← Motley Fool Hidden Gems Investing
Motley Fool Hidden Gems Investing
Is Starbucks Serving Up Promise or Peril?
00:30:36
Same-store sales are down at the coffee chain’s US stores. But a successful turnaround isn’t off the menu yet.
Loading summary
Transcript40 lines
- [00:05]
Mary Long
A dollar saved is a dollar earned. So a minute saved is what you're listening to Motley Fool Money. I'm Mary Long, joined today by Mr. Assit Sharma. Assit, good to see you. How you doing?
- [00:26]
Asit Sharma
I'm great, Mary, how are you doing? Good to see you.
- [00:28]
Mary Long
I'm doing well. We got reports from Starbucks today. That's the coffee chain that most listeners are probably pretty familiar with. They're in the midst of a turnaround. They dropped earnings yesterday after the bell. And I want to kick us off by focusing on Starbucks measurement of a different kind of currency. Not dollars, but time offset. A big focus of Starbucks turnaround is returning the chain to its golden age of being a neighborhood coffee house. But as a part of that, there's also a focus on efficiency. Right? So management seems to think they're making good progress on that efficiency front. The company shaved minutes off its in store wait times thanks to the help of a swanky ordering algorithm. Asit. If you had an extra two minutes in each of your days, what would you be doing with that time?
- [01:11]
Asit Sharma
Well, I'm not giving it back to TikTok and YouTube shorts. I'm done with you guys. I'm grabbing the cast iron bookmark, breaking out of that house and I'm getting two minutes extra to read Orbital by Samantha Harvey, which is my middle aged men's book club read of the month and I'm sort of behind. I got it finished by Saturday.
- [01:34]
Mary Long
So it sounds like you're being very, very productive with those extra two minutes.
- [01:38]
Asit Sharma
Living my best life.
- [01:40]
Mary Long
There's a detail here that's very interesting to me because notably this algorithm that's shaved off these two minutes of order times is not powered by artificial intelligence. Instead, it follows an if, then structure. So, so this is fascinating to me because it seems like every other company is going out of their way to highlight its AI capabilities, build themselves as an AI company, even if they don't really play in the tech space. What does it say about Starbucks that they seemingly have an opportunity to do that with the rollout of this algorithm and yet they're not.
- [02:16]
Asit Sharma
Well, on the one hand, I think they would love to be able to float some great AI stuff to the market. But truthfully, everyone knows that it's going to take more than AI to solve Starbucks problems. So let's get real here and go back to some very elementary type of algorithmic thinking to solve some of the throughput issues they have.
- [02:37]
Mary Long
So again, Starbucks seems pretty proud of these shorter wait times. But that doesn't necessarily seem to be translating into great sales numbers quite yet. I'm going to call out some metrics from the report, including same store sales, which is closely watched here. And you tell me how you're interpreting these numbers. Do they spell to you Asit Shar promise or peril for the coffee company. So we'll kick things off with same store sales in the US that's down about 3% for the quarter. What do you say? Asit? Promise, Peril. Something in between.
- [03:07]
Asit Sharma
Yeah, I think that's an easy peril. I mean, this is the trend at Starbucks. They're losing a little bit of traffic. They're trying to turn it around to get people to come back into the stores or come back to the drive throughs. They have a strategy for this, sort of back to the good old days. We can, we can chat about this, but this is emblematic of Starbucks larger problems. So this is apparel call easy.
- [03:29]
Mary Long
213 net new store openings in the second quarter, bringing the total store count to nearly 40,800 around the world. Promise, Peril. Something in between.
- [03:41]
Asit Sharma
Yeah, promise. I like that. Brian Nicol Turnaround Artist let's slow this puppy down. I mean, why should we be expanding? We don't have the unit economics. Right. Why should we be expanding when capex capital expenditure is one of the things dragging this company down? Most people don't realize Starbucks has a pretty big debt load because it's invested so much in its stores over the years. Why don't we try to figure out how we can solve some of our problems with operating expenses versus capital expenditure. So let's also try to renovate stores at a lower cost. All of this points to taking it very easy on that new store development. So I like that. It's promise.
