As I mentioned yesterday, Starbucks’ stock was crushed at the end of last week when the company announced that its earnings would miss Wall Street estimates by 10 percent and that it was embarking on an ambitious plan to become an online retailer. In one fell swoop (I just realized I don’t even know what a “fell swoop” is), the company offered a perfect tutorial in the limitations of the restaurant business and in the perils of running a company whose stock price is overvalued.
The limitations of the restaurant business are fairly obvious. Most restaurant companies grow their revenues and profits very quickly when they’re in their expansionary phases, because new stores always bring in substantially more business than old ones. (That’s why the key number to look at when you’re trying to figure out if a restaurant company–or a retailer, like the Gap or Home Depot–is doing well is “same-store sales,” which tells you how sales are doing at stores that have been open more than a year.) But the restaurant business is also a capital-intensive business–you know, all that brick-and-mortar requires a lot of money–and it tends to be subject to natural limits, as in there are only so many Starbucks you can fit into New York City. Globalization has obviously expanded those limits, but with a company like Starbucks (which now has 2,000 stores in North America) there are serious questions about how well its brand will travel abroad, unlike, say, McDonald’s.
Starbucks’ management insists, of course, that the company is nowhere near those limits, that its core coffee business is still very strong, and that there’s plenty of room for new Starbucks in North America (where it’s going to add another 400 stores this year) and abroad. But if that’s true, then why is the company trying to create what CEO and founder Howard Schultz calls “the premier lifestyle portal on the Internet”? And why is it rumored to be trying to buy high-end kitchen-supply retailer Williams-Sonoma?
This is where the perils of having to live up to a high-priced stock come in. One important way of thinking about the price of a stock is that it conveys information about what the market expects from a company in the future. A company is worth the discounted value of all the free cash flow–essentially, operating profits minus capital expenditures–it will generate in the future. So, as Alfred Rappaport demonstrates really beautifully in his book Creating Shareholder Value, if you know a company’s stock price you can also figure out how much free cash flow the market thinks that company will generate over the next 10, 15, or 20 years.
The problem is that sometimes the market expects more than a company can deliver, and that appears to be the case with Starbucks. Before last week’s tumble, Starbucks’ price-to-earnings ratio was above 50, even though all of its restaurant peers had p/e ratios below 30 (and even those look a little inflated). In other words, investors were expecting the company to do twice as well as its peers. But even though Starbucks is a terrific place to get coffee, that doesn’t mean it was suddenly going to find a way to turn its core business into the restaurant equivalent of selling Windows or even Pentium processors.
To live up to its stock-market valuation, then, Starbucks has to become more than what it is. Unfortunately, straying from your core business is usually either a disastrous move or else just a feeble one. Schultz told analysts that the company was going to leverage its special relationship with its customers into a powerful Internet brand. But that’s the sort of flimsy reasoning upon which so many brand campaigns are built. Starbucks is about one thing: coffee. The further the company moves away from that, the fewer people will follow. It’s not Howard Schultz’s fault that investors bid his company’s stock price up so high, or that they fooled themselves into thinking that Starbucks really was different from other restaurant companies. But trying to live up to their expectations is now going to be as difficult as engendering those expectations was easy.