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Investors who bought Starbucks (NASDAQ:SBUX) a couple years ago are sitting on massive profits. The shares have returned 813% over the last five years and have taken a top spot on any performance list. The share price of Starbucks has now risen so much that the company trades at a massive premium to its earnings - and free cash flow prospects.


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Due to the lack of equally large, publicly listed specialty coffee companies, I am comparing Starbucks to a variety of companies in the restaurant business. These companies pursue a different retail model but similarly rely on growing a large-scale, store-focused business in order to drive sales. While Starbucks returned 93% over the last two years, Panera Bread (NASDAQ:PNRA) gained 30%, Dunkin' Brands (NASDAQ:DNKN) 88%, Yum! Brands (NYSE:YUM) 37% and McDonald's (NYSE:MCD) 5%.


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Free cash flow projection and valuation

Starbucks' 2013 full year results were impacted by a $2.8 billion litigation charge that distorts performance comparisons. Since I am valuing Starbucks based on normalized, forward free cash flows, extraordinary charges are of no relevance. I conservatively estimate that Starbucks can achieve operating cash flow of $1.9 billion in fiscal year 2014 which should translate to a free cash flow to equity of $755 million.

As a result, I estimate that Starbucks can earn about $0.99 per share in free cash flow to equity. With a current share price of $81.53 this translates to a forward P/FCFE ratio of nearly 83: Investors pay a gigantic growth premium in order to access Starbucks' income stream and the company appears to be highly overvalued at the moment.

Investors also should tread carefully with respect to the above mentioned peer firms Yum! Brands and McDonald's which are also overvalued based on their respective free cash flow prospects (thesis here and here).


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Market valuation

As indicated in the articles about McDonald's and Yum! brands, restaurant retail businesses seem to demand extraordinary growth premiums which I don't think are warranted. Chipotle Mexican Grill (NYSE:CMG) also demands an extreme growth premium which makes it likely that the investment will ultimately disappoint and not live up to the high expectations investors laid on it.

Other companies in the tech space or in the basic materials sector have very attractive earnings- and free cash flow prospects but trade at significantly lower premiums. Value investors therefore are unlikely to find deep value investments in the specialty coffee or restaurant sectors.

The following graphs depict Starbucks' P/E, P/S and D/P ratios and a summary table at the end to demonstrate premiums/discounts to the peer group averages. All companies in the food/coffee retail business exhibit very high multiples and Starbucks fetches a valuation above the respective peer group averages.


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Conclusion

Just like McDonald's, YUM! Brands and Chipotle Mexican Grill, Starbucks exhibits very rich valuation multiples. With a multiple of nearly 83 times free cash flow investors pay a gigantic growth premium upfront. In terms of earnings, Starbucks isn't cheap either. A P/E ratio of 25.65 is among the highest ratios in the peer group only second to Dunkin' Brands with 26.46. Investors who desire dividends should turn to other sectors as Starbucks' yield of 1.28% is unattractive and a reflection of a share price which has run ahead of its fundamentals. Starbucks clearly doesn't make an attractive value proposition at those inflated multiples.

Source: Why You Shouldn't Buy Starbucks At $81 Per Share