New Starbucks CEO Faces Frothy Expectations

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If you look at Chipotle, on average across their system, they can basically make and sell 100 burritos per hour. So mapping that into Starbucks operations, you've gotta think there's a way to fix some of this stuff.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Sean Dunlop. He's a stock analyst at Morningstar, and there's a reason he's talking about burritos and coffee. It's not that Starbucks is testing a carne asada latte or anything like that. It's that the CEO of Chipotle, we've had on this podcast is heading to Starbucks. We'll talk about what that means for the stock, and we'll run through some other restaurant stock picks. Listening in is our audio producer Jackson. Hi, Jackson.

Hi, Jack.

Are you a Starbucks customer?

You know, I, I used to be once in a while. I, I'll, I'll come if I have the Starbucks gift card, but I found that, uh, Cutting coffee out of my budget is a pretty easy, low-hanging fruit. I can make coffee at home pretty easily.

You're cutting costs.

That's why I'm cutting costs. And actually, I've— that's not quite right. I have been ordering coffee out sometimes.

Now it's turning into more of a confessional. Where are you going? What have you left Starbucks for? Tell me.

There's a taco truck by the car charger near my house.

Right.

And it takes about 15 to 20 minutes to charge the car. And that taco truck sells coffee for $2. And, and you gotta think this is pretty horrible coffee, but you look inside the truck and they have one of these specialty drip coffee pour-over apparatuses. I don't know if you know what I'm talking about.

This conversation, this conversation is not going well for Starbucks investors right now. They're weeping in their hands because you've left this, this high-end latte purveyor for a taco truck.

I think the point here is, you know, whether it's at home or in a taco truck, people have learned how to make better coffee.

That's a fair point. I'm not a Starbucks frequenter myself. I'd say I'm most likely to buy coffee out in— going in order— McDonald's, Dunkin', and maybe the local bagel shop. But I have nothing against the Starbucks. It tends to occur to me to hit one when there's one in like a hotel lobby or at an airport or something like that. And I feel like there's often a line. And we're going to talk about that. We're going to talk about wait times and abandonment, which is a key issue facing Starbucks that you'll hear about. That's when people abandon their orders because they're turned off by how long it will take. Not all Starbucks waits are long and not every location has long waits, but it has been something that investors have been talking about and thinking about. The stock has been an underperformer in recent years. Chipotle stock meanwhile has raced ahead since 2018 when Brian Niccol was announced as CEO. Chipotle, Jackson, of course, Spanish for—

I don't think it's Spanish for anything. I think it's just the name of a chipotle pepper.

I thought you were gonna say pepper and I was gonna nail you good. I was gonna never let you hear the end of it. Yeah, it's just, it already is Spanish. Comes from one of the indigenous languages in Mexico. And that company is doing great. In Barron's Magazine, I wrote this year that Brian Nichol— I think I called him the Thomas Edison of burrito drive-throughs— he used the disruption of the pandemic to sort of redesign that business, really building out the capability for digital orders with separate prep lines and fancy software that are can allow him to shift workers on the fly and keep wait times agreeable for customers. And that has kept customer complaints down, and that makes workers happy. And all of that has been very good for business. So I think a lot of chains that are struggling with how they balance their digital orders with maybe their walk-in counter service business, they're looking to what Brian has done at Chipotle for answers. But the board at Starbucks has done one better. They just hired Brian. So he'll start at Starbucks next month. And the stock gained 25% on the day of the announcement that Brian was coming as CEO, which I think is a lot, right? I mean, that's a, that's a big expectation. As I wrote in Barron's, it's basically he's got to be a latte messiah at this point. The man has to walk on oat milk in order to satisfy investors after they've already run up the stock so much.

That's a tall order or venti order.

I see what you did there and you should be ashamed. A 25% gain does sound a lot like the job is done before he's even started, right? I mean, if he had said, if the claim was, hey, I came to Starbucks and the stock went up 25% in my first year, you'd say, wow, that's a great job. Well, that's already accomplished. They ought to find a way to hire this guy everywhere if that's going to be the reaction. What you want to avoid is what happened to Chipotle stock that went down 8% in a day on the news. But how about everyone just take turns hiring him and he never leaves any company and we put him on some kind of a rotation? It's like a, like a shared custody agreement where he manages every company in the S&P 500. That way all of our 401(k)s get a big immediate nickel tickle, as I've coined it.

