Is Starbucks a Bargain? It Almost Goes Without Saying

The hopeless romantic in me fell for Starbucks (SBUX). Who could resist the topless logo lady kept barely modest by flowing tresses alone? She proved to be my siren on the foggy rocks. My ship, the JSS Portfolio, ran aground to the sound of her charms.

Which is to say I was early on Starbucks.

I'll save you the trouble of joining the email chorus mocking me on this one, by coming clean. Wrong more than I should be? Yes. Dishonest? No.

I started liking Starbucks way back in January. Chuck Jaffe invited me onto his Your Money Radio program that month and I told his listeners that it was amazing to see the world's largest coffee retailer on sale for less than $20 per share. "That's down to almost half what it was a year ago," I gushed. "This is not some flier, either. Folks, this is Starbucks I'm talking about!"

It's still Starbucks I'm talking about, but that under-$20 bargain is now an $8 bargain, and still falling. The legion of investors hating the stock has multiplied, and they all know how to reach me. Among the more polite notes I received recently was this one from a professor who recently subscribed to The Kelly Letter:

They have no chance in Europe at all, and they have too many outlets in the U.S. Perhaps Asia might be the place for them, but if then in a small way. When I was in mainland China in 1980 as a guest of the Chinese Academy of Sciences, it was impossible to get a good cup of coffee in Beijing. The same problem existed in Shanghai. Thus, for foreigners, a good cup of coffee in China would probably be profitable.

However, in Europe (excepting, perhaps, England) they have no chance. In Vienna there are a few Starbucks, but only frequented by foreigners. It is absurd to go to Starbucks in Vienna when one can go to Sacher or Demel, established in the time of the Austrian Emperors.

Good points, but I don't think Starbucks ever intended to brew a better cup of coffee than places serving Austrian royalty. As with McDonald's (MCD), Starbucks aims for the fat part of the bell curve where a good enough cup of coffee meets a fair enough price in an atmosphere that's pleasant enough and -- importantly -- convenient

Here in Japan, Starbucks is a sensation and I suppose that's part of why I watched it all the way down to my first buy at $18 and thought I was pulling a fast one to grab a piece of the global empire at that price. I kept buying during the year. My cost basis is $13 now. It's going to take a 63% gain just to get me back to break-even.

Yet, every time I walk into a Starbucks and smell the coffee and hear the voices of the Japanese workers welcoming customers, I'm proud to be an owner. I may not be as twitterpated with Greenie anymore, but I'm confident she'll rush back to my arms one day with a 63% smile on her face.

Here's why.

It almost goes without saying that the stock is a bargain, but only almost - so let me say a little about it. At eight and change, SBUX has a PEG ratio of only 0.5. That's less than half the S&P 500's PEG of 1.1, and you may have noticed that the S&P itself has come down a tad this year. Even by P/E alone, SBUX trumps the index with a 9 versus the 500's 11.

Along with everybody else in this dreamy economy, Starbucks' business results have suffered. Even when we factor in the slowdown, however, the company isn't anything like the charred trees of the subprime forest fire the government is trying to douse with soggy taxpayer money. Its 2007 year-on-year revenue growth was 20.9%. Now it's 10.3%. A lot slower, sure, but not exactly hopeless.

In fact, I'd say the 10-year revenue chart is a thing of beauty, consistent with this little fling of mine. Courtesy of Morningstar, look at her shine:

[click to enlarge]

You'd never guess that's a company caught in the teeth of recession, now, would you? I know I'm showing you how she looks all dressed up for the prom, when the market's seeing her as she looks first thing in the morning, better known as a price chart. We'll skip that, though, because she's a lady and you're too polite to ask and I'm too gracious to offer.

One thing to bear in mind is that on top of the recession headwind, Starbucks is in the middle of a restructuring that includes closing slow stores; reducing headcount; and re-invigorating the Starbucks experience with new equipment, better training for workers, and an expanded menu. Restructurings are always hard on a business. Restructuring while credit markets dry up and talk of a 100-year bear market circulates is even harder. That's especially true of Starbucks, which depends on consumer confidence and discretionary cash, both at low levels.

As the recession grinds on, will consumers drink even less coffee? That's the great fear, of course. Even if they don't drink less coffee overall, they may elect to get their java at a more affordable location. Usually McDonald's is cited here as the cheaper alternative, but I was thinking more of our own kitchens. I make a pretty mean cup of coffee for a few pennies, and I'm sure others can, too.

I don't know about you, but the taste of the coffee is not the only reason I go out for a cup. I want to get out. I want to sit on a couch and read something and nibble on something and hear the sound of machines working and the people mingling and the whole scene. That's what I'm paying for. Should we all get dirt poor and start cutting way back, I think I might just save a few shekels for the much needed escape from recessionary life. We could all feel poor together at Starbucks.

