One has to wonder if the once-vaunted Starbucks business model is in decay. For many years, Starbucks has relied on the overall customer experience as their defacto advertising. Now, Starbucks is engaged in an old-fashioned television, radio, and newspaper media blitz.
In 2007, Starbucks experienced its first-ever store traffic decline. In response, Starbucks lowered prices by introducing the Pike Place brand as well as running a newspaper blitz announcing the introduction of the cheaper coffee. Now, most of America is seeing regular Starbucks television commercials.
For a moment, let’s not debate whether Starbucks marketing through the overall customer experience is better than traditional advertising or worse. My concern is that Starbucks margins have been greatly impaired and perhaps their overall business model.
The single-most important ingredient to a great business model is great margins. Starbucks has lowered prices with the Pike Place brand as well as added traditional marketing expenses. More importantly, the business model Starbucks has successfully used for over twenty years has now changed. The original business model was to market through providing a great customer experience. Now the business model seems to need the augmentation of traditional advertising.
This is a change in the business model to me. Starbucks seems to be saying, we cannot grow the way we used to. That is, our business model is now different. In 2007, Starbucks spent a paltry $95 million in advertising on $9.4 billion in revenue or approximately 1%.
However, what if the new Starbucks business model will require McDonald’s type marketing to maintain or modestly grow revenues? McDonald spends around ten percent (10%) of revenue on marketing vs. only one percent (1%) for Starbucks. Imagine if Starbucks would need to spend so heavily on marketing in the future. If we recast their 2007 operating income of $1.1 billion to include 10% marketing expense vs. their current 1% level, the operating income drops precipitously by $845 million to only $255 million.
Translate this to stock market valuation and you have a real disaster. If the ongoing earning power of Starbucks fell 75% as in the previous example, it is fair to say that the price/earnings ratio (currently 27) of Starbucks would fall as earnings growth potential fell. Let’s say the P/E ration fell to fifteen (15X). Of course, the earnings dropping four times would cut the stock price by four times. This could take the overall market capitalization from the current $20.2 billion level to $3.8 billion, or a difference of $16.4 billion.
