Is a Turnaround Brewing for Starbucks?

Starbucks (SBUX) founder Howard Schultz returned to the job of chief executive at the beginning of 2008, just a month after the start of the most brutal recession in decades. That's hardly the ideal time to turn around a troubled company.

But the latest results from Starbucks, released July 21, are raising hopes that Schultz might be making progress.

Earnings for the coffeehouse chain beat Wall Street expectations, mostly due to cost-cutting, one of Schultz's key initiatives. Responding to complaints that Starbucks grew too fast, he put the brakes on the chain's growth and closed 676 U.S. stores. The firm has cut other costs, too, saving $370 million in the last nine months.

In response to complaints the company had lost touch with its original mission—providing customers with a pleasant environment and a tasty cup of coffee (rather than, say, selling CDs)—Schultz made a number of changes.

At least according to Starbucks' internal metrics, those changes are working. In the last six months, Schultz told analysts, the chain's measures of customer satisfaction have improved, including ratings of employee friendliness, beverage taste, and speed of service.

Same-Store Sales Results Improve

Starbucks also launched an advertising campaign last quarter, while experimenting with new ideas, including a new prototype store in Seattle and a line of instant coffee.

Starbucks' same-store sales still fell 5% last quarter compared to the year before, a sign of the economic distress facing its customers. But that's better than the 8% decline experienced the previous quarter.

Improving sales trends are welcome at a time when the economy remains mired in recession. In a July 21 note, Oppenheimer (OPY) analyst Matthew DiFrisco noted Starbucks' "sales momentum throughout the quarter bucks the trend being reported by the majority of restaurants."

All this news—profits, cost-cutting, and sales trends—sent Starbucks shares 18.4% higher on July 22.

Yet it would be premature to say Schultz has turned Starbucks around. Starbucks shares are still 14% below their price at the beginning of 2008.

"There's no victory lap going on at Starbucks here. We have a lot of work to do," Schultz said, adding, "One quarter does not make a trend."

McDonald's, Dunkin' Donuts Challenging

Indeed, there are plenty of reasons to worry Starbucks' comeback could be derailed.

"They are not out of the woods yet," says John Macaluso, president and chief executive of the Cornell Management Group and an expert on management in the restaurant industry.

One problem that remains is fierce competition from McDonald's (MCD) and Dunkin' Donuts, which are challenging Starbucks with their own high-quality, premium coffee drinks. But in the short term, that competitive challenge may have actually helped Starbucks. Rivals' advertising seemed to spur consumer interest in coffee and Starbucks in particular.

"It appears that the various marketing campaigns and all the media coverage of our coffee has created unprecedented awareness for the coffee category overall," Schultz said.

However, one quarter's results don't mean the competitive challenge has faded. In the long run, "it's inevitable that McDonald's and Dunkin' Donuts are going to take some of Starbucks' market away from them," says John Langston, an analyst at Hodges Capital Management.

Concerns About Cost-Cutting

Because revenue fell, improvements to Starbucks' profits were the result of cost-cutting. "What they've done so far is really just trim the fat," Langston says. "That's what needed to happen," he adds, but now the firm must actually grow sales, a tall order in a recession.

Macaluso worries Starbucks could be cutting costs too deeply, and ultimately could hurt the quality of products or the cleanliness of stores. "They have to be really careful how they cut costs," he says.

The true verdict on Schultz's improvements to Starbucks stores won't be clear until consumer confidence returns, Langston says.

Others disagree, seeing signs in Starbucks' results that consumers' mindsets have already started to shift.

Lately, Macaluso detects more willingness on consumers' part to spend on "affordable indulgences." That doesn't mean the economy has improved exactly, but, he says, "people are getting tired of depriving themselves."

"The consumer is not dead," says John Buckingham, chief investment officer of Al Frank Asset Management. "They're just rethinking how they spend their money."

Long-Term Outlook Unclear

But how long can Starbucks continue to benefit from an improvement in consumers' moods, absent a full-blown economic recovery?

Also, big questions remain about Starbucks' long-term growth prospects, the impact of competition, and the success of its international business, Morgan Stanley (MS) analyst John Glass noted.

"It looks like Schultz has reinvigorated the company," says Buckingham, whose firm owns shares. However, he admits the stock market may have overreacted to the chain's latest results.

Consumer stocks—including Starbucks—have already rallied strongly in the past few months on hopes of an economic recovery. Until that recovery actually arrives, Starbucks' future remains cloudy.

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