That's anecdotal, though, and I admit that a poorer consumer is not in Starbucks' best interest.

One thing that is in Starbucks' best interest is how much people love coffee, and how much growth opportunity that creates for the company. A common objection to Starbucks is that it has too many stores. The market is saturated, say the naysayers, who are everybody except me and CEO Howard Schultz. It isn't saturated, though. Even with its runaway success over the years, Starbucks commands only a 10% share of the U.S. coffee market. Overseas, its market share is around 1%. If 90% and 99% share being up for grabs isn't growth potential, douse me with espresso.

Now, when it comes to ready-to-drink coffee, it's a different story. Thanks to a smart partnership with PepsiCo (PEP), which knows a thing or two about getting drinks into people, Starbucks commands 85% of that market. There's not much left to take, but that's because the company took the market already and now enjoys a stream of cash from all that can-coffee warming hands in winter.

Are there challenges? Of course, hence the current share price. I would say the encroachment of McDonald's and Dunkin' Donuts on Starbucks' turf is the main problem. I mean, the mere existence of DunkinBeatStarbucks.com is a bad sign. There's more competition; that leads to lower margins.

So be it.

When I run the reduced cash flow expectations from the latest quarterly report and factor in cost savings from restructuring, Starbucks doesn't look as promising as it did in January when I first sang its praises. However, I still come up with a reasonable value at $20. With a P/E expansion that should happen when the economy and stock market recover, I can paint a convincing picture for $30 per share.

Even from my bewitched cost basis of $13, that ain't bad. From today's $8, it's positively enchanting.

As this star-crossed lover pulls the petals from a flower reciting "she loves me, she loves me not," I count ahead to the end of the circle and see how the pattern ends: she loves me.

Now give me a 63% gain, lady!

Comments

[pelican:]

Hi Jason,

I read your article with great interest because the same thing happened to me. I also live in Japan (Saitama-ken) and I love my local Starbucks for the reasons you mentioned. I love how the staff reacts to me when I walk through the door. I've been following Starbucks for a while and in January (I kid you not) I prepared myself to buy when it hit $18. The only difference is I...waited. This hesitation was not a moment of genius. I was just worried about the market in general. And when the stream of bad news starting coming I lost the desire to buy. However, I did manage to find other stocks to invest and lose money in. :-)

Anyway, I agree with your analysis and Starbucks is a steal at $8. I bought some recently. I know same store sales will be down next year but this is a long-term holding. International growth alone can drive sales and I think the stock doubles in 2-3 years. Ganbarimasu!

2008 Nov 26 08:11 AM

[User 111058:]

You need to go back and understand the real drivers of value of a company and not rely on PEG or a historical review of growth. Investing is about the FUTURE, not the past. For your own sake, stop your "anecdotal analysis" and put some numbers into the calculations... and numbers beyond next year (a company's value goes far, far, far beyond next year's performance) with a slapped on P/E ratio.

I have no idea if SBUX is a good investment or not. It just pains me to see "analysis" of this type. For your own good, go learn a lot more about finance and start putting some numbers to your anecdotes (which are ver colorful and very good background thinking, I will give you that). I assure you it will help you in your future investing, which should resume after you go study for a year or two.

2008 Nov 26 09:34 AM

[Highrise127:]

I am a "small" owner of SBUX since about 2001 and was lucky enough to get the 2-1 split. There is no doubt this company will be around for a long time and will adapt to the market and reinvent, if necessary. At $8...I have to get more of this and then I'll sit around for a few years and watch it go up!

2008 Nov 26 09:35 AM

[Bubba Jones:]

Jason,

SBUX is going to go even lower...get some numbers into an analysis and get a clue.

2008 Nov 26 11:02 AM

[sundrenched:]

"Even by P/E alone, SBUX trumps the index with a 9 versus the 500's 11."

I looked on Morningstar, Motley Fool, Yahoo Finance and Google Finance -- they all give a PE just short of 20.

And that's my main problem with SBUX -- it's priced as a growth stock, without the growth. Especially in this market with screaming bargains all around.

Another common contention (by Morningstar and others) is that the company has a big moat, but that's also something I'm skeptical of. I travel very extensively (probably 3-4 months a year) in Asia, Europe and the US, and it seems to me that what people want is a comfortable place to sit down. Whether it's Coffee Bean, Spinelli, Peet's, Wayne's, Starbucks, whatever, is only secondary. In Singapore, where I live, I actually prefer Coffee bean, Delifrance and Spinelli because they have more comfortable furniture (those wooden chairs seem designed on purpose to stop people from lingering).

But again, in this market, with all these screaming bargains all round, is this the best an investor can do? Out of the 7000 or so stocks trading in the US, this is THE best place to put some money? Not by a far stretch in my opinion.

