Howard Schultz Wants Starbucks to Be the IBM of Coffee

Tickers in this article: DELL HPQ IBM MCD SBUX

NEW YORK (TheStreet) -- Starbucks' CEO Howard Schultz wants you, his company's shareholders, and coffee drinkers everywhere to know how and why he's spending money.

In talking boldly about relatively small deals -- Monday's $100 million acquisition of bakery La Boulange and the $30 million purchase of juices specialist Evolution Fresh in 2011 -- Schultz is trying to say that after struggling to grow the nation's largest coffee company in the past, he's "cracked the code" on a new model to grow shares and store offerings. It just turns out that the new model is an old one: Schultz's plan is similar in style to the growth path that IBM has outlined to distance itself from its roots in hardware and grow in data analytics, consulting and IT services.
Howard Schultz in 2005, enjoying one of his five daily cups of brewed 'Bucks.

If investors spend the time to listen to Schultz speaking about the two small acquisitions for a company with nearly $12 billion in annual sales, what they would hear is conviction similar in nature to how IBM plans to grow its annual sales far beyond $100 billion.

Both IBM and Starbucks appear to be making two points to investors and, in a sense to consumers. First, they feel they sell a core differentiated product -- the best coffee & the best in tech business services -- that can organically grow in profitability over the years. Second, both companies hope to find a formula to expand from that core to grow sales without diluting existing offerings.

Growth through consolidation or major store additions has been an obvious go-to, and dubious, growth strategy in the tech and consumer sectors-- for instance, Hewlett Packard's acquisition of Compaq in 2001, and in the case of Starbucks, its epic coffee outlet expansion in the 2000s.

Yet Starbucks recent deals make it appear to be as skeptical of this model as IBM. In effect, Starbucks wants to add new business streams without making its coffee brand a commodity product. Nimble acquisitions that don't break the bank backed by multi-year growth initiatives may be the key, and make the selloff in Starbucks shares on the news of its bakery deal seem premature, as well as commentary that the move suggests a hint of "peak coffee" desperation amid Schultz's excitement.

Schultz's Monday afternoon choreography for a $100 million acquisition is worth thinking over carefully.

For those who missed it: On Monday afternoon, Starbucks alerted investors that it would be announcing a move to "further strengthen" its retail business, causing trading in the Seattle-based brewer to spike. At roughly 3:30 pm, Schultz opened a conference call with analysts to unveil his acquisition of La Boulange, a San Francisco-based bakery chain as a "significant next step" in growing Starbucks $1.5 billion selling foods business.

Known to drink four to five cups of Starbucks Aged Sumatra roast a day, some might look at the hoopla over a small deal as cause for Schultz to cut back on the caffeine, when what investors should key on is how Schultz's talk contrasts with what the company was doing 10 years ago.

The most prescient analysis on Starbucks past failings may come from, of all places, comedian Louis Black in a Daily Show monologue. Black proclaimed in 2001 that he'd located the end of the universe when spotting one Starbucks across the street from another.

"What was the gentleman thinking, who stood in the empty lot across from a Starbucks, when he turned to his wife and kids and said 'I have a vision. I am going to build a Starbucks across from a Starbucks?" a perplexed Black joked. The answer: only a person who wants a mochachino from the store across the street but needs a cup of coffee to get there.

Shareholders weren't laughing. Between Schultz's departure as CEO in 2000 and his return in 2008, Starbucks revenue grew nearly fivefold to $10 billion but profits lagged, only growing roughly 75% to $315 million, indicating falling margins reflected in a 50% share slump. During that time, stores also grew faster than profits, roughly doubling to nearly 16,700 by 2008 from less than 8,600 as of 2004.

Black's humor contained the wisdom that Starbucks was testing the limits of a store-driven growth initiative, while diluting its brand. The timing couldn't have been worse; it came amid a wave of competition from lower-end competitors including McDonalds and Dunkin Brands , and high-priced local boutique roasters.

"Starbucks was being squeezed to the middle, and that is an undesirable place for us to be," Schultz conceded in a 2010 Harvard Business Review interview that covered his return to the company he founded and named after a character from Herman Melville's Moby Dick.

Since his second stint as Starbucks CEO began in 2008, Schultz has pointed to a recommitment to employee training and a focus on intangibles like "culture" and "values" as a key to Starbucks recovery -- likely important moves. The company also halted its store growth, shuttered some locations, and has only added 323 stores in the past four years as net income has grown to $1.25 billion from $315 million, and revenue has risen over 12%.

