Starbucks' Chairman sends managers a valentine

From the Wall Street Journal:

Starbucks Corp. built its broad appeal on what Chairman Howard Schultz labeled an "experience," including baristas who know customers' orders by heart and an atmosphere that entices patrons to linger for hours. That experience has enabled the coffee chain to charge the premium prices that fuel its robust earnings growth.

But now Mr. Schultz is questioning whether Starbucks' drive for growth and efficiency has diluted that experience. In a blunt Feb. 14 memo, he warned executives that the chain may be commoditizing its brand and making itself more vulnerable to competition from other coffee shops and fast-food chains. The nearly 800-word memo questioned whether Starbucks' automatic espresso machines, new store designs and elimination of some in-store coffee grinding may have compromised the "romance and theatre" of a visit.

The criticisms pinpoint Starbucks' biggest challenge. Mr. Schultz, the company's resident visionary, wants Starbucks to become one of the world's most recognized brands, with 40,000 locations around the globe, or more than triple its current count of about 13,000. But to do that, Starbucks must improve its efficiencies and make other changes that threaten to erode the virtues that made it so successful -- which in turn could jeopardize its ability to charge premium prices.

"Over the past ten years, in order to achieve the growth, development, and scale necessary to go from less than 1,000 stores to 13,000 stores and beyond, we have had to make a series of decisions that, in retrospect, have lead [sic] to the watering down of the Starbucks experience, and, what some might call the commoditization of our brand," Mr. Schultz wrote in the memo.

"Many of these decisions were probably right at the time, and on their own merit would not have created the dilution of the experience; but in this case, the sum is much greater and, unfortunately, much more damaging than the individual pieces."

Starbucks spokeswoman Valerie O'Neil confirmed that Mr. Schultz wrote the memo. She said it reflects his "passion" and is "a reminder of how success is not an entitlement." She said the company hadn't yet implemented any changes as a result of Mr. Schultz's memo.

Nevertheless, even before Mr. Schultz sent the memo, Starbucks executives had conceded there was a risk that its expansion would move the company away from its roots. "If we just become about products, and not about the people side, I think the experience changes, and changes for the worse," Jim Alling, president of Starbucks' U.S. business, said in an early February interview. "We never want to lose sight of where we came from."

The concern comes as Starbucks faces intensified competition from McDonald's Corp., which has upgraded its coffee, and Dunkin' Brands Inc.'s Dunkin' Donuts, which sells espresso drinks and is plotting a nationwide expansion. In recent years, as both those fast-food chains have added Starbucks-like touches, Starbucks has become more like a fast-food chain, adding drive-through windows, hot food and promotions for movies on its lattes.

Mr. Schultz declined to comment for this article. He sent the memo in an email with the subject line, "The Commoditization of the Starbucks Experience." It then appeared on the Web site starbucksgossip.com.

Although not Starbucks' founder, Mr. Schultz is responsible for building the company into the coffee empire it is today. He led the chain to blanket the U.S. with outlets starting in the 1990s and to expand overseas, and he also has steered it to growth through music and movie collaborations.

Starbucks' steady sales and earnings growth have made the company's shares soar since it went public in 1992. Starbucks said net income for the quarter ended Dec. 31 came to $205 million, or 26 cents a share, up 18% from $174.2 million, or 22 cents a share, a year earlier. Sales rose 22% to $2.36 billion from $1.93 billion. Shares of Starbucks have fallen about 9% in the past year. They fell 26 cents in Nasdaq trading yesterday to close at $32.75.

After growing up poor in a Brooklyn housing project, Mr. Schultz left his job as a salesman and moved to Seattle to join Starbucks in 1982. He envisioned expanding the niche brewer of strong coffee beyond the Pacific Northwest by bringing the romance of Italian coffee bars -- and their espresso -- to Starbucks so it would become an enticing gathering place.

Mr. Schultz has sometimes bristled at changes that were part and parcel of the massive expansion he orchestrated. When an executive suggested Starbucks start offering nonfat milk for its espresso drinks, Mr. Schultz initially refused out of concern the drinks would taste thin. He went along after watching a customer in jogging gear walk out of a Starbucks because she couldn't get nonfat milk in her drink.

