Barron's Streetwise - Why Starbucks Went Cold. Plus, Apple’s A.I. Opportunity.

Episode Date: May 10, 2024

William Blair Analyst Sharon Zackfia talks restaurants including Chipotle, Sweetgreen and CAVA. Jack assesses his relationship with Siri. Learn more about your ad choices. Visit megaphone.fm/adchoices

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Hello and welcome to the Barron Streetwise podcast. I'm Jack Howe, and the voice you just heard is Sharon Zakfia. She's an analyst covering restaurants and more at William Blair, and she's talking about Starbucks, which is not doing great at the moment, or even just okay. Sharon recently downgraded it. We'll hear why, and we'll look at why another analyst or even just okay. Sharon recently downgraded it. We'll hear why, and we'll look at why another analyst sees a buying opportunity.

But we'll start off with some chit-chat about Apple and AI. Listening in is our audio producer, Jackson. Hi, Jackson. Hi, Jack. Big announcement. Well, that's not true. This wasn't really that big. It's just the iPad, right? It's got a new iPad. And it had this commercial. Did you see the commercial? I have not seen the commercial. Should I take a look at it right now? It's got this hydraulic press, and then it's got a lot of artsy stuff that's on it. Like there's a piano and there's paint and there's a sculpture and all this different stuff.

And the hydraulic press comes down and it crushes all this artsy stuff and then it comes up and what's left is the iPad. I think they meant it to say that we're cramming a lot of artistry into the new iPad, but I think that folks who were maybe looking to nitpick took it to mean Apple is crushing creativity. I don't know. I'm not a marketing expert, so I can't tell you if something like that works. What I'm interested in with this one is the chip. The previous Scoopity-Doo top of the line iPad used the M2 chip, and this one's using the M4 chip. That's Apple's own chip, and it has a neural processing unit. That's a separate accelerator that's just for artificial intelligence. That's something that Apple has been doing for a while.

And it said that this one is capable of 38 trillion operations per second, which sounds like a lot. I'm not even sure if I can do one operation per second. TOPS is the acronym there, trillion operations per second. I think you might be hearing more about TOPS, and I'm going to try to explain why. Remember last week on this podcast, we heard from Daniel Pilling. He's the semiconductor analyst at Sands Capital, and he was talking about edge computing. If you look at Amazon Web Services, here's how they define edge computing. The process of bringing information storage and computing abilities closer to the devices that produce that information and the users who consume it.

I compare this in a column this week with the early 1990s. Back then, your personal computer went obsolete faster than you could rewind a VHS tape and chug a crystal Pepsi. And that's because Microsoft would come out with a new version of Windows, and that would require a lot more processing power. come out with a new version of Windows, and that would require a lot more processing power. And since all the processing power lived on your machine, you were off to CompUSA for an upgrade. The internet changed that, and eventually the rise of cloud computing. The processing power shifted to remote servers. Over time, that has not been great for hardware sales. Replacement cycles have lengthened.

Last year, PC sales fell 14.8%. That was the biggest decline ever, and it was also the second consecutive double-digit decline. But there are some early signs of a bounce. In the first quarter, notebook shipments increased 4.2%. That's according to Canalys, which is a data firm. And it reckons that AI is behind the rebound. And there are two factors there that are kind of working together. There's Windows 11.

It has a centralized AI assistant called Copilot. Right now, that runs in the cloud, but it's expected to run locally in the future. And so as companies prepare to upgrade to Windows 11, they're upgrading to new machines. PC makers and chip makers are accommodating those customers by delivering machines that have built-in AI accelerators, including those neural processing units. Remember, Daniel talked about the reasons that AI would make you want to have more computing oomph at the edge. He says that latency is an issue. When I'm asking Siri a question in the car and I'm driving through a woodsy area and she doesn't respond to me right away, I feel unloved. It's bad for my long-term relationship with Siri. I feel it would bring us

closer together if I had more local processing power that would deliver answers with no lag. In the AI world, that processing job is called inferencing. And Daniel said that there's actually a hidden cost benefit there for companies. If you're buying a machine that has Microsoft and its co-pilot on it, and you've got the local processing power to do that inferencing yourself, Microsoft doesn't have to pay to do it remotely. That's a little sliver of savings for Microsoft, which adds up over time.

