Starbucks stores seem ubiquitous in the U.S., but the company is not inclined to throw in the towel on U.S. growth. That's why it has sought to stretch its brand, through book sales, music, movie promotions and expanded menu offerings. The resulting operational diversity has been cited as a culprit in the weak July sales report — supposedly, the time it took to serve new chilled beverages reduced its capacity to move coffee buyers through the checkout line. Yet the data suggests that overall, the company's strategy has been working well so far.
The company-industry comparisons become even more impressive when one notes that many in the restaurant group have sizable franchising operations, an endeavor that requires little capital and, hence, tends to boost returns. Starbucks beats the norms with virtually no use of franchising. Also, Starbucks carries a negligible amount of debt, compared to industry peers for whom debt, on average, amounts to about half of equity.
So at first glance, it looks like nothing is broken and that Starbucks should simply stay the course.
Yet there are some flags out there, albeit small ones, to justify some proactive management tinkering.
One concern is the growth trend.
Sales growth has been fairly steady at a nice pace in recent time periods. But we have been seeing some deceleration in earnings per share [EPS] growth rates. It doesn't justify accusing Starbucks of having hit a wall. But accelerating returns on capital combined with decelerating earnings growth is an inherently unsustainable situation. Over the long term, both trends will have to point in the same direction.
On the competitive front, rivals like Dunkin' Donuts and McDonald's Corp. (MCD) are getting more serious about coffee quality. The ambiance doesn't come close to matching that of Starbucks. But their prices are lower, and when Starbucks is out in the kiosks and food-service venues, it can be argued that ambiance isn't a big deal.
Table B also raises a question of whether Starbucks is really putting enough into non-coffee activities to really make them work or is just dabbling. Note the difference between the five-year sales and capital spending growth rates. While this relationship can vary over time as "capex" programs ramp up and wind down, over the long term, the two should be more or less equal. Yet here, for Starbucks and the industry, capex growth trails sales growth.
The fact that the restaurant industry shows a bigger shortfall provides no consolation. As noted, many in the industry are heavily engaged in the low-capital-need franchising strategy. Also, we don't take much solace from the fact that capex growth also falls short for the Services sector (which includes other low-capital-intensity business) or the S&P 500. Given that Starbucks' returns on capital and valuation metrics — see below — are so much higher, the company ought not settle for a capex growth to sales growth relationship that is merely in line.
Speaking of valuation, Starbucks' numbers come in quite high across the board.
We do not join with those who quickly brush Starbucks aside as being overvalued. Whether that's so or not depends on the company's ability to grow.
We have estimated that it would take a five-year earnings-per-share growth rate of at least 15.58 percent for an investment to break even. The company is still growing faster than that and analysts expect a bit of re-acceleration. As a result, the consensus long-term EPS growth-rate projection now stands at 21.53 percent with a range of 20 percent to 25 percent.
But achieving any of these growth targets is not something that can be taken for granted.
That's what makes the company's identity issues so important.
If the increasingly diverse range of activities can generate the needed growth, so be it. But the numbers raise questions, albeit subtle ones at this point, as to whether this is so. Ditto the company's sudden decision to reassert its coffee heritage. It's not so much that we question the wisdom on the latter. It's probably a terrific idea. We do, however, worry about vacillation or confusion from a brand image standpoint if Starbucks goes in too many directions at once.
Re-assessment of a particular brand is nothing new. We see Wal-Mart Stores Inc. (WMT) seeking to edge above its traditionally downscale image. We see McDonald's successfully stretching beyond cheap burgers. We see Nike Inc. (NKE) reaching beyond domestics sales of sneakers into other kinds of athletic apparel.
But those three companies have trailing 12 month price/earnings ratios near 15, compared to 41.95 for Starbucks. It would, therefore, seem that Wal Mart, Nike and McDonald's can afford to tolerate some imperfection as their brands evolve. Starbucks shares, on the other hand, do not appear to be priced for a period of corporate self discovery.
At the time of publication, Marc H. Gerstein did not own shares of any of the aforementioned companies. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.
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