Here Is How You Should Trade Starbucks

| About: Starbucks Corporation (SBUX)

The share price of Starbucks Corporation (NASDAQ:SBUX) has rebounded by 35.4% from its 52-week low of $43.04 which it touched in August 2012. At $58.28, the stock is trading near the 52-week high of $62.00 and offers a 1.4% dividend yield. Should investors buy into the current price momentum? In this article, I will elaborate on the valuation analysis which may assist you in formulating an appropriate investment decision

From a relative valuation perspective, Starbucks shares are priced somewhat attractively based on the company's solid financial performance relative to its peers (see chart below). Consensus estimates on average predict the firm's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 12.2%, 23.2%, and 21.8%, respectively. Those figures are considerably above the averages of 5.2%, 7.3%, and 12.3%, respectively, for a group consisting of Starbucks' primary industry peers. Similarly, Starbucks' long-term earnings growth rate is forecast to be 19.2%, markedly above the peer average at only 13.2%. On the profit side, Starbucks' performance is generally in line with the group. The firm carries a very low level of debt as reflected by its below-average leverage ratios. In terms of liquidity, Starbucks' free cash flow margin is comparable to the peer average. Due to the lower debt load, the company was able to maintain a healthy interest coverage ratio. Both Starbucks' current and quick ratios are significantly above par, reflecting an excellent balance sheet condition.

To summarize, given the superior growth potential, in-line profitability, and healthy liquidity position, I believe Starbucks' fair value should reasonably command a solid premium over the peer-average valuation level. The current price multiples at 13.1x forward EBITDA (next 12 months) and 25.5x forward EPS (next 12 months) together represent an average premium of 22.7% over the same peer-average trading multiples. However, after accounting for the robust EPS growth estimate, the stock's PEG ratio of 1.3x is 18.3% below the peer average at 1.6x, suggesting a somewhat attractive valuation on a relative basis as the market has likely not given enough credit to the company's solid profitability and balance sheet performance (see chart above).

Further, Starbucks' trailing P/E multiple is now trading just slightly above its 2-year historical average at 28.3x (see chart below). This appears to be a favorable valuation level given the following positive fundamental developments over the past 2 years:

1. Starbucks has been able to produce higher return on investments as reflected by its rising capital return metrics including ROA, ROE, and ROIC (see chart below);

2. The company has also managed to improve the profitability and free cash flow margins (see chart below); and

3. The consensus revenue, EBITDA, and EPS estimates reveal a stable growth trajectory over 2013 and 2014, which is roughly comparable to the historical rates in 2011 (see chart below).

Moreover, throughout the past 6 months, the consensus revenue, EBITDA, and EPS estimates have experienced multiple upward revisions and their current levels are notably above the historical levels reached 6 months ago (see charts below). In addition, sell-side analysts' average long-term EPS growth rate has been raised from 18.3% to 19.2% since 6 months ago (see chart below). Despite the positive market sentiment, the stock's forward P/E multiple remains in line with the level seen 6 months ago, implying a slightly cheaper valuation (see chart below).

According to Thomson One, analysts continue to be very bullish on the stock. Of the total 30 stock ratings, there are 12 strong buys and 11 buys. In a research note dated March 5, 2013, John Glass commented on his key takeaways from a meeting with Starbucks' CFO (sourced from Thomson One, Equity Research) and I have summarized below the key points that will likely serve as near-term price catalysts:

1) SBUX has invested heavily in tools from loyalty program and mobile to better cost management to prevent repetition of 08/09 slowdown; strong holiday gift card sales/redemptions also part of the mix.

2) Food will likely be largest incremental comp driver over next 2-3 years; La Boulange roll out to 2,500 stores this yr still on track, with a full roll out in FY14.

3) CPG growth will likely remain at current low- to mid- teen levels for the rest of FY13, but expected to accelerate in '14 and '15 as Verismo, Teavana, and Evolution Fresh become a bigger part of the mix.

4) Reiterated refranchising as key upside in Europe; that along with tailwinds from recent supply chain investments and loyalty program intro should drive LT mid-teens operating margin target.

Bottom line, in the light of the solid financials, promising growth prospects, and favorable valuation, Starbucks shares should be worth long-term investors' consideration. For a short-term trade, since the stock is not selling at a notable discount, investors may consider selling out-of-money put option to either collect an upfront premium or take an opportunity to acquire the shares at a lower price.

All charts are created by the author except for the consensus estimate tables, which are sourced from Capital IQ, and all financial data used in the article and the charts is sourced from Capital IQ unless otherwise specified.

Disclosure: I am long SBUX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.