Last fall, Starbucks said it would add hot egg-and-cheese breakfast sandwiches, in part to attract customers who went to competitors to eat. Starbucks executives conceded there was a danger the sandwiches would make customers think of Starbucks as a fast-food restaurant. To prevent that, the company included more-sophisticated combinations, including eggs Florentine and tomato Parmesan.

When workers first tried cooking the sandwiches, cheese sometimes dripped off them and into the warming oven, sending a strong odor of burned cheese through the cafes. Mr. Schultz complained when he walked into a Starbucks near the company's Seattle headquarters and smelled a burning sandwich, according to a manager at the store. Starbucks switched ovens and told workers to clean them regularly.

More than one-quarter of Starbucks stores now have drive-through windows, and Starbucks says that over the next two years, that will grow to one-third of stores. At her Seattle store, shift supervisor Tanisha Jones says she concocts nicknames for drive-through customers based on their cars to make them feel the same warmth employees try to convey inside the stores. One customer who drives a Mini Cooper now orders the "Mini Cooper special," and Ms. Jones has instructed workers that that means a Quadruple Grande Americano with cream. "It's almost a hook to keep him from going to another coffee shop," she says.

In his memo, Mr. Schultz wrote that when in recent years the company switched to automatic espresso machines -- which have been used in some stores for at least five years and currently are in thousands of outlets -- "we solved a major problem in terms of speed of service and efficiency. At the same time, we overlooked the fact that we would remove much of the romance and theatre." Starbucks used to have all its baristas pull espresso shots by hand.

That move "became even more damaging" because the new automatic machines "blocked the visual sight line the customer previously had to watch the drink being made, and for the intimate experience with the barista," he wrote.

Mr. Schultz wrote that Starbucks switched to "flavor locked packaging" for its coffees that eliminated the task of scooping fresh coffee from bins in stores and grinding it in front of customers. "We achieved fresh roasted bagged coffee, but at what cost?" Mr. Schultz wrote. "The loss of aroma -- perhaps the most powerful non-verbal signal we had in our stores."

Mr. Schultz also wrote that streamlining the store-design process had created "stores that no longer have the soul of the past. . . .Some people even call our stores sterile, cookie cutter," he wrote.

Some Starbucks stores no longer have coffee grinders or coffee filters. "In fact, I am not sure people today even know we are roasting coffee. You certainly can't get the message from being in our stores," the memo says.

"While the current state of affairs for the most part is self induced, that has lead [sic] to competitors of all kinds, small and large coffee companies, fast food operators, and mom and pops, to position themselves in a way that creates awareness. . . and loyalty of people who previously have been Starbucks customers. This must be eradicated," he wrote.

Some customers have noticed. Brad Luyster, a 41-year-old marketing manager from Canal Fulton, Ohio, says he used to seek out a Starbucks each morning to get a cup of coffee because he likes the atmosphere. But he was disappointed when he recently ordered a bacon-and-egg sandwich at a Starbucks in Chicago. The taste of the sandwich was fine, he says. It just didn't fit the experience.

At the end of his memo, Mr. Schultz said he took full responsibility for the decisions Starbucks has made. "We desperately need to look into the mirror and realize it's time to get back to the core," he wrote. "I have said for 20 years that our success is not an entitlement and now it's proving to be a reality."

Portfolio Recovery Associates Beats

Portfolio Recover Associates announced better earnings than expected. The stock gained about 10% during the week.

Motley Fool covers the company and had some nice commentary on the earnings report. Two points stand out. First, the company has been misunderstood, and some press have contributed to the confusion:

The Associated Press added to the general lack of understanding last month with a completely misleading article, which claimed that higher prices paid as a percentage of the original debt's face value was indicative of increased competition and lower returns for industry players... If a company spends 10 cents on the face-value dollar for a portfolio on which it reasonably expects to recoup 300% of its outlay, is that not preferable to spending 5 cents on the dollar for a chance to recover 250% of its expenditure? Someone at AP certainly doesn't understand that math.