2008 Nov 26 11:04 AM

[maz:]

Not a bad article but puhlease do yourself a favor and stop quoting PEG which is one of the most flawed ratios ever invented. Its only merit is that its easy to understand and calculate - it has little to do with value

When I see PEG quoted in an article my immediate thought is "journalist not financial analyst" and I'm sure that's not true here

Seriously - stop using it, it doesn't look good on you

2008 Nov 26 11:04 AM

[BerkeleyBob:]

Peet's (PEET) reported a pretty good quarter and has grown with little reliance on outside debt. It has not been a "hot" performer, but its shareholders probably sleep better at night... PS: Their coffee is better.

2008 Nov 26 01:08 PM

[ockham:]

Jason,

I agree with your analysis at $8 SBUX is a steal, and I think you humor makes you article a pleasure to read. I have added you to my watchlist. Thanks and cheers from a Starbucks coffee lover.

2008 Nov 26 03:09 PM

[swagvalance:]

Competitors, such as Tully's and Peet's, are making profits quarter after quarter while Starbucks blames the economy. That level of disingenuous behavior right there is a red flag.

Furthermore, Starbucks has placed itself out of the quality market. They are now a numbers game that has to compete with the likes of McDonald's and Dunkin' Donuts. The sheen of an elite product is now off their brand (after all, they have dumbed down their production and staff skills so much to keep stores opening that their baristas could not even quality for a barista competition), with independents and smaller chains carrying that forward.

In the process, Starbucks has essentially lost its identity. It's been a decade since they've been relevant to the best coffee available, and they must refashion themselves for retail warfare in the trenches with fast-food giants and the Wal-Marts of the world.

They can survive if they refashion their identity to compete in this new climate. But if they do not -- if they hold on to the mistaken belief that competitors haven't long passed them by in quality and they have set themselves on a course never to return there -- they are doomed to continual failure. Suffering is the avoidance of necessary pain. I'm still waiting for Starbucks to face these truths and confront that necessary pain if they are to ever recover.

2008 Nov 26 04:30 PM

[Sam Liu:]

starbucks keep s on trying to go through high-media ways to improve its corporate image, but the problem without all the bells and whistles, ... the coffee sucks!

so then. what is that worth?

2008 Nov 26 04:39 PM

[billddrummer:]

I was a steady SBUX patron until my income went down and my expenses went up.

Then I occasionally stopped in for a short coffee--$1.50+ tax.

Shortly thereafter SBUX stopped advertising it, although you could still get it if you knew to ask.

A couple days ago I 'treated' myself to a frou-frou latte. It tasted bad.

I think it might go lower than $8 before it goes up.

2008 Nov 26 07:29 PM

[delcape:]

I've been fortunate w/ 'bux... Had it for two 2 for1's, sold a few hundred at the top (about $38), now own a nice block for free! -
I WILL acquire more, in these changing times, see no need for expediency. Suggest that anyone interested in this issue read Howard Schultz' autobiography. I believe that a philosophy such as his can only succeed, especially with him at the helm. It'll take time... I have grandchildren... At 8, it's a deal, but in these uncertain, unexplainable times, could yet drop more.
- As always, DO THE RESEARCH !

2008 Nov 26 07:55 PM

[sundrenched:]

Something below the surface here that I don't like (but it's your money!) is a subjective approach to stock selection. I'm very wary of "story stocks". There's several thousand stocks traded on exchanges in the US alone, tens of thousands worldwide. Your goal as an investor should be to put your money to work in the 15 or so that have the best prospects. The human mind is utterly and completely unequal to the task of comparing these thousand of stocks using a subjective approach. So first order of the day should always be to run a screen with certain criteria (deep value with strong balance sheet, for instance), which narrows it down to perhaps 20-30 stocks, and OK, from there you can start to look at the story.

But just to say because you like Starbucks, you also want to own the shares in the company.... That gets us exactly to the reason why large cap growth companies as a class underperform the market: they're glamourous and make the owner feel good, and people overpay.

Like people have said before, you may love the stock, but the stock doesn't know you!

2008 Nov 27 01:07 AM

[ally mcbeal:]

I like your optimism. But i think it would be a buy at about $5..... I think SBUX's main problem is that they havent really diversified enough to cater to the changing consumer patterns. A premium coffee is the last thing on a consumer's mind. Its not about brand image etc but about "smart business"..... The store traffic numbers were pretty bad last quarter.

Also another problem for SBUX is their higher mix of lower margin-owned stores. They not only have lower margins so you see SBUX' margins really laggin its peers. These stores also have higher operating leverage. So during lower sales you can expect margins to erode even more.