Well, that's disgusting, and you should never say it again. But who needs interest rate cuts when you got Brian Nicol?

That's right. He's basically walking stock market stimulus at this point.

But there's going to have to be some sort of results there, right? Like earnings growth or—

Jackson, I'm not a details man. You're trying to bog me down. I'm a big thinker. Okay, put this guy at Intel. You get a bump. Look, the semiconductors, somebody else can figure that out. I'm just saying, bring in Brian Niccol. Chipotle CEO experience is probably a good fit for running Starbucks, but not a perfect fit. Let's look at some of the similarities between these businesses. I think of both of them as kind of premium products compared with their competitors. People are willing to pay a little bit more for what they perceive as good quality. And of course, they both handle lots of digital orders and they have rewards programs through their apps. But there are also key differences. Starbucks is around 10 times the size in terms of store locations. It has a much bigger international business. It's also, how shall I say, it's more grown up than Chipotle. When, when, when Brian took over at Chipotle, he took over from the company's founder. And this was sometime after there had been these, these outbreaks. There was an E. coli episode and a norovirus episode. And that was bad for business, for the reputation, for the traffic, for the stock price. The stock price had been shattered. And so Brian brought experience from Taco Bell, including how to run a modern supply chain and put in better safety protocols, especially at a company like Chipotle, where a lot of the experience is more cooking, more handling of ingredients in the stores. And I think you'd have to say it has been a raging success at Chipotle. But Starbucks is a much larger corporation that has been under mega corporate management for years. When it faced some criticism earlier this year over wait times, management put out a blog post where it talked about its advanced software system for allocating workers. It sounds like it believes it's already doing some of the things that Brian had put in place at Chipotle. So what's left for Brian to do, and what are his chances, and what does it mean for the stock price? Is there more room for Starbucks after its big one-day gain? For some perspective on that, I reached out to Sean Dunlop. He's a stock analyst at Morningstar. Let's hear part of that conversation. Brian Niccol going to Starbucks. What do we make of that? I get the appeal. He's done a great job over at Chipotle. What do you think he's going to be able to do there?

Yeah, it's a good question. I mean, Niccol's track record is obviously very good in the restaurant industry. Had a brilliant time with Taco Bell, moved over to Chipotle in 2018. At that time, Chipotle was navigating a really tough stretch, uh, with its E. coli outbreak. So I think the hope is that the success that we've seen at Chipotle from 2018 to 2024 will be replicated at Starbucks, uh, in the next couple of years. I think that's the idea.

What are the chief complaints? There's, there's activist attention at Starbucks. So when you look at the activists and what they're complaining about, what is it that they say that the company should be doing better? Where do they think it's going wrong right now?

Yeah, there are a number of complaints. So I think to be fair to Lakshmi, he came in at precisely the wrong time. It may be the worst decision that he made as CEO was joining what he did. Consumers are not feeling good and they're trading down. When they do that, nobody really trades down into Starbucks. But as you look at some of the company-specific issues, obviously they're dealing with a decent subset of their US stores coming up on almost 500 that have voted to unionize. Beyond the labor relations angle, they've had issues with PR with the conflict between Israel and Gaza. It's the first time I can think of where both sides sides of kind of boycotting a company at the same time. And then in China, obviously, you've got really sharply slowing consumer demand and a lot of competitive pressure from tier 2 and tier 3 market specialists like Luckin Coffee that sell coffee at about a quarter of the price that Starbucks does in those markets. So that combination of factors has really driven an uptick in promotional activity and a lot of the pressure that we've seen here at Starbucks lately.

How about the, the competitive backdrop in the U.S.? I notice, I never know if it's just me or if everybody's seeing it. In my area, there's been a lot of remodelings of Dunkin' Donuts. They seem to be sharpening their game. I went to one the other day and my daughter said, Dad, get the app and you'll be able to get a free drink every day for like 2 weeks. And I did. I got the app and they gave me a free drink every day for 2 weeks. And then McDonald's, they do a coupon where it's like you can pay $0.99 and get a nice coffee over there. That's pretty tough competition when, if you go to Starbucks, I don't know what you're paying over there, $5, $6 or something for a coffee. Has the competition gotten sharper or has it always been this, this tough in coffee?

