Jun 9, 2010
Starbucks and the Art of the Turnaround
Fortune has a good article today about Howard Schultz and his turnaround efforts at Starbucks (NASDAQ:):
He started the Starbucks turnaround with what for many companies is the hardest thing to do: confessing its sins. Schultz had to tell his employees that the company had made mistakes and would pay the price by taking $600 million in costs out of the business. Part of that would come from laying off employees and shutting down 600 stores. 80% of them had been open for less than two years.
Even amid the cost-cutting Schultz refused to drop health care for his employees, a line item that tallies $300 million. That’s more than the company spends on coffee. A shareholder called Schultz and said the crisis would provide him the perfect cover to cut benefits for part-time employees. He refused, and told his investor if he felt so strongly about it he should sell his stock. (The shareholder ended up cutting his position.)
Much to the dismay of Wall Street, Schultz decided to stop reporting monthly same-store sales in an attempt to move the pressure from producing good numbers to producing good coffee. “Monthly comps are like a harness around your neck,” he says…
Starbucks’ premium image also started to backfire. “Starbucks became the posterchild for excess,” Schultz says. Consumers who had once embraced the brand’s cachet now started to view the $4 latte as frivolous and a not very smart purchase.
Today Starbucks has managed to avert crisis and is diving into new areas of growth beyond simply opening new stores. Schultz says its VIA instant coffee line, which many saw as a move of desperation, will have 37,000 points of distribution by the end of the month. The company sees a hungry market in China and India, and in the U.S. the company is pushing out its newly rebranded Seattle’s Best line.
I’ve always been pretty fascinated by turnarounds. Yes, Warren Buffett says that turnarounds often keep turning. Sometimes though, a great brand will make a misstep which kills the stock price, but can be corrected with some diligent work by management. So when Starbucks ran into trouble, I was interested.
I often tell friends that I think what Starbucks did is introduce America to casual coffee drinking. Before Starbucks, I think most people drank coffee in the mornings, before work. Starbucks really changed that by introducing beverages like frappuccinos and iced coffee drinks. But during the financial crisis, their business really came under assault. Starbucks did all the heavy lifting with introducing consumers to coffee and figured out what kinds of drinks sold well. All that was out in the open for the taking. And it was taken.
To put things in perspective, a $6 canister of instant coffee can yield around 120 cups. That comes out to $0.05 a cup. You might be able to get a tall coffee at Starbucks for $1.80. Starbucks’ management team miscalculated in expecting that their product was so ingrained in popular culture that spending habits would remain consistent during an economic downturn. McDonalds and every other major fast food chain came out with their own new brands of coffee drinks that were sold at lower price points than the ones at Starbucks. The margins on coffee are pretty high so every major chain wanted to get a piece of that market. Then, there were some customers who kept consuming coffee, but brewed it themselves.
What I find most interesting about the Starbucks case is how low it traded during the crisis, hitting a level below $8.00 per share. At that price, I estimate that the company had an enterprise value of around $6.7B (market cap + total debt – cash). If you looked backwards, you would assume that the company was trading at a really rich multiple north of 20x Enterprise Value / Free Cash Flow. But, investing is often a matter of analyzing what cash flows will be like in the future.
Here is where the Starbucks story really improves. When the company was growing their store count, capital expenditures were quite high. They had to be to cover the expansion costs. By slowing down store expansion rates and closing newer underperforming stores, capital expenditures were slashed by more than half. Accordingly, FCF tripled (from $274M in 2008 to $943M in 2009), meaning you could have purchased SBUX at only 8x. Getting a double digit free cash flow yield on a world class business with a great brand is a good opportunity.
So far, Schultz has helped improve Starbucks. The company is in much better shape than before and there are new opportunities for growth such as new supermarket lines like Via which require only a fraction of the capital expenditures as store expansions. These kinds of offerings also leverage the already established brand, keeping it fresh in the minds of consumers. I highly suggest his book () to get an idea of how the brand was built and how a great entrepreneur operates.
So what is the lesson here? As an analyst you need to look at businesses as if they are organisms. They aren’t these static beings, frozen in time. Looking at Starbucks during that one slice of time in the crisis would have been scary. With the heavy capex required to keep up the pace with new store openings and the decreased sales, the business looked bad — especially if you were using a short term perspective like most sell side analysts. But if you looked at the business as something truly variable, you could have sat down and modeled out what would happen if things like the pace of expansion slowed down. Or if new stores were closed.
Performing this kind of sensitivity analysis is highly useful and should be done whenever you analyze a potential investment. That is the kind of thought process used by most activist investors think and it is incredibly useful for analyzing businesses that are in turnaround mode. Obviously, you need to also look at what the management team is committing to doing during the turnaround. If Starbucks didn’t plan on closing underperforming stores, that would severely handicap your lower capex scenario. But because they did, that particular scenario would gain a greater likelihood of occurring.
Whenever there is widespread market turmoil, even great businesses will see their stock prices decline. When that happens, you need to keep your head above the crowd and look out at what the business is capable of doing versus what it is currently doing.