2008 Nov 30 06:12 AM

[Konsta:]

what numbers into your analysis! Here is the deal, once consumer stocks start to recover, so will Starbucks. It will likely go back to 23 within 2 years, unless the world ends, which is what the market had been pricing in in the recent past.
That's my guess. Seems like a proven leader that will continue to dominate. A well run cash cow.

2008 Nov 30 06:09 PM

[PalinTologist:]

'cow' is right, Konsta. i'm curious as to how the economy will treat SBUX.


On Nov 30 06:09 PM Konsta wrote:

> what numbers into your analysis, nincompoop! Here is the deal, once
> consumer stocks start to recover, so will Starbucks. It will likely
> go back to 23 within 2 years, unless the world ends, which is what
> the market had been pricing in in the recent past.
> That's my guess. Seems like a proven leader that will continue to
> dominate. A well run cash cow.

2008 Dec 01 04:40 AM

[Greg Weston:]

The Starbucks brand I think has been permanently tarnished in the USA by retails sales at places like 7-11 and Wal-Mart and by the sales of energy drinks in tall aluminum cans. Earnings can always be boosted short-term by cutting prices on a product that has a high margin and strong brand, but this cannot continue to work.

Another risk: At my old employer, which had about 500 white collar workers on site and provided a lot of the business for one SBUX location, decided to install a few espresso machines in the employee lunch room.

Boom! There went tons of sales.

Finally it is folly to invest on the idea that P/E will soon return to "normal" levels. You have no way of knowing this, and if you need you could make a much larger fortune trading SPY LEAPS.

I would be a buyer of SBUX around 5.5, and have an alert to tell me as soon as it does.

2008 Dec 03 11:00 AM

[maelstrom:]

I must agree with the many who believe SBUX is still pricey. I too see $5-6 as a more realistic price. They should have LOWERED prices instead of raising them and totally re-do the dessert selections. Quality should count there also. Many of the stores are not clean or comfortable and I feel as though only a fool stands in line 15minutes to order a $4-5.00 coffee then waites another 5minutes for the Barista to make it. Then they must drink it in there car from lack of seating. I used to love starbucks, very nice staff met very nice people in comfortable surrounding. That changed drastically in most locations as they canabalized themselvs..pure shortsighted greed..they destroyed the cache..regards to all

2008 Dec 04 02:18 PM

[frankie cooper:]

funny.i did some looking into jason kelly and i must say that i am impressed. out of some 36 "gurus" who put out newsletters/have websites, jason ranks 2nd out of 36. pretty good when you look at some of the company on the list (most of whom are finance "pros with years and years of experience/studying). his accuracy is WAY ahead of the likes of cliff droke, cramer, brinker, and jubak.
and it looks like since your post, sbux is up some 13%. looks like he does know what he is talking about. and you look like you need to take a lesson from kelly.

i also like that he doesn't feel the need to defend his position. i guess he let's profit do the talking....LOLOLOLOL

wtg, jason. you've made most who've replied to your article look rather dumb. love it.


On Nov 26 09:34 AM User 111058 wrote:

> You need to go back and understand the real drivers of value of a
> company and not rely on PEG or a historical review of growth. Investing
> is about the FUTURE, not the past. For your own sake, stop your
> "anecdotal analysis" and put some numbers into the calculations...
> and numbers beyond next year (a company's value goes far, far, far
> beyond next year's performance) with a slapped on P/E ratio.
>
> I have no idea if SBUX is a good investment or not. It just pains
> me to see "analysis" of this type. For your own good, go learn a
> lot more about finance and start putting some numbers to your anecdotes
> (which are ver colorful and very good background thinking, I will
> give you that). I assure you it will help you in your future investing,
> which should resume after you go study for a year or two.

2008 Dec 06 09:30 PM

[frankie cooper:]

looks like SBUX is still up from the posting of the article. good call, jason. looks like the people who told you that YOU don't know what you are talking about, don't really know what they are talking about......

and it looks like User 111058 is eating a bit of crow right about now. (what a genius he is. LOLOLOLOLOL). looks like all of that "studying" has done him a great deal of good.


On Dec 04 02:18 PM maelstrom wrote:

> I must agree with the many who believe SBUX is still pricey. I too
> see $5-6 as a more realistic price. They should have LOWERED prices
> instead of raising them and totally re-do the dessert selections.
> Quality should count there also. Many of the stores are not clean
> or comfortable and I feel as though only a fool stands in line 15minutes
> to order a $4-5.00 coffee then waites another 5minutes for the Barista
> to make it. Then they must drink it in there car from lack of seating.
> I used to love starbucks, very nice staff met very nice people in
> comfortable surrounding. That changed drastically in most locations
> as they canabalized themselvs..pure shortsighted greed..they destroyed
> the cache..regards to all

2008 Dec 21 08:59 PM