Yeah, it's certainly got a little bit tougher. If you look back even at the last quarter, the amount of money that Starbucks has spent on discounting has ticked up pretty noticeably. That's obviously been depressing restaurant-level margin. They would point to 14% of orders having some sort of coupon in the most recent quarter, some sort of coupon or discount, which for them is unusually high. Now for perspective across the industry, it's about 29%. That's a little bit more than double that purportedly. So it's a challenging environment. And to be fair, Starbucks doesn't usually play particularly well when consumers are feeling stretched. It's a premium-priced product. Their core consumer doesn't usually trade down the menu toward cheaper items. They just stop coming entirely, which is exactly what we've seen over the past couple of quarters.

I spoke with an analyst recently and she mentioned, yeah, you know, my last trip to Starbucks, I had to wait a long time for my coffee. I was waiting 10, 15 minutes, something like this. Do they keep track of levels of customer satisfaction? Has there been any signs of customer dissatisfaction with the waiting times?

Yeah, it's a good question.

It's a brand that's high enough frequency that they've got really good data on that. They don't share it with us, unfortunately. The data points that I could funnel you toward would be they cited a mid-teen cart abandonment rate, not this quarter, but the quarter prior, which basically means that you've got some sort of Starbucks item in the cart. You see how long it's going to take to fulfill it. And then you bulk, you don't make that purchase. They obviously, they didn't contextualize that. So we don't know if that number is normally 10% or if it's normally 0%, which makes it a little bit tougher to evaluate. The other place you can look is, is Bloomberg's second measure has decent data that sort of looks at cell phones and, and wait times. And we saw a pretty market uptick in the percentage of orders that take 10 or 15 minutes or longer to fulfill. I think if you really had to pinpoint it though, nominal wages at Starbucks stores in the US actually declined year over year. In the fiscal first and fiscal second quarter. So what that tells me is that they're potentially understaffing, or they've got fewer better-paid staff. Obviously, we saw that materialize in terms of service times lengthening.

I mean, these— this is not the worst set of problems. Am I wrong about that? I mean, part of it stems from the place is popular, it's got a lot of customers, and, uh, you know, so you can get some long wait times. It sounds like somebody who knows a thing or two about digital ordering and about the kind of fine-tuning operations could fix that. Maybe they need to put a little more money into labor. But then again, it sounds simple, but people have been trying for a while, right? So am I wrong that it looks like a straightforward job, or what's your sort of prognosis here for fixing Starbucks?

Yeah, it's a really good question, Jack.

I think eventually they'll figure it out. Starbucks is a really smart brand. Obviously, Nichols got a great operational pedigree. If you look at Chipotle, on average across their system, they can basically make and sell 100 burritos per hour. So mapping that into Starbucks operations, you've got to think there's a way to fix some of this stuff. It could be as simple as gating digital orders that you lengthen the wait time if you get above a certain threshold per 15 minutes so that consumers aren't sitting around waiting at the store, or maybe they'll funnel to a different store. You could be looking at different capacity expanding initiatives like their cold bar they've been rolling out. Very slowly across their US store base. Could be as simple as adding staff. Obviously, something that they have struggled with is managing that digital business, as you alluded to. About $6.10 that they sell in the US come through their loyalty program. About 40% of orders come through mobile order and pickup. So being able to balance that with the order flow in-store is extremely important. That's obviously something that, that Brian has done well at Chipotle. That's something that Starbucks and investors are hoping he's able to replicate at Starbucks. It won't be a next quarter fix, but it's something that hopefully they're able to work through in the next couple of quarters.

What is a better fix? Going from Taco Bell to Chipotle, right? On some level, there are tacos at, at both places, or burritos, or going from Chipotle to Starbucks, because there it's a little bit of a higher dollar customer that's coming in, a little bit of a value-added item? What do you think is the best— and I realize it's a bit of a ridiculous question, but how well do you think his skills are going to translate?