- [04:20]
Mary Long
So just to be clear, you're saying that that 213net new store openings number kind of sits right at this sweet spot of hey, you're still growing, but it's at a small enough clip that it's not distracting from the real focus, which is improving throughput at existing stores.
- [04:35]
Asit Sharma
Yeah, and it's also a signal that the new management isn't taking the easy way out. So conceivably, one way you could solve Starbucks problems would be to take on a little bit more debt and to speed up new stores and to say we're going to increase revenue but traffic will take a bit of time to come back to the stores. We know people love our brand, so we're going to throw a bunch more stores out in places where we don't have this dense concentration and cannibalization. We're going to map this great real estate strategy out. They could have easily said that, but I don't think the market would have liked it too much. So they're doing this sensible thing which is like we're not really worried about adding new stores right now. That's not the problem that we have to solve today.
- [05:13]
Mary Long
Okay, our next quick hit metric, GAAP operating margin down about 7% compared to a year ago. How you feel about that one?
- [05:21]
Asit Sharma
Yeah, it's a little bit of peril situation going on there, Mary. So Starbucks is doing something which I think should help the business, which is to say we've got a couple of pain points for customers. One is the time that it takes for customers to get through their order. Average wait times of four minutes. You pointed out, going this algorithmic route, so very old school. So if a drink is very complex to make, don't make that the first thing you do. Or in some cases maybe you should if it has X number of ingredients so that way it's ready and the stuff isn't melting on top. When the customer gets it. Don't just do first come first serve. I think that is a really insightful way to start from scratch if you're a new CEO. Starbucks has these problems which they're thinking can be solved by labor. So then bring more people in so that we can satisfy customers, we can keep that throughput moving. But that increases your operating expenses and they've got leftover depreciation from all of the investments they've made in technology. Under the previous CEO they were trying to solve their problems by having more components like the Clover Vertica which make things automatic. And they had a cold brew system which was very expensive. So now we're seeing that work through the profit and loss statement. So what we're seeing in the GAAP numbers is that net income is going to be pressured. Number one, they still have a lot of depreciation that they have to account for. And number two, to keep customers happy, which should be the first order of business, they're going to have to hire more Paristas, keep those shifts occupied. So that is not a clear out type situation. It will take time to resolve. That's apparel.
- [07:10]
Mary Long
Last but not least, we got GAAP earnings per share. That's down about 50% compared to a year ago. I think I know where you might land on this one. What do you say?
- [07:18]
Asit Sharma
Yeah, I mean it's apparel and something that was a little iffy in the Earnings call is both Brian Nicol and his new cfo who's actually a veteran of this business, of the retail business, Cathy Smith. They were like, don't worry about earnings per share too much. We really think you should focus on us taking care of the customer, us becoming that third place again, us becoming the brand that attracts people, us being the place where you can have these day parts like the afternoon where we're going to revive your desire to come into the store and maybe have an aperitif, a non alcoholic aperitif. Mind you, I'm not sure that's what investors want to hear. Investors will give a long line to Brian Nicol because he has been successful in the past and so has his new cfo. But I didn't like that. Sort of don't pay attention to this because we're investors, we want money, we give you money, you make money, you give us back money in terms of dividends and share price. So a little bit of peril there.
- [08:16]
Mary Long
Another data point that I do think is relevant to the Starbucks story and just like the consumer story more broadly is GDP data which we got out this morning that showed a contraction of 0.3% down 2.4% down from 2.4% growth a quarter ago. So this is the first decline since the start of 2022. Starbucks can improve wait times all they want. They can implement this back to Starbucks strategy. But if we are headed towards a recession and the company is already still struggling, how does that macro picture affect this chain that sells $7 drip coffees and $10 lattes to people?