The second point was some commentary from the company's conference call, in which CEO Steve Fredrickson stated that Portfolio Recovery was "overcapitalized". This is a fancy way of saying that the company has the enviable problem of having too much cash. It led to a flurry of questions during the call as to what to do with the problem. Frederickson indicated that they intended to hang on to the cash to use as opportunities might present themselves. Dry powder, in other words.

One final point about the Fool article is that Portfolio has made some acquisitions over the past few years. It turns out that these purchases were funded out of earnings, instead of debt. This company has done very well managing its capital, and it looks like it is continuing to do so.

Carnage In The Subprime Mortgage Market, Part Two

HSBC shocked the investment community with their $1.8B increase in loss reserves. HSBC has put the best possible face on the announcement. From Reuters:

"HSBC doesn't like losing money, it prides itself on its credit quality. It has been let down in one subsidiary. We are focusing on it and we're going to get it right," Michael Geoghegan, HSBC chief executive, told analysts on a conference call.

Reuters includes the bear point of view:

"The disturbing fact is that it's recent loans, it's not something that's gone wobbly over time. It's stuff that they've acquired that has gone spectacularly wrong in a short space of time," said Mike Trippitt, analyst at Oriel Securities in London.

He said the key issue was whether all the bad news was now out or if the delinquencies could spread.

But what the article omits is the reaction from the established brokerage community. Early article contained some extremely negative commentary from the major players on Wall Street. I read these earlier this week, but these comments aren't mentioned in the recent Reuters articles. I was able to hunt them down with Google. Also from Reuters is this more urgent warning. Compare it to the quote above. It appears to have been edited to make it more placid in tone:

"The disturbing fact is that it's recent loans, it's not something that's gone wobbly over time, it's stuff that they've acquired that have gone spectacularly wrong in a short space of time," said Mike Trippitt, analyst at Oriel Securities in London.

He said the key issue was whether all the bad news was now out or if the delinquencies could spread.

HSBC's announcement triggered a ratings downgrade by JPMorgan, while Merrill Lynch dropped its earnings forecast ahead of the global bank's expected March 5 results.

JPMorgan cut its rating to "underweight" from "neutral" and advised investors to sell the stock short, as it had further room to drop, and said the higher bad debt charge would cut its pre-tax earnings estimate by 8 percent.

Merrill called HSBC's announcement surprising, as it was the first time in memory that the bank had released material information ahead of its results release.

"We would have to increase our 2006 provision forecast by 24 percent to match the bank's new guidance," Merrill said in a research note. "This would result in a cut of nearly 10 percent to our 2006 net profit forecast of US$16.6 billion for HSBC."

Merrill reiterated its "sell" rating.

"We downgraded HSBC to a sell in early January 2007, highlighting the vulnerability of the bank's share price to negative news flow on the U.S. consumer finance market and consequent earnings downgrades," Merrill said.

Carnage In The Subprime Mortgage Market, Part One

The subprime mortgage market is in fullscale meltdown. This involves one of our companies, HSBC. Earlier in the week HSBC dropped a bombshell when it announced that it is upping loss reserves by 20%. Elsewhere, New Century annouced that it was going to restate most of its results for 2006, and guided revenue for 2007 to a whopping 20% below 2006 levels. Here's a picture of what happened next:



Here's what the Wall Street Journal had to say about the situation:

Default worries are growing at the risky end of the mortgage market.

Those worries sent some home lenders' shares plunging yesterday and highlighted uncertainties about how many investors in mortgage-backed securities might be vulnerable.

New Century Financial Corp. shares dropped $10.92, or 36%, to $19.24 in 4 p.m. composite trading on the New York Stock Exchange after the big Irvine, Calif., lender disclosed late Wednesday that it expects to report a fourth-quarter loss and will restate results for the previous three quarters to correct accounting errors.

New Century is one of the nation's biggest specialists in "subprime" mortgage loans, or home loans for borrowers with weak credit histories. The company blamed its woes on "the increasing industry trend of early-payment defaults," those that occur within the first few months after a loan is made.

