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Tickers in this Article: SBUX, WFMI, WSM, BC, PNRA, MCD, GMCR, CBOU, KO
Is a morning coffee or two addictive? Is it the fuel for a nation of two-income households? When is enough, enough?

How about the 40-plus P/E multiple valuation of the ubiquitous coffee seller, Starbucks (SBUX), which recently posted just 4% same store sales growth? Well, one of America's favorite growth stories may well be stumbling.

According to the Wall Street Journal in August, consumers are cutting back on high-priced coffee, fashion accessories, clothing, and other luxury items. Consider that last summer, SBUX, Whole Foods (WFMI), Williams-Sonoma (WSM), Brunswick Corp (BC) and Panera Bread Co (PNRA) all missed their comps targets.

SBUX is a well-known and generously-valued consumer marketing success story with 15 years of 5% or greater same store comparisons until July this year. SBUX's long term goals are to achieve 20% annual sales and 20%-25% annual EPS growth.

Its "folklore" is continuously trumpeted by billionaire founder, Howard Schultz, although Schultz, CEO Mike Casey and three other officers have been selling their stock aggressively this year, to the tune of nearly $100 million so far.

And in late September, SBUX was sued for anti-competitive and predatory sales practices such as competitor intimidation and customer poaching (i.e. by providing free coffee in front of other vendors' establishments).

With 12,000 stores (8,500 in the U.S.) in 37 countries and an estimated 73% share of the specialty coffee market, SBUX has plenty of market power, and has just raised prices an average of 3.9%.

This price increase may be an effort to get same store sales comparisons back over 5%, since comps began missing some analyst expectations in April and fell below 5% in July. Another SBUX response has been to increase U.S. planned store openings from 1000 to 1800 this year (versus a 500/year historical average), a move which will expand capex, hurt margins, and possibly cannibalize existing outlets.

Panic Expansion, Failed Diversification and The Holy Grail
Moreover, this panic expansion plan will not hurt other coffee pushers including McDonald's (MCD), Dunkin' Donuts, Green Mountain Coffee Roasters (GMCR) and Caribou Coffee Co. (CBOU).

As well, the legendary "ambiance" of its stores is being killed by a push to build drive-thru stores (currently 1,300 of 8,500 stores) in high density areas like California with the next push in New York, to attack Dunkin' Donuts there.

But McDonald's franchises launched a premium coffee under the name Newman's Own early in 2006. The coffee is enabling MCD franchises to compete with SBUX, Dunkin' Donuts and Burger King, which launched its own premium coffee, BK Joe this past summer. Canada's Tim Horton's has also entered the fray.

Strong, well-blended coffee at 50% discounts to SBUX prices just may end up resonating with some customers, most of whom are facing sharp increases in mortgage payments starting this fall when nearly 40% of all mortgages reset.

Diversification efforts into new drinks (Ethos Water with Pepsico), breakfast foods (Kellogg), movies (Lionsgate Films), books (Mitch Albom) and couponing have been bungled, maybe highlighting the value of ex-marketing head Greg Maffei (who quit SBUX in March 2006).

Of course, the SBUX "holy grail" is international expansion, increasing its existing 3,500 stores to 15,000 by 2010, and the road towards it has begun with recent pushes into China, India, Brazil and France. Operating profit margins for the international division over the past four quarters averaged 9.1%, compared with negative margins in fiscal 2003.

But new expansion in France and China is moving to second- and third-tier cities, some where cultural resistance may prevail. In addition, internationally savvy Coca-Cola (KO) is getting into the coffee business, setting up mini-cafes in retail stores, offices, fast-food outlets and movie theaters that will brew espresso drinks in 30 seconds for under $3.

"We're not going to be in the real estate business - we're going to sell brewed coffee and teas wherever Coke is sold," said Udaiyan Jatar, head of Coke's coffee project.

The Street Loves Strong Coffee
The lack of negative opinions on the stock, with sponsorship and coverage coming from Goldman Sachs, JP Morgan, CIBC, UBS, Think Equity and new summer coverage from Deutsche Bank, is striking. Full year 2006 EPS may reach $0.75 when Q4 is reported soon and $0.90 is foreseeable for 2007. But with the U.S. middle income consumer retrenching and the Chinese yuan finally appreciating against the dollar, SBUX looks vulnerable during a period of heavy overseas capital commitments.

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