- [08:58]
Asit Sharma
So Mary, the first thing I'm going to ask you is I actually through sort of circumstance am at a Starbucks once every two weeks and I buy drip coffee and sometimes hot chocolate and we'll buy a pastry here and there. Where are you getting these $7 drip coffees from? Is that some kind of fenty with adding some sort of special milk? I don't get that. It is expensive stuff but seven sounds excessive.
- [09:22]
Mary Long
Okay, Asad, I was at a Marriott hotel earlier this month for a wedding, Collierville Tenness.
- [09:29]
Asit Sharma
Here we have the first qualification like well, I was at the airport Starbucks. It's not the airport Starbucks, but everyone listen to Mary. Granted, Marriott hotel.
- [09:38]
Mary Long
There are some asterisks attached to this example but it fired me up. So I'm gonna use this platform to share it. Okay? I'm at Amerriat in Collierville, Tennessee for a wedding earlier this month. There is no free coffee in the lobby at this hotel which was my first red flag. So I go down searching for coffee and all that there is is a Starbucks bistro. So I say, okay, I'll go to the Starbucks bistro, buy my coffee, get a. It was a large, but it was a drip coffee, no frills, so easy they turn around like pour the cup. And it cost me $7.50. And I was so enraged I was ready to throw that coffee across the the lobby. I did not. I held it in. But I'm using this moment to, to share that. So that is a real number. Though again, there's perhaps that's not the price bucks.
- [10:28]
Asit Sharma
Well, you know, I want to extrapolate from that, which is to say if it's seven bucks at that Marriott, that tells us something about what's happened to the price over the last few years. Because in all honesty, that entry level drip coffee, a tall order with nothing on it, has increased. I'm going to guess it's 30 to 40% more than it was just two years ago. Now some may say that this is taking a little bit advantage of commodity inflation and inflation in general that Starbucks took an opportunity to bump up those prices even though it has tremendous purchasing power. And it should be one of the first places to say, hey, we're going to hold your price steady because we're Starbucks, because we buy from I don't know how many coffee providers across the globe. It's interesting Brian Nicholl is saying we're not going to raise prices anymore this year. I think he's sensing the winds and maybe realizes that Starbucks took a little bit of advantage of its most loyal customers by bumping up these prices. So this is yet another thing that makes this very hard. But you know, all in all, I do want to give the new team credit for leaning towards again opex people versus machines because under the previous management, Starbucks was really thinking that it could solve so many things by having automation. They could improve the rate at which people are going through the drive thru lines and the wait times that you have even if you order advance on your mobile order app. And it became something where they lost connection with the customer. And management of course is well aware of that. But it reminds me of something that Ray Kroc said years ago, the man who bought McDonald's when it was all of like two restaurants I think, and turned it into what it is today. He said, hell, if I listened to the computers and did what they proposed with McDonald's, I'd have a store with the row of vending machines in it under the previous leadership, I almost felt like that's where they thought they could go. It was just a really automated format without this customer connection. And so bringing that back, even though it sounds a little iffy, Mary, I mean, whoever is going to go back to Starbucks as a real third place when so many great community coffee shops have sprung up and our consumption preferences have changed, I still applaud management for getting that. That you've got to do right by your customers, price wise, ambiance wise, connection wise, brand wise. So maybe there's something in there. Of course, this is a harder problem to solve than Brian Niccol had at Chipotle.
- [13:04]
Mary Long
I want to close this out by getting another look at the fast casual business from a different kind of company. One that really is leaning more into this digital landscape and that's Wingstop. So not even a year ago, this chicken wing joint was flying very, very high indeed. Shares have dropped significantly since, down about 45% from their high in September 2024. We're going to get to their earnings that dropped this morning, which were more positive in just a moment. But before we get them, let's look at like the past several months. Why that drop? What kind of headwinds was this company up against?