You're footing the bill for the inferencing. And then finally, there's privacy. If you have an AI assistant that you're using, and if it's something that remembers you over time, it learns about you, it's tailoring its responses to you, it's getting to know you, you would prefer to have that model live right next to you instead of being shared somewhere on the cloud. So all of that means you might need more processing power locally. Remember, Daniel felt that there was going to be an explosion of chip demand for artificial intelligence uses, both for edge devices,

the devices we hold in our hands, and centrally for data centers and hyperscale operators and so forth. He felt that as the hardware gets better, the algorithms will improve exponentially, the machines will talk to each other, and they will learn new use cases for AI. I want to focus here on the edge, those personal devices. B of A security says that we're about to see the battle of the tops. Remember, Apple's cruising along at 38 tops with its new iPad. Microsoft has a Windows AI event scheduled for later this month. And one theory about that event is that it's going to announce

a minimum specification for computers that are running AI locally. That's kind of how things worked back in the early 1990s. Microsoft would come out with its new operating system. It would list the specifications that you needed for your computer. You compare that with what you had. You would realize that you were coming up woefully short and you had to buy a new machine. So the thinking is that Microsoft might say 40 tops, 40 trillion operations per second is this new minimum requirement for local AI.

And that's something that you can find today nowhere. None of the computers have it. But there are machines coming by year's end that will do just over 40 tops, maybe 45. That's one reason to believe that there might be legs to this latest bounce for PC demand. Customers haven't had a good reason to buy a new PC in a long time. Local AI processing might be that reason. But it's hard to figure out when the applications will become cool enough for the customers to want the AI badly enough that they're willing to buy a new machine for it. Jackson, how old is your laptop? Not your work laptop where someone else is paying for it. You got a personal machine? Yeah, I have a 2014 MacBook Pro that I got when I was going to college.

2014 as in the year 2014. Do I have that right? The year 2014. Does it have a rotary dial anywhere on the computer? No dials. I'm trying to think what laptops had in 2014. Can I assume that you're not doing any audio or video editing on this machine? You're just using it to go on the internet.

What else do you do with it? Anything? Watch sports. Can it handle Netflix? Yeah, it can handle Netflix. Yeah. Now, if I told you that you could have a new AI assistant that could open your sports or Netflix for you, but you had to buy a $1,500 machine to get it,

you'd probably just say, I'll stick with my index finger. Have I got that right? Yeah, you got that right. I'm not the most creative in thinking up new and coming uses for AI. And remember, Daniel was telling us that this is like, we're like where we were in the early days of the App Store for Apple, when the applications that we had were not that sophisticated because the hardware wasn't yet that sophisticated. Now you have millions upon millions of apps because the hardware got better. The same thing will happen with AI over time as the hardware becomes more powerful and machines talk to each other and come up with new use cases for AI and so forth. That's the thinking anyhow. Well, B of A for one is bullish on the outlook for AI enabled PCs and tablets. They say that consumer awareness is growing and that they think AI PCs will reach

167 million units by 2027 from 50 million units today. That sounds like good growth. B of A says the stock beneficiaries from this will include AMD, ARM, and NVIDIA, also Micron Technologies. Those are all buy rated by B of A. It also thinks it will help neutral rated Intel. Now, what about Apple? It's playing a little coy on its AI strategy, I think. There was an analyst earlier this year at an earnings call. There was an analyst who asked this question. Are you a believer in the edge thesis that AI and processing on smartphones and devices like yours is going to have a huge role in AI. It's what we call a softball in the business. That's kind of a nice slow meatball right down the middle.

The question is basically, are the stars lining up for you perfectly? Are you going to make a skajillion dollars off of everything that's happening now? And Tim Cook didn't really give a full answer. He said AI was a huge opportunity, but he said he didn't want to give more details or get, as he said, out in front of myself. It sounds like a man with an announcement coming. What do you think, Jackson? And I don't think the iPad was that announcement. There's not enough AI stuff going on with that iPad.

Maybe he had a clone right behind him and he didn't want to trip him up. So that's what he meant by I didn't want to get in front of myself. Maybe he was a clone right behind him and he didn't want to trip him up. So that's what he meant by I didn't want to get in front of myself. Maybe he was the clone. Well, Dan Ives, the analyst over at Wedbush Securities, he thinks that the big to-do about AI for Apple is coming next month. That's at the WWDC, the Worldwide Developers Conference. This is a yearly meeting that Apple has where it talks about software. That's at the WWDC, the Worldwide Developers Conference. This is a yearly meeting that Apple has where it talks about software. Dan's theory is that at this year's Developers Conference, it's going to lay out its AI strategy.

