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Tech stocks - Monday, December 29, 2008

Give Us A Venti Latte, But Not Shares In Starbucks

Like many investors, we expected the markets to remain fairly steady the last few weeks of December. And like many investors, we were wrong. Unfortunately, the bad news doesn't stop and skittish investors keep pulling out of the markets. We expect this trend to continue for the next six months. While we believe there will be some surprises in earnings announcements next month, there triumphs will be drowned out by the sounds of groaning investors over the majority of the market.

We did find Hewlett Packard's (HPQ:NYSE) announcement that they were entering the data warehousing segment fairly interesting. With their purchase of Electronic Data Systems, HP can finally make some headway in this profitable sector without having to spend the time and money on R&D. While this announcement is hardly a "get rich" scheme for the company, it does make sense and is another reason why we like this stock.

This week the tech:stocker columnists are working on a "grab bag" of stock picks that were suggested by our readers. We asked for stocks that were not in our usual areas of focus, financial services and technology. We received emails about several interesting companies and everyone can thank Kristin in Atlanta for today's pick, Starbucks (SBUX:NASDAQ).

In the interest of full disclosure, the tech:stocker staff is completely addicted to Peet's Coffee (PEET:NASDAQ). Do we drink Starbucks? Of course we do. Unless you view Starbucks as an evil empire, most people enjoy a tall coffee from the java bean empire when running through an airport or shopping in a local mall. It's ok to admit it. To make sure we were current with the latest version of Starbucks, we spent much of a last week visiting the seven locations that were within five miles of our zip code (in comparison, there's only five Peet's locations within five miles of our zip code).

Location is definitely the strength, and weakness, of Starbucks. When we lived in NYC, we enjoyed spending hours hanging out at the Starbucks at Astor Place sipping lattes (or coffee when we couldn't afford lattes) and scanning The Voice for cheap apartments while watching misplaced tourists try to spin the cube or desperately look cool while they scanned their street maps. While we frequented many coffee places that we thought served a better cup of joe, none of them compared to the ambiance and location of this Starbucks.

Having this pleasant association with the brand, we had no problems patronizing the local Starbucks that was just close enough to wherever we worked to satisfy our caffeine craving. And we worked in many different locations in Manhattan.

While the aggressive expansion of Starbucks initially served as convenience to its loyalists, in recent years the growth has led to overcrowding and certain disdain for the brand amongst its original followers. For example, Starbucks now has "outlets" in most Safeway grocery stores. In Terra Linda, CA, you have a dedicated Starbucks store in the same mall (less than 100 yards walk) from an "outlet" in a Safeway store. Even more interesting is that the store is usually hosting a steady crowd while the barristas at the Safeway outlet look incredibly bored and can be often spotted sneaking bites of brownies every chance they get. How this outlet didn't get marked for elimination back in July during the big "transformation strategy" is a mystery. It also makes us wonder how the eliminated stores could be achieving less revenue than this outlet.

To Starbucks credit, every time we ordered a venti latte last week, the quality of the drink didn't vary. For many patrons, this had been a source of discontent. In one of their more successful public relations promotions, Starbucks closed all their stores back in February to retrain their staff on how to make the perfect drink. We definitely think it is important for the company to invest in more public relations activities on this scale as it is far too difficult to have individual stores engage in their own PR initiatives.

While the retraining program may have helped the consistency of drinks, it did little to help the company's customer service. In each visit last week, we purchased a pound of espresso beans for use at the office. Some times we were asked if we wanted a free cup of coffee with our purchase, other times we were not. At one Starbucks, they didn't have any prepackaged bags of espresso for sale so they offered to measure out a pound from a bag they use to refill their espresso machines. When they said the bag had approximately 1.5 pounds of beans, we offered to take the whole bag knowing that it would be used eventually. The clerk sold us the bag for the price of a 1 pound bag. Back at the office, we weighed the bag and found it was just shy of 2 pounds. And we did get a free cup of coffee with our 2 pounds of beans.

And with the company possibly eliminating its matching 401k contributions for its employees, we have a hard time seeing how customer service will improve in the upcoming year.

Inconsistencies aside, our real concern about Starbucks is their ability to increase their revenues in a tough economic environment. Back in September the company announced healthier menu options including "Perfect Oatmeal", "Chewy Fruit & Nut Bar", and "Berry Stella". In our 14 trips to Starbucks last week, none of us ever saw a customer order any of the new healthy menu items. We also believe that consumers will be ordering less Cinnamon Dolce Frappucinos and Caramel Macchiattos. These drinks, along with Starbucks other specialty items, is what truly distinguishes the company from its competitors. If Starbucks loses these dedicated, but fringe coffee drinkers, profits will shrink even further.

Even though the company faces a tough time brewing profits in 2009, we can't help but be tempted the share price that is continually hovering near its 52-week low. The company's P/E ratio of 21.74 is a little high for our liking even though lesser-known Peet's Coffee has a well-steeped P/E ratio of 31.14. And even though Peet's always offers us a free cup of coffee every time we order a pound of espresso forte, we can't recommend investing in them either. If you have to invest in java, we would probably recommend investing in a Dunkin' Donuts franchise or trying to buy the farm of Juan Valdez versus buying shares of Starbucks or Peet's.
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