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Starbucks Stays Neutral

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We have maintained a Neutral recommendation on Starbucks Corporation (SBUX - Free Report) following appraisal of fiscal third quarter 2012 results.

Starbucks reported earnings of 43 cents per share for fiscal third quarter 2012, which missed both the Zacks Consensus Estimate of 45 cents as well as the company expectations. Starbucks was expecting to post earnings within a range of 44 cents -45 cents in the quarter. The lower-than-expected results were due to soft consumer traffic trends in the U.S. in June and a weakening global consumer environment. The company has also been struggling in Europe for some time. Quarterly earnings however increased 19% year over year due to top-line and margin growth.

Total sales for the third quarter increased 13% year over year to $3.3 billion. The sales growth was driven by strong global same store sales and substantial top-line growth in the Channel Development (also referred to as CPG business) segment. The quarterly revenues were however almost in line with the Zacks Consensus Estimate of $3.31 billion. Following the third quarter miss, the company cut its outlook for the fourth quarter due to the economic downturn.

Starbucks is one of the most recognized coffee brands in the world. Other than fresh, rich-brewed coffees, Starbucks’ offerings also include many complementary food items and a selection of premium teas, sold mainly through the company’s retail stores. Popular company brands include Starbucks coffee, Tazo Tea, Seattle's Best Coffee, and Starbucks VIA Ready Brew.

Starbucks’ CPG business, which comprises everything outside the Starbucks stores like packaged coffee, foodservice operations, K-Cups, Starbucks VIA Ready Brew and Tazo tea, is growing rapidly. It is a largely diverse (in terms of revenue mix), high-margin, high-return on capital business, which has given a fillip to both top- and bottom-line growth in the past few quarters. The company expects this business, which deepens Starbucks’ presence in the at-home coffee and away-from-home coffee segments, to continue to grow over the long term.

Starbucks focuses on brand innovation and new products to create differentiated value proposition for its customers. Among the recently launched products, Starbucks VIA Ready Brew and Starbucks K-Cups helped it to capture 22% share of the premium single-cup market against a zero presence in this segment just 2-3 years back. The Verismo system (available online and expected in stores in early October) and the expanded partnership with Green Mountain Coffee Roasters (to use Starbucks-branded Vue packs on the latter’s Keurig Brewers) are expected to help Starbucks capture further share of this potential $8 billion market in the coffee industry. Other successful recent product launches include Starbucks Refreshers, made from real fruit juice and green coffee extract, Blonde Roast coffee and Evolution Fresh juices. Continued innovation and new product offerings would drive both top- and bottom-line growth for the company, going forward.

Moreover, Starbucks’ U.S. operations have witnessed a substantial turnaround since the last couple of years. The segment regularly posts an operating margin of around 20%, which is expected to improve further through new store openings, remodeling of existing stores, new product launches like Blonde Roast, Verismo, K-Cup, VIA single serve and Evolution Fresh juices over time. Further, Starbucks' business in China is rapidly growing and the region is expected to become the company’s second-largest market by 2014.

Despite the positives, poor sales in Europe due to depressed macroeconomic conditions and rising cost of commodities, especially coffee, keep us on the sidelines.

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