- [13:37]
Asit Sharma
Wingstop created its own headwinds in a way, Mary, because it had been so successful improving same store sales. The company has a really light real estate footprint in stores are incredibly small compared to some of their wing competitors. And they're meant for just going in, maybe sitting down, but mostly picking up and taking away. And they really started to get a deeper concentration, some good metropolitan markets, not huge ones, but decent markets, they saw such an increase in traffic that their comparable stores went through the roof on what's called a two year stack. So you compare what you sold today versus not just one year but two years ago. And when you lap great results, it becomes really hard. You can't keep increasing those results exponentially. So this year it turns out what they're doing is holding the gains of the past two years. But it's not like they're having another year where you're seeing same store sales increase by 25%. So the projections were this year we're going to grow those same store sales by, I don't know, mid to digits to single high digits. And with this latest report they're saying, well, they could be flat this year. The market liked the report for different reasons. But that's what happened to the stock, because investors are like, wait a minute, you're spending More on marketing. Yeah, because we're getting into the NBA. We're the official wing of the NBA. But I want those profits. Well, you're not going to get them because we're scaling and people are just lining up to develop new franchises and we're going to build this business out through globally. So investors were a little bit confused last quarter. We're not getting profits that we want or as much profit as we want. We're not getting the growth that we want to see. But in the grand scheme of things, those were very understandable sort of pauses in the business model and the economic model. And I think over time it's destined to pick up. But you had some questions about the earnings today. Yeah.
- [15:30]
Mary Long
So help us make sense of this most recent quarter because, okay, we saw a teeny tiny improvement in same store sales. That number only ticked up by 0.5%. But there are some other numbers that seemed pretty impressive. You've got system wide sales increasing almost 16%, hitting $1.3 billion. Total revenue up almost 17.5%. Net income increasing, wait for it, 221%. That's all in spite of what's obviously a very tricky, very uncertain macro environment. And we've already seen that impact trickle down to other fast casual chains. Domino's, for instance, reported a decline in same store sales earlier this week, which is pretty rare for what's working and what's not in the Wingstop model as we've just seen it reported today.
- [16:16]
Asit Sharma
Wingstop has been a company that's invested a lot in its technology. They've moved digital orders to Some, I think 70% now of their sales. That helps them with a leaner cost structure. Also, Mary, the company has this tremendous cash on cash returns. If you're an investor, let's say a franchisee in a Wingstop business, you can make 70% cash on cash returns, 50% if you use financing. And that's just like a stellar type of return in the QSR quick service restaurant industry. So what they have is tremendous demand in their development pipeline. Their franchise groups are like, we love this, we want more. And that's propelling a really fast store growth count. So with Starbucks, they're slowing down. Wingstop is trying to build out new units as fast as possible, and that's where the growth is coming from. So what investors are seeing is, okay, I can live with this equation. You have a lean operation. You don't really own your own supply chain. You work with partners, so you've got less exposure to that. You seem to be able to manage the all important bone in chicken price really well and not pass those increases on to customers for the most part. So I want in, I want to develop more stores and I will note that the company, one of the things that investors did like earlier this year is the company keeps increasing its total advertising spend based on system wide sales. So it used to be like 3%, then it was 4% of system wide sales was advertising budget for local markets. Now it's something like five and a half percent. But look, with these big brand partnerships like I mentioned with the NBA and a lot more advertising in local markets, that's only increasing the flywheel of returns for the franchisees. So this is a company that just looks sort of destined to grow almost like Dunkin Donuts did in the early days. And that's a powerful equation for investors who can withstand the volatility of angst over same store sales in any given quarter. And think of this as like okay, I'm going to buy this business for 10 years and I'm going to watch it expand into Europe, into the Middle east, here in the States and I'm going to watch it take market share from some of the bigger competitors who have like larger stores footprints. Of course there's a lot that can go wrong in that they have to keep executing and they have to make sure that they do manage those all important bone in chicken costs over time. But I like their chances in this environment.
- [18:41]
Mary Long
Asit Sharma, always a pleasure to have you on the show. Thanks so much for giving us some insight into coffee and bone in chicken wings today.
