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1 Thing Starbucks Absolutely Has to Fix

Sunday - 3/24/2013, 12:00pm  ET

It's an understatement to say that Starbucks has been doing some things right lately.

Valued at below $10 a share right after the financial crisis, the coffee champ posted a blockbuster recovery in a business that Wall Street had just about written off. Investors who held their shares were rewarded for their faith, though. The stock is now near $60 a share -- up more than 500% since early 2009.

Here are a few examples of the stunning rebound in operating metrics that fueled Starbucks' great run:

  • Profit margin: Since hitting a low in 2009, operating profit margin has more than tripled to more than 15% now. That's a better than 10-year high for the company.
  • Comparable sales: After posting a 6% drop in comparable sales in 2009, growth has returned to Starbucks -- with a vengeance. The company logged a 7%, 8%, and 7% increase in same-store sales for 2010, 2011, and 2012.
  • Operating cash flow: Starbucks is now swimming in cash. Annual cash flow has doubled in five years, climbing to a rate of more than $2 billion per year.

However, there's one number Starbucks hasn't managed to improve at all over the past three years. And it's something that the company absolutely needs to fix if it wants to keep the great run going.

Feed me
We're talking about food.

Take a look at Starbucks' food sales as a percentage of the company's total sales for the past three years.

Item

2012

2011

2010

Food

19%

19%

19%

Source: Starbucks financial filings.

Beverages account for the lion's share of Starbucks' sales. And after ticking up by 1 percentage point in 2009, and by another in 2010, the fraction of sales that Starbucks gets from food has been stuck at 19%. That's not too surprising, considering the limited food options available at most locations.

And that's too bad, because food could drive major growth at Starbucks. For an idea of that growth potential, take a closer look at Panera's results. The baker clocks weekly sales of more than $45,000 for each of its bakery-cafes, boosted by a healthy midday business and super-high check averages. And its large food menu has helped ignite comparable-store sales increases lately. For example, last year Panera's menu mix changes added 3% to the company's sales growth.

It makes sense, then, that Panera is encouraged by its expansion into more of what you might consider restaurant-level food. The company has doubled down on those heftier food choices and has just added a new line of pasta options to its menu.

Of course, Starbucks isn't blind to the potential that food brings to its business model. That's one reason the company shelled out $100 million in cash last year to buy the La Boulange bakery brand. A Starbucks executive said at the time that the new brand would "help us expand day-parts, drive customer loyalty, and ultimately grow the overall business."

Still thirsty
Sure, drinks have always been Starbucks' strength, and that's not likely to change anytime soon. But one reason the company needs to broaden its menu is that the competition over coffee dollars is fierce. And it's leaving less room for sales growth in the category.

McDonald's , for one, credited premium beverages such as the new Chocolate Chip Frappe for helping drive revenue growth last year. The fast-food giant plans to keep leaning on its McCafe lineup as a big part of its growth strategy for 2013. And Dunkin' Brands pointed to "strong beverage sales growth" at its Dunkin' Donuts stores in the U.S as a major reason for the sales spike it booked last year.

Yes, Starbucks will need to continue fending off those rivals in its core drinks business. But it's clear that the beverage business can't power big sales growth on its own. 

Looking ahead
The company has started testing a deeper food menu by adding La Boulange options in some of its Northern California stores. CEO Howard Schultz said the results were strong so far, calling the food "significantly better than what we have right now, candidly."

That's a good sign, and it means that the likely next step will be for those menu options to be rolled out nationally. That should help food finally climb to a higher percentage of Starbucks' sales, potentially boosting revenue and profitability at the same time.

Get your fix
One of Starbucks' newest competitors, Green Mountain Coffee Roasters, is cheaper than it's ever been. And many investors are wondering whether this is the end of the former market darling or the perfect entry point for an enormous rebound. You can find our recommendation for how to play the company in our new premium research report. In it you'll find everything you need to know about Green Mountain, including whether it's a buy at today's prices. Click here for instant access.

 
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