a scant 2% gain. In the best case scenario, the comps will flatten now that just about every possible use for a coffee bean or add-on impulse item has been exhausted. That puts the burden now on unit growth, and there is only so much real estate to go around. Even if the chain opens 400 new stores over the next year, that is just a 22% increase from the 1800 already in existence -- and the operating trends are clearly in a state of deterioration.

This is a Three Stooges film festival with just Larry, Curly, Shemp, and Curly Joe. There's no Moe. The Moe-mentum is gone, and with slowing growth and earnings there is no jolt of caffeine that is going to win back the investors who are looking for a high-octane kick elsewhere. Nyuk, nyuk, nyuk.

Naturally, the bulls are excited about the prospects of international expansion; they hope that if the company opens 1000 stores overseas in five years the world will belong to Starbucks. How pompous! It's one thing to think that we as Americans can successfully export burger chains and soft drinks. It's indigenously righteous. But has anyone bothered to realize that the words cafe, latte, espresso, cappuccino -- they're imported.

Other domestic "can't miss" retailers like Wal-Mart <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMT)") else Response.Write("(NYSE: WMT)") end if %> and The Gap <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GPS)") else Response.Write("(NYSE: GPS)") end if %> have had hard times duplicating their stateside success overseas. To think that the international market will be in awe of an American chain selling Brazilian bean brews with European names is as egotistical as it is naive. The company expects the limited overseas presence, which is just over 100 units today, will be dilutive this year and next. The chain will succeed in niche markets but certainly not without growing pains along the way -- and in the process hosing down the optimists with more realistic growth expectations and a market saturation date that is closer than one might believe.

I may be bearish on McDonald's <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MCD)") else Response.Write("(NYSE: MCD)") end if %>, but at least I recognize its role in suburban America. But Starbucks? Will people who expect to pay $0.99 for a burger pay $2 for a cup of frilly Joe? No, I think that's why Starbucks is confined to the densely commerce-populated metropolitan markets where its stores are already overexposed.

Call your broker. Can your barista. I don't care if Dirk Benedict, the actor who played Starbuck on Battlestar Galactica, eventually wound up on the A-Team. All I know is the great actor who played his father, Lorne Greene, wound up pitching Alpo. So, if the question on the table is whether this is an A-grade investment or a dog stock of the future, I would have to think back yet again to my syndicated youth, watching reruns of Father Knows Best.

Next: The Bull Responds