Starbucks also is increasingly diverse in its in-store wares, serving up new foods and drinks, and as Starbucks halted store growth, its consumer products business of frappuccino bottles, packaged coffee and Tazo Tea bags doubled sales. Those brands and recent launches like Via instant coffee, K-Cup packs and Starbuck's own K-Cup style home brewing system will be a staple of Starbucks stores and distribution agreements with supermarkets and foods giants like Kraft .

Starbucks La Boulange bakery is just the latest example of Schultz's comment from November, "We've cracked the code on growth plans." When buying Evolution Fresh last year, Schultz said Starbucks will sell new juices in its coffee-selling chains outlets, and by the end of 2012, it will use the deal to introduce a new health and wellness line of stores.

"Even though this is a small acquisition in size, it is a significant strategic decision and direction for the company," Starbucks said in a statement, adding that the deal taps a $1.6 billion super-premium juice market and is a big step entering a larger $50 billion "Health and Wellness" sector. To make the investment pay off relative to expectations, Starbucks said it will also invest in the distribution and growth of juices products.

With the bakery deal, Starbucks will sell the La Boulange breads in existing stores and expand the chain nationally, at once adding to its food proposition in existing stores, while growing non-Starbucks branded stores. In talking about building the La Boulange brand as a premium retail bakery café, Schultz noted that one-third of Starbucks visitors now buy food.

"Now is the time for us to invest into the core business and take full advantage of the position we occupy," Schultz said. "If you go back a year and a half ago, when we began to see the success of Via, I think this is exactly the same play run a different way. We believe that we have a unique opportunity to create sub-brands and categories within our stores," said Schultz, who also highlights the company's home brewing initiative.

The company will also be growing its store count through non-branded La Boulange and Evolution Fresh stores, in contrast to the epic Starbucks store expansion that a decade ago served as an albatross. In fact, one day three Starbucks owned stores may be able to exist on a street corner without giving Louis Black a heart attack.

IBM has cut a string of small-sized deals in recent years that leverage its existing IT services, software and consulting divisions that earn roughly 60% of IBM's $100 billion plus in revenue and are key to Big Blue's overall 15% profit margin.

When buying cloud specialist DemandTec for $440 million, IBM laid out a case for why the move fit within a much larger $20 billion Smarter Commerce push. That initiative, which ties to a much larger Smarter Planet strategy, also was a key in the divestiture of IBM's Retail Store Solutions unit and a large licensing agreement with Toshiba Tec in 2012. Acquisitions, IBM says time and again, are used to bolster an existing product or service - or to gain entry into a new market -- such as cloud computing -- that fits with its profitable core.

Just over a decade ago, IBM was facing an existential crisis as an onslaught of competition from Dell , Hewlett Packard and Apple eroded profits, making it a losing proposition for "Big Blue" to manufacture the personal computers it had pioneered.

Instead of trying to scale the business for synergies, IBM spun the unit and under former CEOs Lou Gerstner and Samuel Palmisano, it transformed into a tech consulting and IT services giant. Years later, IBM's near-record share price stands apart from former competitors like Dell and Hewlett Packard, who continue to struggle to sell computers profitably.

Like IBM, Starbucks is saying it's high margin core is here to stay. To continue growth, though, the company has to look for new products and customer draws in which it can invest and that in turn can benefit from existing business, enhancing as opposed to diluting the core.

There are risks, highlighted by Starbucks near 3% Tuesday share drop.

Starbucks noted that the deal will dilute earnings by a few pennies, likely causing some investor concern. "We struggle with a dilutive deal because it suggests both aggressive spending as well as a lack of operating income from the current business," wrote Bank of America Merrill Lynch analyst Joseph Buckley, who lowered his earnings per share estimate for Starbucks by 2 cents in 2012 and 4 cents in 2013. Still, he rates shares a buy with a $68 price target on the company's existing growth prospects.

Many see benefits outweighing EPS dilution. "This marks a material attempt at a somewhat needed upgrade to the quality of core baked goods.," said Credit Suisse analyst Keith Siegner in a Tuesday note. "This is just another example of investing some of the upside from K-cups and coffee deflation in longer-term growth drivers, and we continue to believe this is the path to long-term shareholder value creation," Siegner added.

Brian Bittner of Oppenheimer wrote, "while the acquisition is small in dollar terms, its potential is substantial as distribution to SBUX locations increases, the retail footprint expands and the possibility of another thriving CPG offering now exists."

A bet on Starbucks is simpler than all this, though: Big Bean is hoping that a strategy similar to Big Blue will result in a continued jolt for its shareholders.

Here's another take on Starbucks in a peak coffee era.

See top rated restaurant stocks for more on Starbucks.

-- Written by Antoine Gara in New York

Tickers in this article: DELL HPQ IBM MCD SBUX