And that strategy is going to include an AI app store. So now you don't have a lot of AI use cases today. You don't have enough apps. You don't have an app store where you can go to find them. But what if you had an app store and there was a place where developers could make these apps and stick them and you could download them. And as the hardware got better, including higher tops and more neural processing engines on the hardware, maybe that's the uptake that we're waiting for, for AI on personal devices. I don't know. Dan Ives says this lays the foundation for what he thinks will be an iPhone super cycle starting this fall. He says that next month will be the biggest

unveil event for Cook and Cupertino, a reference to the CEO and the headquarters, in roughly a decade. You know, you haven't had a super cycle in a while because people don't have enough of a reason. What do you do? I just get a phone every three years. I don't really care what's on a new phone. I feel like my phone kind of fizzles after three years.

It doesn't seem to be holding its battery charge enough. And so I just get a new one. I don't really care about the specs or I just assume it's a little better. As soon as the telecom stopped giving you just a free phone every two or three years, I've just started buying like the iPhone mini from three years ago because I've lost my phone. I've had it stolen a couple of times. So I know there's already a $200 refurbished iPhone 12 mini like sitting for me on Amazon. Well, you're a high risk user. You're young and wild and

impetuous and you live a life of chaos. So, you know, I never leave the house. So I'm not a high risk. So that's Apple and AI. And we'll have to see if all this tops talk will be enough to get people rushing to stores to buy new phones this fall. The stock is $184. Dan Ives over at Wedbush says it's headed to $250. We shall see. And that's probably a good place to shift our attention to Starbucks. Maybe we take a quick break. What do you say, Jackson?

Sounds like a plan. Spray some WD-40 on that 2014 computer of yours and watch a little Netflix for a minute. We'll be right back. Welcome back. We're talking about Starbucks, and the reason we're talking about it is because at the beginning of this

month, the company reported earnings and the stock in response fell 16% in a day. It's a humongous move for Starbucks. Jackson, are you a Starbucks customer, a Starbucks regular? I got nothing against Starbucks, but I'm not a regular. Me neither. I feel kind of the same way. I went nothing against Starbucks, but I'm not a regular. Me neither. I feel kind of the same way. I went in there just one week ago and I decided to get something fancy. I don't know all the fancy ones. So there was a picture of one. I just pointed to that, had the name right under it. And that's what I got. It was just okay. I think it had oat milk, which I wasn't really looking for, but usually I'm just, I'm just looking for a medium coffee.

And I used to feel like, you know, they have, they have their own words and they're kind of weird. Like, I don't think, I don't think they're their own words. I think they're Italian words. They want you to, they want you to say grande for medium, which I'm pretty sure is a Spanish for large. So I don't know why I'm calling a medium a large. So I just always say medium. I feel like they used to judge me for that. But lately they seem more accepting. I say,

you know, medium coffee. They just say, okay, medium coffee. I think the theme of Starbucks ordering anxiety is widely shared and no one that I know of has captured it better than Nate Bargetze. He's a stand-up comic from Tennessee, and he did a well-known routine on this after he'd been drinking coffee for about four years. I get very nervous when I order coffee because it's a whole world, and I don't know the world, you know. They always ask you a bunch of stuff. Like, they're like, what kind of cream? I'm like, just please do it. Just do it.

You know? Sometimes they're like, do you want heavy cream or half and half? And I'll go, I'm sorry, just please do it. Just do it. You know, sometimes they're like, do you want heavy cream or half and half? And I'll go, I'm sorry, I'm not taking questions right now. So. Thank you, Nate. These days you can just order right on the app. So there's dramatically lower risk of being misunderstood or having extra questions that you don't want. Business has been booming until just recently. It seems like a really abrupt slowdown. So what's wrong? I reached out to Sharon Zakfia. She's an analyst covering restaurants at William Blair, and she had a long wait recently for a coffee. There are more questions than answers on what's

