Keep buying $5 coffee drinks, America!

Posted on Posted in Financial Blog

There are certain companies that investors use as a barometer of an industry’s or sector’s overall “health.” For the technology sector, we often look to Intel (NYSE: INTC), while Proctor and Gamble (NYSE: PG) is a bellwether for consumer staples (must-haves) and Exxon Mobil (NYSE: XOM) for oil & gas. Investors like to use these companies because they have been around for a long time, they are among the largest in their industry, and most importantly have core lines of business that allow us to get a good sense of how that industry is doing. Johnson & Johnson (NYSE: JNJ) is certainly an ancient cash-cow, but with three diverse lines of business (consumer, pharmaceutical and medical devices), you can’t draw a clear conclusion about the overall health of drug manufacturing from JNJ’s performance. On the other hand, Proctor and Gamble generates nearly 100% of its revenue from consumer staples products.

Discretionary spending refers to the things we want but don’t necessarily need, such as jewelry, expensive clothing, a new automobile and smaller purchases like eating out and buying expensive coffee. A more sophisticated way to distinguish between discretionary and non-discretionary (staples) items is to look at how companies that sell those products perform during certain economic climates. Companies that specialize in discretionary products usually see a significant decrease in sales during recessions, far more than staples retailers experience. Some consumer staples actually sell better in hard times, such as lower-cost food substitutes. In a good economy, companies that sell discretionary products to consumers see significant sales increases, while staples retailers experience only moderate sales increases or even a decline in sales. The family that only ate out once or twice a month in 2008 may eat at a restaurant twice a week now, so that they decrease their spending on groceries.

Starbucks and Discretionary Spending in the US

I believe, and many investors probably agree, that there is no better indicator of US (and soon, global) consumer sentiment and willingness to spend than Starbucks (NASDAQ: SBUX). On one hand, serious coffee drinkers will have their coffee in any economic climate, so that you could consider coffee a staple item. However, when money gets really tight, the Starbucks customer has the option to buy coffee at the grocery store. A quick look at SBUX’s performance during the last economic downturn shows that people did just that, as SBUX plummeted to $7.83 per share in late 2008 from its January 2007 price of $35/share.

This is what makes Starbucks such an excellent barometer of the US consumer discretionary sector—there is an easily available, cheaper substitute. When Americans realized they had too much debt and not enough income to support their current spending, Starbucks and restaurants were among the first purchases eliminated, followed by luxury cars, clothing, home improvements and other non-essential purchases. You can switch from Starbucks and restaurants to grocery store food and coffee and cut costs instantly; however, it can be difficult to trade in your Mercedes for a non-luxury car, return your new suits clothes or postpone your home remodeling in progress.

In considering Starbucks a good indicator of consumer confidence and spending proclivity, it makes sense that the company beating expectations in this economic environment would be a sign that consumers are increasing their discretionary spending. And not only did Starbucks beat its fourth quarter earnings targets earlier this month, but the company also raised its dividend, earnings forecast and its store opening target for fiscal 2013. All of these factors combined to catapult SBUX to a November 2nd closing price of $50.84, a +9.1% increase in a single day. And some of this growth is being driven by Starbucks’ expansion into China and other Asia/Pacific markets such as India, a sign that discretionary spending is increasing in other parts of the world and not just in the US.

NOTE: This article is not an endorsement of Starbucks, nor a recommendation to buy Starbucks stock. 

For further reading on the consumer discretionary sector, I suggest you read my most recent newsletter.