Heat Is on Starbucks

SAN FRANCISCO -- Now that Howard Schultz has taken back the reins of coffee giant Starbucks ( SBUX), the question remains: What next?

Schultz, Starbucks' founder and chief executive from 1987 to 2000, earlier this month replaced Jim Donald as CEO of the company. In comments to analysts following his appointment, Schultz pledged to repair the damage caused by the chain's rapid growth, which is now taking a toll on sales.

How exactly he plans to do that should become more clear on Wednesday, when Starbucks reports its fiscal first-quarter earnings after the closing bell. Schultz is expected to elaborate on some of the changes he's alluded to, which include slowing store growth in the U.S., as well as restoring Starbucks' brand image.

Shares of Starbucks have fallen 44% from a 52-week high last February as the company faces increasing competition from cheaper coffee alternatives like McDonald's ( MCD) and Dunkin' Donuts. Schultz also has acknowledged that the Starbucks name has become diluted by its own presence on seemingly every street corner.

Robert Toomey, an analyst for E.K. Riley Investments, says it's possible that Starbucks will cut guidance for the year given its cutback plans and failing efforts to significantly boost same-store sales, or sales at stores open at least a year.

"Unless they can get same-store sales ramping up significantly, it raises the question of how fast the U.S. can grow," Toomey says.

In November, Starbucks reported its first quarterly decline in U.S. store traffic in at least three years. It also provided a disappointing outlook for 2008, predicting full-year earnings of $1.02 to $1.05 a share, allowing downside to Wall Street's forecast at the time of $1.05. Analysts have since lowered their estimates to $1.01 a share.

For the first quarter, Starbucks has forecast earnings of 28 cents a share, which is where analysts' average target currently stands.

In addition to Starbucks' self-imposed problems, it's also battling broader economic headwinds that could damage first-quarter results. Howard Penney, an analyst for Friedman Billings Ramsey, notes that December was a particularly harsh month, not just for Starbucks but other food and beverage chains as well.

"We believe that the sub-par performance was driven by an inflationary environment and difficult same-store sales trends in the quarter," he wrote in a recent research note.

McDonald's, for instance, on Monday, reported flat same-store sales for December, which the fast-food giant attributed to cold weather and softer consumer spending. Most retailers as a whole reported weakness for the month as consumers tightened their purse strings around the holidays, which could signal weak demand for Starbucks' $4 lattes.

As well, Starbucks also has been hit by higher commodity costs, particularly for dairy products. Those inflationary pressures showed no signs of abating in the latest quarter, with food giants ranging from Hershey ( HSY) to Kraft ( KFT) reporting sharp drops in profits amid rising dairy expenses.

In Starbucks' case, Penney believes that what the company says about the future is more important than the first-quarter results.

Although Penney said he has been encouraged by Schultz's initial comments, "the magnitude of the changes, which should be quantified for us on Jan. 30, will be essential to the future sustainability of the company regarding its operating margins, free cash flow and ROIIC (return on incremental invested capital)," he wrote in his research.

Steven Kron, an analyst for Goldman Sachs, said he expects weak operating results to be balanced by the company's plans to slow growth.

"Our directional bias, though, is to the downside as investors may feel skittish if traffic trends slow with ongoing macro concerns, and with greater competition on the horizon," Kron wrote in his most recent research.

Like Toomey, Kron said that Starbucks may lower its full-year guidance, the reaction to which might end up getting overshadowed by any new management initiatives.

"That said, it will be hard for investors to ignore current trends if they have worsened since a disappointing fourth quarter," Kron added.

Shares of Starbucks were down 18 cents, or 0.9%, to $19.79 ahead of the report.