Shares of other subprime lenders, including Fremont General Corp. and NovaStar Financial Inc., also plummeted. The combined market value of seven U.S.-based lenders active in the subprime market dropped more than $3.7 billion yesterday.

Contributing to the selloff was an announcement, late Wednesday, by British banking giant HSBC Holdings PLC that problems in its subprime- mortgage business were worse than previously indicated. Yesterday, shares of HSBC, whose operations extend well beyond the subprime sector, fell $2.44, or 2.7%, to $89.78 in 4 p.m. Big Board composite trading.

Many in the industry are wondering how well investors in mortgage- backed securities will cope as delinquencies rise. Lenders quickly sell most subprime mortgage loans to packagers of securities, such as investments banks, or directly to investors. The riskiest of those securities, those that absorb some of the first losses from defaults, are typically sold to money managers and hedge funds in the U.S. and abroad.

"The thing none of us know, including the [Federal Reserve], is who is holding this stuff," Richard Kovacevich, chief executive of Wells Fargo & Co., one of the nation's biggest mortgage lenders, said in a recent interview. "The assumption is that it is well-diversified. If it's concentrated, it's going to be a disaster."

For now, most people in the $10 trillion U.S. mortgage market argue that the current slump in housing and surge in loan defaults won't lead to a disaster. "The mortgage market is vast, and the vast majority of the mortgage market is fine," says Lewis Ranieri, a pioneer in mortgage-backed securities in the 1980s, when he was a star trader at investment bank Salomon Brothers.

But some investors are getting singed, and jitters are growing about how widespread the damage will be and where it will show up next.

The number and variety of investors in U.S. mortgage securities has mushroomed in recent years even as lenders made riskier loans to help stretched consumers afford pricier homes. "There's been a sea change in the market," says Mr. Ranieri.

By packaging loans into securities, lenders can spread their risk and issue more loans than they might otherwise. But they aren't fully insulated. Investors have been forcing lenders to buy back many dud loans, creating a sudden financial burden that has led to the closure of several smaller subprime lenders in the past two months.

A report issued by Credit Suisse on Wednesday found that nearly one in four subprime mortgage deals issued in 2006 had a delinquency rate of at least 8% as of December. The analysis looked at loans that were at least 60 days past due.

Until about three years ago, two U.S. government-sponsored companies -- Fannie Mae and Freddie Mac -- dominated the market for mortgage loans purchased from the original lenders. Fannie and Freddie package loans into securities and guarantee that holders of those securities will receive principal and interest payments. But, as Fannie and Freddie found themselves hobbled by accounting scandals, other investors flooded into the market, snapping up loans that the two companies otherwise might have bought.

As a result, the two companies' share of the market has plunged to about 40% at the end of last year from 70% in 2003, according to Inside Mortgage Finance, a trade publication.

When Fannie and Freddie dominated the market, Mr. Ranieri says, they generally set the standards for what types of loans would be made. Now, those standards are largely set by the risk appetites of thousands of hedge funds, pension funds and other money managers around the world. Emboldened by good returns on mortgage investments, they have encouraged lenders to experiment with a profusion of loans.

Many subprime borrowers aren't required to prove their financial health with tax forms or other documents. Lenders also sometimes rely on computer programs, rather than human appraisers, to estimate the value of homes.

"We don't know how much the guy makes or what the house is worth," says Mr. Ranieri.

The housing boom of recent years held defaults to very low levels because borrowers who fell behind on payments could easily sell their homes or refinance into a loan with easier terms. But as house prices have flattened or dipped in many parts of the country, far more borrowers are falling behind.

In November, payments were at least 60 days overdue on 12.9% of subprime loans packaged into mortgage securities, up from 8.1% a year earlier, according to First American LoanPerformance, a research firm in San Francisco.

Another innovation of recent years -- the collateralized debt obligation, or CDO -- has made it possible for far more investors to make bets on U.S. mortgages. They are akin to mutual funds. By investing in a single CDO, investors can gain exposure to hundreds of different mortgage securities of varying quality.