It's not a one-to-one fit. I mean, Taco Bell obviously has a very unique niche. It's got a little bit of a younger audience in general. It typically skews toward late night. Chipotle is very much a value-for-the-money concept. Neither really have a big international footprint the way that Starbucks has, or even a big consumer packaged goods or grocery business the way that Starbucks has. But in terms of blocking and tackling and running good restaurants, that's certainly a competency that he does have. And in terms of timing with Chipotle, he came in 2018 and was able to turn around that brand that already had strong relationships with consumers and strong underlying momentum and brand equity. With Starbucks over the next couple of quarters, he has the benefit of blaming the problems that we see today on his predecessor and probably the benefit of consumer spending rebounding in the second half of 2025. So if nothing else, his timing is impeccable, I think, here.

That's always nice when you can say, hey, none of that stuff is my fault. I'm just the person here to fix the stuff that the last folks did. That's a nice starting point. When I look at the stock, the stock had a big jump when the news was announced, a big one-day jump, Starbucks stock. So I guess that that's investors saying, hey, you found the right guy for the job here. But what does it mean for investors who are looking at Starbucks stock now? When you look at Starbucks stock, do you see value there? Is it a good deal? Is it pricey? What do you think about the stock?

Yeah, I guess you have to balance that leadership matters in terms of leveraging the brand to create competitive advantages to generate growth at scale over time. And I think Brian Niccol is a great guy. He's one of the most talented executives in the industry. He could do really well at Starbucks. Should he do 25% better than Laxman did? That feels a little bit— a lot of optimism has to be priced in for that to work out. Now, to be fair, The market had priced Starbucks as if we'd already seen peak Starbucks and they're going to have to deal with these problems forever. It's a big brand with great cash. It's got incredible store economics, which is probably the single most important determinant of future success in the restaurant industry. So I think things ultimately would've worked out. We had a fair value estimate analogous to a price target of $95 going into today. The only thing that's changed is Brian Nichols now sitting in the driver's seat, and we think that the stock looks fairly valued at this point. On the other side of the coin, Chipotle shares were down 7 or 8% today during intraday trading. So it attests to the degree to which the Street regards Brian. I do think it's important to note that any changes that he enacts are going to hit on a 2 or 3 or 4-quarter delay. So maybe it's a little bit short-sighted.

Do you have any predictions? And it's okay if you don't. This is a pretty new development, but anything you think that Brian Niccol is going to come in, he's going to have his review period, maybe it's a couple of months or something like that, and then he is going to come out with a big slide deck, let's say, or an announcement about a new direction or a new plan or a new something, what do you think might be his first big changes? What's the first order of business, you think?

The proverbial triple shot espresso plan with 3 pumps this time. We're missing one last time. No, it's in all seriousness, I think we'll see, and they kind of allude to this in the press release, I think we'll see some changes to Starbucks' labor model in terms of investing in worker benefits and right-sizing staffing. That's something that Chipotle has done really well over the last couple of years, and that was something that they were very clear to emphasize in the press release as being part of the reason for his success with Chipotle. I think you'll probably see some operational throughput-driven initiatives. Obviously, speed of service has been an issue in, in recent quarters for Starbucks.

There's more of my conversation with Sean at Morningstar to come. We're gonna hear about some of his favorite restaurant stocks. Let's take a quick break. Jackson's going to run out to the taco truck for a mocha latte.

Yeah, I don't think they have a milk frother, so I'll just have to stick with horchata.

We'll be right back.

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Welcome back. We're speaking with Sean Dunlop. He covers restaurant stocks at Morningstar. I asked Sean to tell me about some of his favorite restaurant stocks and about the methodology they use over at Morningstar. They don't have buy or sell or hold ratings. They calculate a fair value for stocks. I'll let Sean tell you about it.

We use a discounted cash flow model. We basically assume that ultimately a business is worth the cash flow that it's going to return to investors in some capacity. And for a lot of, particularly the high-growth companies like a Wingstop, sometimes at times like a Chipotle, the street gets so ahead of itself with pricing based on multiples and just staying ahead of the stock that you risk pretty substantial shareholder value destruction if you're not careful. On the inverse, when you've got a company that's been beaten down for a while, but is in reasonably healthy shape, you can get pretty sizable buying opportunities. So an example of that today would be Papa John's. Todd Penegor was just announced as CEO, the former Wendy's CEO. It's a firm that lost Rob Lynch to Shake Shack in a similar situation to what Chipotle finds itself in today. They lost both the CEO and CFO in a couple of months. But fundamentally, if I were to open a new Papa John's in the United States, I get my money back in 5 years. And from a franchisee perspective, that's still very attractive from a food quality perspective, from a consumer resonance perspective. Papa John's remains pretty healthy. That's a company where we've got our, our current fair value estimate is $69. So even with that, you've got about 25% or 30% upside from current prices. Another good example would be Restaurant Brands International. Pulled back on their system-wide sales growth target for this year, but we see a lot of underlying momentum in the Burger King brand in the US that has been obfuscated by Current pressures as the firm has started to renovate that footprint. And obviously Tim Hortons goes from strength to strength. They're able to comp 4.9% despite having a striking 70% market share in Canadian brewed coffee.