- [18:49]
Asit Sharma
Thanks a lot Mary. I had a lot of fun.
- [18:54]
Yasser El Shimmy
Right now the Home Depot has spring deals under $20. So what are you working on? If you're planning on cooking out this season, head to the Home Depot so you can fire up the grill with deals on charcoal. Right now get two 16 pound bags of Kingsford charcoal for only $17.88 was $19.98. Don't miss spring deals under $20 now through May 7th at the home Depot subject to availability valid on select items. Only.
- [19:29]
Mary Long
Two of the biggest movies of the year, a Minecraft movie and Sinners, both came out of Warner Bros. Studios. But there's a lot more to this company than its moviemaking business. And despite the success of those two films, the stock WBD has been far from a winner for its shareholders. Up next, I talked to fool analyst Yasser El Shimmy about Warner Bros. Discovery. This is the first in a two part series. So today we talk about the business. Tomorrow, we shine the spotlight on David Zaslav, the character charged with leading this conglomerate into the future. Warner Brothers Discovery came to be as a result of a 2022 merger between WarnerMedia, which is the film and television studio that was spun off from AT&T, and Discovery, another television studio, together. Today, this is a massive entertainment conglomerate and it owns the likes of hbo, Max, cnn, Discovery, the Discovery Channel, a mix of streaming services and traditional cable networks. One of the reasons, Yasser, why I find this company so interesting is because you can't really talk too much about it without hearing all these different names, all these different services. A fascinating history of mergers and acquisitions and spinoffs, et cetera. I want to focus today mostly on the person who has been tasked with leading this massive conglomerate into the shaky future of media. But before we get to David Zaslav, let's talk first about the company again. WBD is a big conglomerate. What are the most important things about this business as it exists today that investors need to know?
- [21:00]
Unnamed Analyst
Well, thanks, Mary. I mean, to tell the story of WBD is to almost tell the story of entertainment itself in the United States. I mean, we're talking about structural challenges that are afflicting almost all television and film studios across the board, as well as TVs on TV networks. So on the one hand, you have a structural decline of linear TV viewership, that is your basic cable, basically, people paying a monthly fee for whatever provider there might be to get a whole host of channels that they flip through at home. We have heard of the phenomenon of cord cutting. It has almost become a cliche at this point. It has been going on for years, at least over a decade at this point. But recently it seems to have accelerated even further as people migrate more and more towards streaming options, subscribing to such channels as Netflix and Disney and Max and others. And this has created quite a dilemma for a lot of studios like Warner Brothers Discovery, where much of the profits and the free cash flow has traditionally come from those very lucrative linear TV deals that they have had with the likes of Charter Communications and others. So they've had to effectively wage a war on two fronts, right? They are being disrupted by the likes of Netflix. They're losing subscribers on the linear TV side, but at the same time, they can't go all in on streaming, at least not just yet, because so much of their profit and so much of their sales actually come from that linear TV side that is declining. So what do you do? You try and just be everything to all people. And that has become a challenge. And Warner Brothers is no different here. We're talking about a company that started off in 2022 as a result of that merger you talked about between Discovery and Warner Brothers. And since then, they have focused on two main objectives. The first one is to pay down as much of the debt on the balance sheet as possible. And we can get to that later. And the second goal has been to try and effectively promote and develop their streaming business. Initially it was hbo, now it's called Max. And try and actively compete with the likes of Netflix and Disney. And they've actually done rather okay on that front as well.
- [23:38]
Mary Long
So let's talk about the debt before we, before we move on, because this is a big gripe with the business as it exists today. Warner Brothers discovery carries $34.6 billion in net debt. That's as of the end of fiscal 2024. So you get to that number because there's $40 billion gross debt, minus five and a half billion dollars of cash on hand. How did they end up with so much debt? Billion $34.6 billion is a lot of debt. How did they end up with so much of that in the first place?
