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Why Starbucks Has Room to Improve


Be critical before buying.

From buy upgrades to the 150% it's gained over the last year, investors have bought into Starbucks' (SBUX) rebirthing story. But CEO Howard Schultz's comment in this week's quarterly conference call -- "I think we still have a lot to prove, these are still early days" -- should not be taken lightly.

Starbucks is finally not just talking about change, but showing signs that change is working. For the first time in eight quarters, the company posted positive comps. In fact, all US company-operated store regions reported positive comp growth.

Recovering from exaggerated over-expansion, Starbucks has done an impressive job restructuring itself and returning to profitability. Shuttering stores and slimming down its workforce over the past year, the company eliminated excessive waste in the business model.

The effects were remarkable. In the first quarter the operating margin grew 850 basis points, helping the bottom line more than triple from $0.09 to $0.32.

I applaud Starbucks for executing such an impressive operational turnaround and recovering from such over-expansion. That said, price increases significantly contributed to the comps increase, with traffic up just 1%. While price increases and operational restructuring can lead to impressive short-term improvements, neither methods are sustainable.

In order to generate future growth, Starbucks needs to increase store traffic. Plain and simple.

Howard Schultz stated that "Starbucks today is a better and stronger company than it has ever been and I am more optimistic than ever about its future." I find it hard to truly believe this statement. Starbucks is better and stronger today than it has been in years, but not in its entire history. The comment has a tad too much of an entrepreneurial feel for my taste.

But then again, Schultz seems to still view his company as a growth company, which can be both good and bad for Starbucks.

On the one hand, the company's innovative nature has allowed it to capitalize on the social networking phenomenon, as Starbucks is the most popular brand on both Twitter and Facebook. And of course, Starbucks even has an iPhone (AAPL) application. Technological media is expected to be the future of marketing, giving Starbucks an edge with its marketing strategy.

On the other hand, I'm hesitant to believe in some of the new growth avenues Starbucks is going after. Specifically, the new 15th Avenue and Tea initiative and the instant coffee market.

Green Mountain Coffee Roasters (GMCR) already has a strong foothold in the luxury at-home coffee market. And I question how competitive Starbucks will really be against existing dissolvable coffees like Folgers and Taster's Choice. My understanding is that the major audience for instant coffee is typically older folks who may not be over-the-top excited to try a hip brand.

As I stated both today and after last quarter's earnings report, I do question some of Starbucks' initiatives. And at 21 times forward earnings, the company is far more expensive than one of its biggest coffee rivals McDonald's (MCD). However, Starbucks likely has more growth potential than the fast-food behemoth and while risky at this price, I'm willing to hold onto my shares and bet that Starbucks has what it takes to generate the growth currently priced in.
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