happened to Starbucks. They seem to have very strong underlying demand that was almost taken for granted by investors in the U.S. Really until November, that happened to coincide with some boycotts that they were getting from a social media standpoint, happened to coincide with some union noise as well. So I think, at least my initial thought was there's a bit of noise here that will dissipate. They'll be able to architect their way out of it, but things just got worse in the March quarter. So there's a bit of noise here that will dissipate. They'll be able to architect their way out of it. But things just got worse in the March quarter. So there's a big head scratcher going on. Is it price? Is it speed? I mean, I went to Starbucks yesterday and waited 15 minutes after doing my mobile order and pay for my iced coffee. So I think there are a lot of things they need to work on at Starbucks to

kind of get that traffic back into sustainably positive territory. Sharon mentioned boycotts and social media that relates to Israel and Gaza. So the union made a post and included the comment solidarity with Palestine and Starbucks sued the union for trademark infringement. It said it condemns violence and it described the post as, quote, reckless, the union countersued. Starbucks is not the only company that has faced a consumer boycott over what its critics see as aiding Israel. Starbucks put out a statement on this issue with some questions and answers.

The first question on the list, is it true that Starbucks or Howard Schultz provides financial support to Israel? The answer is no, this is absolutely untrue. This is obviously a sensitive issue. When there's a boycott, I always wonder how effective is it? How many people are participating? Is it making a dent in sales? With Starbucks, the answer seems to be it's making a dent. Bank of America put out a note recently titled, What's Really Behind the Starbucks-US Same-Store Sales Collapse? It said, a sudden slowdown requires a sudden cause. It compares the pace of the decline at Starbucks with what happened at Chipotle years ago at the time of an E. coli outbreak.

It also doesn't see signs that consumers are engaging in what it calls check management. In other words, trading down on the menu to save money or adding fewer items. If this were related to the economy, that's just what you'd see. B of A says, we think social media coverage is the likeliest cause. It says the cadence of the slowdown combined with the absence of the usual signs of consumer check fatigue suggests that a social media narrative around Starbucks' position on the Middle East may be the primary driver. Starbucks spends little on advertising and plans to spend more.

B of A thinks that will help. Starbucks is also making improvements to its app. B of A predicts a rebound in sales and calls the stock valuation, quote, lower than small. I mean, it's 21 times the consensus estimate for earnings in the fiscal year that runs through this coming September. Is that lower than small, Jackson? fiscal year that runs through this coming September. Is that lower than small, Jackson? What's small and what's lower than small? I think 21 times is like where the market is. That's where the S&P 500 is roughly. If we're going by Starbucks, lower than small would be tall. Is this a Venti? I don't know. If you think that Starbucks is going to get back to good growth and is going to outgrow the S&P 500, then it's now trading in line with the S&P 500, whereas previously it traded at a premium. So there you are. B of A is bullish. Sharon at William Blair is not. She downgraded the stock to market perform after the company's latest quarterly report. I asked Sharon how big of a role she thought the boycott was playing.

It's possible they're not giving us enough information to connect those don'ts, if that's the case. The best that we can garner is that their more occasional user is the softest, and that's where they're seeing the struggle. is the softest, and that's where they're seeing the struggle. But we did see active rewards members unusually dip sequentially, which hasn't been the case for quite a while. So I can't rule it out. Certainly, I think the persistence of the impact of social media boycotts has been defying expectations over the past year and a half. If you go back and look at Bud Light and Target,

and Starbucks has wrapped up and at McDonald's got wrapped up a little bit, it's hard to just aggregate kind of what's social media boycott for the Starbucks of the world versus other issues. I asked Sharon, what do you need to see to turn bullish again on Starbucks? What I need is greater visibility on a return to growth. If you think about kind of what was provided in the outlook, there's a big question on what 25 would look like. There are questions about execution. There's been a change in leadership as well. And so although I like new leadership, I also have done this long enough to know that there's going to be questions now about

whether they can handle what's going on with the business because they don't have a long time of experience running Starbucks. So yeah, for me, it's got to be visibility. How do you get back to double-digit earnings growth? And there didn't seem to be a silver bullet on how they're going to do that. I asked Sharon if she thought the downturn at Starbucks might be due to competition. I've noticed anecdotally in my area, a lot of re-Duncanization. Jackson, what kind of re-Duncanization are you seeing in your area?

I feel like they're upgrading a lot of Duncans right now. Like they shut down your Duncan for a while and then they put in new mobile ordering, jazz and stuff like that. And you go in and it's spiffier and it's faster. What are you seeing? There's only a couple of Dunkin's around where I live. You're in the West. But they've definitely gotten fancier.