- [24:10]
Unnamed Analyst
That is a lot of debt. And let's just say that David Zaslav, who is the head of Discovery, he kind of was very enthusiastic about kind of putting his hands on those assets from Warner Brothers. And as a result, he actively saw that merger with the Warner brothers assets from AT&T. And AT&T took a huge loss on the price it had originally paid to acquire Time Warner, a 40% loss. However, what they did do is that they effectively put all the debt that they had from that business as well some of their own debt into this new entity that was to merge with Discovery. And so Warner Brothers Discovery just was born with a massive debt load of 55 billion or so that was nearly five times net debt to EBITDA or earnings before interest, taxes, depreciation and amortization, which was very, very high leverage for this, for this new company. And so from the very beginning, Warner Brothers Discovery had to deal with paying down that huge debt load. Luckily, a lot of that debt was in long term debt. Effectively that most of it will mature around 2035 can be easily rolled. It has an average interest rate of about 4.7%. So it's not the worst in the world. And considering how much cash flow per year that Warner Brothers Discovery is able to produce around again in the $5 billion range or more, you can see that the company has been able to effectively navigate this and pay down that debt that David Zaslav has paid down over around $12 billion since that merger took place. That leaves him with the 40 billion dol dollars you're talking about and still more to go. But at least you can. You can see that they are able to accomplish that feat.
- [26:12]
Mary Long
So let's also hit on the streaming service, because that's an essential part WBD and where it wants to go in the future. So Max, which is the streaming service that's basically HBO plus others, allegedly has a clear path to hitting this is, per their most recent earnings, at least 150 million global subscribers by the end of 2026. So that would make it at 150 million global subscribers. That would make it half of Netflix's current size.
- [26:37]
Unnamed Analyst
Yes.
- [26:38]
Mary Long
What metrics and what numbers does Max have to post in order to be considered a success?
- [26:44]
Unnamed Analyst
I would say that, you know, Max has to again focus on growing that subscriber base. And they have done an excellent job at that. They've almost doubled subscribers year over year, reaching around 117 million subscribers currently. And they accomplished that through a strategy that had kind of two wings to it. The first is that they. They effectively bundled a lot of content into the ma. So the previous HBO service, it merely had some TV and film IP that the studios produced from the namesake hbo, but also from the Warner Brothers studios. But then they decided to kind of expand that to include also shows and other content from the reality TV side of the discovery side of the business. So think of your home network, HGTV or Food Network and so on. They accommodate a lot of that content in there. They also introduced live sports and live news into the max. So that made it a lot more appealing to be kind of a place where you can have almost all of your viewing needs met. So that has been a successful strategy for them. They've also struck a partnership with Disney to bundle Disney, Hulu and Max together for a reduced price. But that has definitely also helped with the increase in their subscription subscription numbers. But I would also be remiss to say that they have successfully and actively sought to expand their presence in international markets. They are still at less than half the markets where Netflix is, so the opportunity is still pretty vast on there. However, as you know, you started your question with asking about the metrics that we need to be watching out for. Obviously, we need to be watching out, as I said, for subscriber numbers as well, well as the EBITDA operating margins that will come from the streaming side, they are targeting around 20%, which would be actually very good if that turns out to be the case long term. But also we need to look at things like average revenue per user or arpu. How much are these subscribers contributing both to the top and bottom line for Max? And I think on this metric there might be a little less confidence because especially when you expand internationally, you're going to get a lot subscribers who are not paying as much as a US Subscriber might. So you might be looking at a decline there. You know, on the bright side, they've introduced advertising as part of the kind of the package, but the basic package that you get kind of that strategy. We have seen, we have seen it successfully play up with Netflix. And I think that they may be able to increase their ad revenue on Max and that can can be a big contributor for their profits as well.
- [29:42]
Mary Long
As always, people on the program may have interest in the stocks they talk about and the Motley fool may have formal recommendations for or against. So don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley fool editorial standards and is not approved by advertisers. For the Motley fool money team, I'm Mary Long. Thanks for listening. We'll see you tomorrow.