CDOs buy the bulk of the lower-rated rungs of subprime-mortgage securities, those that take some of the first hits if defaults are higher than expected, says Kedran Garrison, a CDO analyst at J.P. Morgan Chase & Co. CDOs are especially attractive to investors in Europe and Asia, as well as many in the U.S. But there is no way to identify the biggest holders of CDO notes and shares or to know how well they understand the risks and have hedged themselves.

That could be a problem for regulators. In 1998, the Fed convened investment banks and worked out a rescue plan for hedge fund Long Term Capital Management LP, which was on the verge of collapse. But in today's splintered mortgage-securities market, the Fed wouldn't be able to "get the involved players into a room" to work out a plan to help a distressed institution sell off assets in an orderly manner, says Josh Rosner, managing director of Graham Fisher & Co., a New York investment research firm.

A spokeswoman for the Fed declined to comment.

CDOs aren't the only ones on the hook. Hedge funds, mortgage real- estate investment trusts and the trading desks of Wall Street firms are among those that could be hurt if their bets on the mortgage market don't turn out as planned.

A interesting bit of info for those who have DSX or other dividend stocks

Evaluating dividend stocks
Posted Jan 29th 2007 3:24PM by Zac BissonnetteFiled under: Technical Analysis
Several weeks ago, I wrote a piece about how I feel about dividends as a matter of principle: I strongly believe that share buybacks and paying down debt are much better ways for companies to increase shareholder value. However, some investors cling to the (illusion of) safety created by dividends, and so I'm going to provide a few pointers on how to evaluate dividend-paying stocks. When evaluating stocks for income, we want to examine the size of the yield, the sustainability of the yield, and potential for capital appreciation. Generally, it's very hard to find stocks with large sustainable yields and the potential for capital appreciation, so you will probably have to settle for two of the three.
For the purpose of this tutorial, we will be evaluating three stocks: The Altria Group (NYSE: MO), The Boulder Growth and Income Fund (NYSE: BIF), and Diana Shipping (NYSE: DSX).
Evaluating the Size of the Dividend: This is the easiest part. This consists of dividing the total value of the dividends each year by the current share price. This gives you a percentage. MO has a yield of 3.91%. DSX has a yield of 10.03%, and BIF has a yield of 11.85%. So the Boulder Growth and Income Fund is offering the largest dividend, but all three are solidly above the 1.52% yield of the average S&P 500 stock. (Source: indexarb.com.)
Sustainability of the Yield: To understand whether the stock is safe as an income investment, you need to ask the question: How likely is the company to be able to continue to pay, or even increase, its dividend? The payout ratio will serve as a quick litmus test of sustainability. According to Capital IQ, MO has a payout ratio of 59%, which means that it pays 59% of its earnings back to shareholders. So, assuming that MO's earnings will not decline rapidly, the dividend appears to be safe. DSX has a payout ratio of over 200%, which means that it pays more dividends than it earns. However because it is a shipping company, DSX has large depreciation expenses, and its policy is to pay nearly all of its cash flow out as dividends. The company is largely dependent on the spot market for leasing out its ships, so its future earnings can be somewhat unpredictable. BIF is a closed-end fund and its policy is to pay out a dividend of 10 cents each month, regardless of earnings. Of course, in the long-run, the fund will not be able to pay out a dividend if it isn't able to earn that amount on its investments.
Potential for Capital Appreciation: This is where you evaluate whether, in addition to the dividend, the stock itself will have a good chance at appreciation. This is also closely tied to the payout ratio. A company that is paying a large portion of its earnings back to shareholders may not have the money to expand the business. Generally, there's a trade-off. A company that returns cash to shareholders will be forgoing opportunities to reinvest in the business, and so the share-price may have less potential for appreciation. In the case of DSX, an increase in the amount the company is able to collect for its ships will increase the earnings and therefore the dividend, and therefore the yield, and therefore the stock price.
So these are the three important factors to consider when investing for income. While I remain steadfast in my opposition to dividends as a matter of corporate governance, some investors may still want to invest in dividend-paying stocks.