The Real Story Behind Starbucks’ Rising Prices

According to a Starbucks (SBUX) rep, the company is raising prices by an average of about 1% to manage business costs such as labor and rent. The average drink will rise by 5 to 20 cents. The rep said, “Our pricing philosophy is to balance our need to run our business effectively while providing maximum value to our customers.”

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Normally, SBUX and other commodity-linked companies will raise prices in line with any rise in the cost of the underlying commodity. However, coffee prices are down 42% year over year, de-linking the latest increase from the coffee price situation.

This raises the question: If coffee prices are so much lower, shouldn’t overall expenses be declining? Why raise prices to offset expenses?

Personally, I don’t believe this is the real reason for the price increase, nor do I care. As a shareholder, I want SBUX to wring every penny out of customers.

As the dominant coffee player in the U.S., SBUX has pricing power. In more formal economic parlance, we are talking about the “price elasticity of demand.” As we know from Econ 101, if the price of a given product increases, sales of that product are likely to decline…unless the product has price elasticity.

SBUX coffee has price elasticity. I do not believe demand will be affected, much less materially affected, by this tiny increase.

This situation illustrates how a dominant player can raise prices in a competitive market, and it also speaks to Howard Schultz’s vision when he created SBUX.

He did not see SBUX as a coffee shop, but rather a place people could meet that was between home and work. This was originally designed as a social strategy, which would be girded by the sale of an addictive product. However, SBUX has since grown far beyond the concept of a centralized meeting place.

Starbucks has become the place to meet, especially on short notice. SBUX stores have become landmarks, and what one urban engineer calls a “zone of attraction.” They are ubiquitous and easy to spot. They offer food and drink while you wait for your companions. They are, in essence, the modern day version of the town square.

That is why SBUX has pricing power.

However, there’s another element. It’s subtle, but it makes a difference. The stores offer wireless charging stations for laptops and smartphones? SBUX now wants you to stick around and type that screenplay you will never sell, do your homework, and while you’re at it, have some late afternoon snacks and slightly more expensive drinks.

You know the old adage: Get an addict hooked on free stuff, then charge him big bucks. Well, two bucks for espresso isn’t big bucks, but you know what I mean.

SBUX stock is trading near its all-time high, and at 32x earnings. There’s $400 million in net cash on the books, and free cash flow is over $2 billion in the TTM. Analysts estimate annualized growth at 18.5% plus a 1.2% dividend. I give Starbucks a 10% valuation premium for having a world class brand name, great cash flow and plenty of cash on hand…meaning I’d pay 26x for this company.

At 32x, though, it’s a tad expensive, but when it comes to growth stocks, my target PEG of 1.0 doesn’t apply. I am willing to go as high at 1.7, and SBUX stock comes in below that.

So, buy yourself a slightly more expensive cup of coffee and SBUX stock.

Lawrence Meyers owns shares of SBUX.

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