Trouble brewing for Starbucks?

By The Associated Press

With its affluent customer base and uncanny knack for drawing crowds, Starbucks has long seemed immune to the slowdowns that plague most retailers when the economy falters.

But the king of the $4 coffee is feeling the pinch now. Dairy prices have skyrocketed, fast-food chains have made it easier to find a good cup of joe, and traffic in U.S. stores has flattened amid high fuel prices and turmoil in the housing and credit markets.

Add it all up, and it's dragged the company's stock down nearly 40% since it hit an all-time high one year ago.

Starbucks (SBUX, news, msgs) said Nov. 15 its fiscal fourth-quarter profit jumped 35 percent, despite a slowdown in store openings and a drop in U.S. traffic.

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While many analysts remain bullish on the company's long-term growth prospects, they're keeping a close eye on same-store sales -- a key measure of a retailer's health -- and some are wondering if certain U.S. markets have gotten saturated.

"At some point, the growth sort of levels out," said Robert Toomey, an analyst with E.K. Riley Investments. "How much more of the market can you continue to penetrate? How many more people are going to be emerging as new latte drinkers at Starbucks?"

Some aren't convinced that market saturation is a problem for a company that has remained steadily profitable while opening an average of six stores a day.

"It's always been a part of Starbucks' operating model . . . to open stores near one another," said Sharon Zackfia, an analyst with William Blair. "Initially, they often do cannibalize the nearest store when they do open, and then after a while the store that was cannibalized bounces back."

The company declined to comment for this story, citing its policy of not discussing the business in the days ahead of quarterly earnings reports.

Diluting the experience?

In an infamous leaked memo earlier this year, Chairman Howard Schultz lamented that the company's aggressive growth had led to "a watering down of the Starbucks experience." Yet it shows no signs of slowing down.

In August, it stuck by guidance that it would open at least 2,400 new stores worldwide in the current fiscal year -- twice as many as in 2003 -- and slightly more next year. Last fall, the company set a global long-term goal of having 40,000 stores, 10,000 more than its previous target.

It has more than 14,000 stores today, 10 times more than a decade ago. Most are in the United States, but eventually the company envisions serving half its coffee overseas, where executives and analysts see huge potential for growth, particularly in China.

With a steady stream of new stores to staff, the blistering pace of Starbucks' expansion has occasionally led to long lines. The company has hired more assistant managers and recently started streamlining menus, moves aimed at filling orders more quickly.

And this summer, the president of its international segment got promoted to chief operating officer, a newly created post that "will be invaluable as the company continues on pace to double in size in the next four to five years," Jim Donald, Starbucks' chief executive, said in a statement.

Those changes give some analysts confidence that Starbucks is doing what it takes to stay on top of growth.

"I think Starbucks will probably emerge from 2007 as a stronger operator than it's ever been before," Zackfia said. "But the question is, when does that materialize in the numbers?"

Make do with one less trip?

For the past two quarters, sales at stores open at least 13 months have come in toward the low end of the company's guidance of 3% to 7%.

Analysts are guessing that a late-July price increase on most drinks in the United States -- the second in less than a year -- could boost same-store sales a bit. And some say the stock could rise or fall sharply based purely on traffic in U.S. stores.

The difference between a 1% drop in traffic and a 1% increase boils down to just 14 to 15 customers per day per store, Zackfia noted. "That's a very fine hair to split," she said.

Starbucks estimates its average first-time customer makes $80,000 a year, enough to keep him or her lining up for mochas even when things like high gas prices might force others to cut back on indulgences.

But amid an ongoing housing slump and plunging consumer confidence, Starbucks regulars may make do with one less trip.

"Even relatively high-income earners -- if they see their adjustable-rate mortgages go up $300 a month, they go, 'Well, maybe I don't need that second latte today,'" Toomey said.

Or are they defecting to cheaper competitors?

McDonald's (MCD, news, msgs) has been testing sweet lattes and other espresso drinks in 800 restaurants across the country this year and on Nov. 13 announced plans to roll them out nationally over the next two years. The world's biggest fast-food chain scored big this spring, when Consumer Reports ranked its premium coffee No. 1, beating Starbucks, Dunkin' Donuts and Burger King (BKC, news, msgs) on taste and value.

As the competition escalates, Starbucks continues branching out beyond coffee in its bid to lure new business -- from adding warm sandwiches to more stores to teaming up with Apple (AAPL, news, msgs) with a new in-store wireless iTunes music service.

"In some ways, they bred their own competition," said James Maher, a research analyst with ThinkEquity Partners. "I do think that the fact that you can get lattes at McDonald's is just a consequence of constantly rising consumer expectations, fueled in part by Starbucks' continued innovation."

This article was reported and written by Elizabeth M. Gillespie for The Associated Press.