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Starbucks' Bitter Taste

Nat Worden

Investors are tasting hints of a slowdown in Starbucks' (SBUX Quote) latest brew.

They looked past the java giant's solid third-quarter earnings on Thursday and instead focused on its July sales results, which contained the whiff of deceleration that may threaten the stock's rich valuation.

While Wall Street may be notorious for attributing undue significance to a single monthly sales number, the 4% comp rise posted by Starbucks for July marked its slowest month since December of 2001. It was at the low end of its target of 3% to 7% growth and continued a streak of slowing same-store sales growth to three months in a row.

For its part, Starbucks says the sales misstep was merely the result of being too popular and having long lines in its stores. But with the stock market being whipsawed back and forth as investors fret about the potential for a major slowdown in consumer spending, Starbucks' July results played into the market's fears.

Matthew DiFrisco, an analyst with Thomas Weisel Partners, said in a research note that Starbucks' sales partly reflect a "broader consumer slowdown." He downgraded the stock to peer perform from outperform based on the results.

Shares of Starbucks closed down $2.66, or 8%, to $30.64, having plunged as much as 14% to $28.72 earlier in the day.

For the quarter ended July 2, Starbucks earned $145 million, or 18 cents a share. That marked a 16% increase from the $125.5 million, or 16 cents a share, the company recorded a year earlier. Excluding a penny a share that was related to a one-time tax benefit, it met Wall Street's average forecast for earnings of 17 cents a share, according to Thomson First Call.

The coffee retailer's total revenue rose 23% to $1.96 billion as it continued to open stores at a vigorous clip. Quarterly same-store sales rose 6% for company-operated stores.

To view Street Insight's video review of Starbucks, please click here.

Starbucks left its 2006 earnings guidance in place, forecasting a profit of 71 cents to 72 cents a share. But it ratcheted up its plans for store openings for the year to at least 2,000 net new stores on a global basis, up from its previous plan for 1,800. The company aims to add another 2,400 stores in 2007.

When asked about the July comps on a conference call with analysts, Starbucks Chief Executive Jim Donald rejected the idea that the July slowdown reflected any macroeconomic forces acting on consumer spending habits. Instead, he blamed the result on bottlenecks at Starbucks stores during the recent heat waves as customers waited longer for its icy, blended drinks, known as Frappucinos, which take longer to make than the typical cup of joe.

Donald said the company was slow to act on providing quicker service, and it missed out on sales as a result.

Marc Greenberg, an analyst with Deutsche Bank, said in a report that the July slowdown showed the risks inherent to Starbucks' aggressive growth plans.

"At some point, this blistering pace of store openings may not be sustainable," Greenberg wrote. "Growth will inevitably slow, and unexpected challenges will arise."

With this in mind, Greenberg sees greater risk that investors will start to balk at the high price tag attached to Starbucks' shares. It's currently trading at roughly 35 times earnings estimates through 2007.

"We're trying to draw a balance between investing in our stores to drive growth and maintaining our short-term profitability," said Donald.

Meanwhile, the company is rolling out new product offerings to sustain sales growth, such as breakfast sandwiches, lunchtime snacks and other merchandise.

"As the company moves further and further away from its core coffee business, we believe it may run into the problem of an increasingly complex and inherently slower business model," Greenberg wrote.