Starbucks (SBUX 28) is the world’s leading
purveyor of fine coffee. The universal acceptance
and affinity of people in 39 countries for the inexpensive luxury of a cup of
Starbucks’ coffee is truly amazing. The worldwide
strength of such a young brand name is unprecedented. The company opened 2,199 new stores in fiscal
2006, and is on track to add an additional 2,400 in fiscal 2007, of which 1,700
will be in the
Company-owned stores, including 11 Seattle’s
Best Coffee stores and 4 Hear Music retail stores, generated 85% of total
revenues in fiscal 2006. Licensed stores,
such as those in airports and in certain foreign countries, added 7% of
revenues while requiring little investment by Starbucks. It is notable that licensing is both the
fastest growing revenue sector of the company and the most profitable. Coffee sales in grocery stores and warehouse
clubs added 4%, while institutional foodservice sales generated an additional 4%.
Starbucks is expanding its food business by
offering warm breakfasts in 500 stores. Added
to cold sandwiches and salads at lunch, this provides a boost to sales in
existing stores. However, it also
creates some concerns. First and
foremost, will selling food dilute the uniqueness of the Starbucks coffee
experience and franchise? Will Starbucks
still seem as special if it is selling food like fast food restaurants? Or, will consumers appreciate the convenience
of getting food at the same time as their prized coffee, and spend more per
visit? Finally, food items take longer
to prepare than coffee, potentially impacting customer flow and profit margins.
Starbucks continually battles costs and has experienced
a steady decline in profit margins over the past year. A change in accounting for employee stock
option compensation was the largest factor.
Coffee and milk costs have also risen over this period. Arabica coffee beans, of which Starbucks
purchased 300 million pounds last year, accounts for 10 to 20% of cost of sales. Milk accounts for about 5% of cost of sales. Rents are rising, but have been offset by both
lower store operating expenses and lower general and administrative costs, as a
percentage of revenues. Finally, as
noted above, food sales carry lower profit margins than coffee.
To quote the 2006 Starbucks annual report,
management targets “total revenue growth of approximately 20 percent and annual
earnings-per-share growth of approximately 20 to 25 percent for the next three
to five years.” Our internal projections
are more conservative, anticipating a gradual slowing in revenue growth over
the next five years. Analyst consensus
earnings estimates for the next five fiscal years are $.89, $1.08, $1.32,
$1.61, and $1.96, respectively. Again,
our internal estimates are lower, supporting an intrinsic value estimate in the
low $30’s. The stock has declined from last
year’s $40 peak, but the P/E is still quite high, reflecting an optimistic
consensus for future growth. The company
is aggressively buying back stock. In
fiscal 2006 it repurchased 14.5 million shares at an average of $32.57 and in
the first half of fiscal 2007 it repurchased 17.9 million shares at
$33.18. It appears the company repurchased
little stock over $35, but has been very aggressive below that price.
Risks: Donut shops and fast food restaurants continue
to work on improving coffee quality, and more “mom & pop” coffee cafes are opening,
both of which increase competitive pressure on Starbucks. The financial health of the
In summary, we continue to find that Starbucks
is an incredible franchise, which will sustain growth for years to come, while
profit margins will be challenged by inflation of costs inherent in the
business.
Netflix
(NFLX $22.00) is the premier innovator in delivering
movies to the home. Currently, it
provides DVD rentals via the U.S. Post Office on a subscription basis, making
visits to the video store obsolete. Already
leading the next delivery innovation, it is piloting a program to deliver
digital movies directly to subscriber’s televisions and computers via the Internet.
Consumers have responded very positively to
the value of the subscription rental model. Netflix has experienced 153% subscriber growth
over the past three years. In most
locations, customers can receive their next movie in two business days, allowing
customers to watch up to 15 movies per month at an effective rental cost of $1.20
per movie. This is a very competitive
rate when compared to the old model, in which movie rentals cost $3 to $4 each.
The pressure of obsolescence is on the physical
movie rental store. Blockbuster, the
world’s leading movie rental chain, has closed 500 of its 5,000
Some Wall Street analysts are skeptical that
Netflix will exist in 10 or 15 years. They believe that either Blockbuster will
dominate the subscription industry, or that the industry itself will be
replaced by video-on-demand through cable companies. This overly pessimistic view is depressing
the price of Netflix stock. There are three
strengths to the Netflix business model that we believe are under-appreciated
by Wall Street. First, Netflix
facilitates the desire of consumers to watch a movie when they wish - free of
deadlines, late fees, and trips to the movie store. Second, Netflix does not have the cost of
operating physical stores and passes those savings on to its subscribers. Third, Netflix is confident it can eventually migrate its subscribers to a completely digital delivery
system. In fact, it arguably has the
best pilot effort currently available in digital delivery, called Watch Now.
This digital download service enables
subscribers to watch movies by connecting their computers to Netflix via the
Internet. While there are currently only
2,000 movies and television shows available through this service, we tested it
and the performance was very good. (In
contrast, Netflix has a 75,000 title DVD library available by mail.)
Blockbuster and Netflix have entered a stage
of fierce competition. With 5,000
stores, Blockbuster has a perceived size advantage in the short term. However, the overhead from maintaining these
stores makes it difficult for Blockbuster to compete profitably at the Netflix
price. Blockbuster is doing all it can
to drive subscriber growth, including losing money on its Total Access
plan by matching Netflix’ price. Blockbuster is willing to lose money now to
grow the number of subscribers in hopes of finding a path to profitability
later. Meanwhile, Netflix has stated
that it intends to lower prices at some point in the future, and we believe
that customers Blockbuster is able to acquire during this ultra-competitive
stage will simply switch over to the then less expensive Netflix service. The superiority of Netflix’ business model is
validated by Blockbuster’s store closures. Further, closures of local stores alienate
Blockbuster’s customers.
For 2007, Netflix projects 10% subscriber
growth to 7.5 million, revenues of $1.2 billion, and earnings per share of
$0.78. For 2008 through 2011, analyst
consensus earnings per share estimates are $.98, $1.27, $1.66, and $2.15, respectively.
While we calculate an intrinsic value in
the low-to-mid $20s, we are postponing purchases as we await further
manifestation of competitive fallout in coming quarterly earnings reports. The recent increase in postage costs will
also impact earnings.
Risks include ongoing
technological evolution, competition with movie rental outlets, and potential
competition from emerging Internet movie vendors and cable “video-on-demand.”
Steven L. Ré, CFA
David R.
Marchesani, CFA
May 17, 2007
This report contains the current opinions of the author and such opinions are subject to change without notice. It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The information contained herein is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is no guarantee of future results. Earnings projections often miss, and markets go up and down. The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.