So this is a, this business is a mashup of Burger King and Tim Hortons and Popeyes.

Popeyes. Popeyes.

Oh yeah. Forgot about Firehouse.

Yeah. Who, who knows who's coming next?

Is Burger King, how do I feel about Burger King? What's the best way to say this?

Still solvent in the US and thriving everywhere else.

Is that a business that is turnaroundable? What does that business need?

Ian Formigle: Yeah, it's a good question. Maybe I'll have to eat these words, but I would say it's more of like managed decline situations. They're closing stores at about 2% a year right now in the US. Typically with the restaurant industry, you'll see a third of the stores are doing okay, a third of stores are very healthy, and then a third of stores are typically losing money. And the way that franchise arrangements work, you're strongly disincentivized from closing stores. You have to pay very punitive lease breakage fees and so on. So As long as you're covering your variable costs, companies will keep those open. Over time, those stores will close. So I think we'll probably be left with a smaller, healthier Burger King. If you were to look at unit economics though, they still cost about the same to build as like a McDonald's or Wendy's would cost. They only generate about $1.7 or $1.8 million in per-store sales. For perspective, McDonald's is in the high $3 million range.

So then your hopes for that stock or, or you're devaluing that stock is based on which part of the business?

It's based on pretty much everything else, right? So Tim Hortons is growing very strongly in Canada from a comparable sales perspective. It's actually found pretty reasonable traction in Asia Pacific. Popeyes is a strong growth brand for the chain that we expect to account for somewhere between 15% and 20% of operating profit in the long run. The Burger King International business from an EBITDA perspective is about 60% of that brand's total EBITDA. So it's going to become increasingly important over time. The brand has been able to cross-sell a lot of its concepts with big international franchisees. That's one of the big draws. So if I'm a Burger King franchisee in India or in Indonesia, they've had pretty good success also cross-selling Popeyes or cross-selling to a lesser extent Firehouse, more recently Tim Hortons. And that's the big part of the narrative. If you look at that international business, we expect it to go from 25% of profit today to just shy of 40% in a decade.

So restaurant brands, Was there a third one or is that— are those the main two that you like?

We like McDonald's. Honestly, McDonald's sits on the right side of a lot of industry trends today. It's a very cash generative company. Operating margins are in the high 40s and set to expand even further given the owned land. And we think that the market typically underappreciates its loyalty program. So it's got a little bit north of 150 million, I think it's 166 million loyalty program members today. And they only launched that in 2021. Big, big upside from increasing guest frequency within that loyalty program could add upward of 2 points of comparable store sales growth per year. Obviously, it's been a pretty challenging stretch for them, but wouldn't want to get in a value war with McDonald's.

Thank you, Sean Jackson. You think we've got it covered here on restaurants and Starbucks in particular? Describe this episode using an adjective that you could also use to describe a Starbucks beverage. Don't say foamy. How about quickly now?

Spicy.

That's— they're not supposed to be spicy. Someone's playing a joke on you.

No, spicy is all the rage. There is the Hot Cheetos movie.

What's there spicy at Starbucks?

Yeah, I'm reading the Starbucks blog. It says Starbucks new spicy lemonade refreshers and spicy cream cold foam are coming in hot.

Do we need spicy cream?

Yeah, it goes on to say it's inspired by the quote, "swicy" trend.

I've already learned.

Do you know what that's for?

Is it sweet and spicy?

Bingo.

I've already learned too much. Thank you all for listening. Jackson Cantrell is our producer. You can subscribe to the podcast on Apple or Spotify. You can rate it. You can review it if you're listening on Apple. I'm still a little bit thrown by the spicy foam business.

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