I'm not sure how much I like it. I like my Dunkin's with two giant styrofoam cups, one in the other. That's a heavy environmental toll for your morning coffee. It's a Rhode Island thing. All right. Well, Sharon says that it's hard to tell because Dunkin' is not a publicly traded company, but she said just given the speed of the decline at Starbucks that that seems unlikely. I also asked if this is maybe a bad sign for the economy, but like B of A, she didn't really think that. She said that for every story like Starbucks out there, there's a Chipotle and Chipotle is doing quite well. Speaking of which, I asked Sharon for some favorite stocks in the restaurant group.

entered this year with Chipotle as our favorite idea. And I think it's still an amazingly well-run company doing very, very well in terms of kind of providing that value to the customer and the consumers voting with their wallet. And Chipotle has seen growth across all income demographics, you know, coming into Chipotle, which is phenomenal. I love that they discovered the drive-through and that the next, you know, 3,000 stores are going to be a higher ROI than the first 3,000. That's pretty unusual. And it also feels like they're just scratching the surface on what Chippewa's potential could be

in the rest of the world. You know, we like Cava and the opportunity there to grow into something of a sizable scale. It's a very interesting concept and that you know it has very high frequency similar to kind of like a chipotle so we're always looking at where do you have that repeat visitation kava is like mediterranean type of food and when you say high frequency you mean that the people who like it they go back again and again they'll eat it you know a few times a week. Yeah. So it's good to have loyalists.

It's almost like a subscription revenue component to your business. And what you find in terms of frequency, coffee is the highest frequency. People really have their coffee habits. And then when you get into kind of veggie-centric salads, bowls, things like that. Those are very high frequency, as is Mexican. So everything we've talked about right now would be in those high frequency buckets. Sharon doesn't only cover restaurants. She also covers leisure. I asked her for her favorite pick in the leisure group. We really like Royal Caribbean.

That was my second favorite stock entering the year. I mean, I think the cruise industry is very interesting that it's still kind of recovering. We're not even two years from when kind of the authorities that be waved the white flag and said, you know, COVID's over, it's safe to cruise again, right? So we've been going through this rapid recovery in the cruise space.

The industry was shut down for a good amount of time so they took down a lot of debt just to survive there's a big deleveraging story as we see that cash kind of start to pile back in and royal caribbean in particular has been really innovative about pushing the envelope it's ship design pushing the envelope in owned destinations which it turns out people love and want to go to and creates a halo across the ticket as well. And I think as we look throughout the next few years, there's an interesting story to be told. If we do have a more value conscious consumer, I think cruise can do really, really well in that because the gap right now in cruise pricing versus land base is much wider than it typically had been pre-pandemic because, again, the industry was closed for a while.

So if you were to compare a Disney vacation versus Royal Caribbean right now, that discount would be greater than it would have been in 2019. And I think that's a nice tailwind to demand as they continue to fill those ships. The stereotype about cruises is you think of older travelers. Is Royal Caribbean finding ways to bring in millennials? Are they bringing in younger customers? I love this question because it used to be there was a saying that the cruise industry was the, I'm going to get the order wrong, but it was the newlyweds, overfeds, and nearly deads. That was kind of the saying. Was that the name of a cruise theme? Is that an actual theme?

It was not the name of an actual theme cruise. But the good news has been the amount of innovation that's happened in the space, right? Again, I think really repelled by a lot of what Royal Caribbean has done. And, you know, Royal Caribbean now, the, you know, close to half of their passengers are millennials or younger. Thank you, Sharon. Jackson, you ever been on a cruise? I've never been on a cruise. I'm sorry to report.

Me neither. Me neither. I read somewhere recently, I can't remember where, you know how sometimes a travel writer would do like a snooty thing about a cruise and they really look down on it and everything. It was one of those type of deals. And I just remember that he mentioned an upside down pineapple. If you have an upside down pineapple on the door, on your door at the cruise ship, it means you're a swinger. Did you know that? on the door, on your door at the cruise ship, it means you're a swinger. Did you know that? I told him.

You learn something new every day. Careful with the door decorations out there, folks. There's some hidden meanings in these things. I just, you know. Oh, man. I just had mine there because I like Hawaiian pizza. Thanks to all of you for listening. And thanks to Nate bargetzi too for those thoughts on starbucks jackson cantrell is our producer you can follow the podcast on apple podcast spotify youtube wherever you listen to podcasts see you next week