High Conviction: Starbucks Has Its Buzz Back

Editor's note: Starbucks (SBUX) this morning declared it would start paying its first dividend and announced an expanded repurchase effort; the company will broadcast its annual meeting at 1 p.m. EDT today.

Steven Benharris is the sole proprietor of Active Asset Management, a registered investment advisor in Hermosa Beach, California. We recently had the opportunity to ask Steven about his top stock pick at present.

What is your highest conviction stock position in your fund - long or short?

My highest conviction selection is Starbucks (SBUX), the $10B coffee chain mogul. In its most recent quarter, Starbucks reported a 4% increase in revenue to $2.7B, with comparable store sales up 4%. Earnings per share were $0.32 compared with $0.09 from the prior year.

Starbucks generates a healthy $1.5B/year of free cash flow and provides a 19.14% return on equity. I believe long-term growth prospects for Starbucks remain good. Long term, Starbucks plans to have 40,000 stores open, with half of them overseas.

SBUX is not the compelling buy it was when it traded in the single digits at the depth of the market collapse in late 2008/early 2009, but on pullbacks, I believe it is worth accumulating. (Full disclosure: The shares we own of SBUX are at a significantly lower cost basis than today's price.)

Starbucks operates approximately 17,000 stores in 50 countries, and is renowned for setting an example of corporate responsibility and treating its employees properly. There are few brands in the world that have the name recognition that Starbucks has. Saying you want a "Starbucks" is synonymous with saying you would like a coffee drink, much like requesting a Kleenex means asking for a Kleenex - I mean, tissue.

Through its Starbucks Entertainment division, the company has successfully branched into the music arena. Its coffee and ice cream products are sold in grocery and retail stores throughout the world. Starbucks gift cards are amongst the most popular. Starbucks' reward card provides discounts and perks to customers to insure loyalty.

To what extent is this an industry pick on coffee shops as opposed to a pure bottom-up pick on Starbucks?

The growth in coffee shops has been very high for the past two decades, and Starbucks is certainly a best-in-breed selection. For a large chain, Starbucks has done a good job of preserving a sense of “localness” to each store. The Starbucks I frequent most often is so architecturally pleasing that it is often pictured on postcards or photos of the community. Howard Schultz leads a strong management team. Insider selling of shares has been minimal in the past year or two.

As a person who drinks a lot of coffee, I have spent a lot of time in Starbucks locations. I find the Starbucks experience superior to the smaller competitors and “mom and pop” shops. Starbucks' product and service is consistent and positive. Many of the smaller coffee shops focus on the youth crowd, and do not provide an atmosphere that is welcoming to older patrons. The quality of their coffee drinks can be inconsistent, and the service primarily oriented to those familiar to them - at the expense of other customers. Starbucks provides more than coffee; they provide a comfortable place to relax, that is perhaps even trendy at times. Many business meetings as well as personal meetings, for a wide variety of reasons, take place in Starbucks.

How do you assess Starbucks' competitive environment?

Starbucks has more than 11,000 coffee shops in the U.S. alone. As of 2009, the next seven largest chains had the following number of retail outlets (worldwide):

2. Coffee Bean & Tea Leaf – 750
3. Caribou Coffee – 511
4. Seattle’s Best (a subsidiary of Starbucks) – 160, plus 400 in Borders Books and on ships, and soon to be in over 7,000 Burger King locations.
5. Peet’s Coffee – 192
6. Tim Horton’s – 160
7. Coffee Beanery – 131
8. Tully’s – 100-plus (sold to Green Mountain Coffee Roasters)

In addition to these, there are scores of smaller regional chains, franchises, licensed stores, and individual coffee shops. The acquisitions of units or chains by other chains happens at a dizzying pace.

Fast-food chains like McDonalds (MCD) are also stepping into the arena by offering premium coffee. Last month, Burger King (BKC) announced it will be selling Starbucks and Seattle's Best (owned by Starbucks) coffee in its restaurants.

Starbucks' menu includes sandwiches, pastries, and snacks that are superior in variety and quality to other coffee shops. Starbucks has revamped its menu to include healthier items, and it continually adds new products to the mix.

How do you assess Starbucks' valuation in comparison with competitors?

Presently selling for just over $25/share, Starbucks is trading at 19 times 2011 earnings. There are no competitors similar enough with published earnings estimates to make a truly fair comparison. Caribou Coffee (CBOU) has estimated earnings of $0.43 for 2010, which gives it a similar earnings multiple.

Green Mountain Coffee Roasters (GMCR) has risen from $16 in November 2008 to a mind-boggling $95 today. The stock was only $8 in 2006 and below $1 in 1999. It trades at 32 times 2011 earnings projections and more than 70 times trailing earnings. GMCR has been driven up to these levels by a short squeeze that now has about 17% of the float held short. Green Mountain is in the process of attempting to buy out Diedrich Coffee (DDRX), a Southern California-based chain that Peet's Coffee was also attempting to buy. GMCR is offering $35/share for DDRX, whose stock sold for less than $0.35 in the past year. Peet's Coffee trades for 26 times 2011 projected earnings.

Speaking of Green Mountain's big deal, Starbucks has a fair amount of cash - could this mean more growth through acquisition?

Starbucks has well over $1B it could put toward innovation and new stores, but is being more cautious on opening new Starbucks brand stores. I believe Green Mountain has overpaid in this acquisition and Starbucks is wise to not compete to acquire these units at these price levels.

What is the current sentiment on the stock? How does your view differ from the consensus?

The sentiment on SBUX is mixed, with a predominance of analysts cautiously optimistic. Eight analysts have a strong buy on it, three have a buy, and eight have it as hold. The concern amongst those less bullish is whether or not Starbucks can maintain its extraordinary growth. The fact that there are some who are on the other side of the SBUX trade is a positive to me; I am less comfortable being on the same side of a position where the consensus in entirely one-sided - it doesn't account for potential risk. Institutional price targets are in the upper 20s, from 10-20% above its current value.

Does the company's management play a role in your position?

Howard Schultz returned to the helm at Starbucks three years ago and has led the turnaround effort. Under CEO Jim Donald, there had been too much emphasis on growth and it wasn't well managed. During the downturn, Starbucks closed more than 700 stores and implemented cost-cutting measures, which have paid off. Starbucks store managers, area managers, and employees receive more training than other outfits provide, and it shows.

What catalysts do you see that could move SBUX stock?

Starbucks did experience a small decline in revenue during the depths of the recession, but that has already turned around. With the economy still sluggish, a Starbucks visit is one of the few luxuries that many people can still afford. Continued economic improvement also bodes well for Starbucks, as customers will gradually loosen purse strings a bit further. The profitability of their international business has increased, and is expected to grow at a faster pace than their domestic units.

Starbucks' recent foray into the $21B instant coffee market with its Via product has received mixed reviews. It tastes better than the old instant coffee we all came to hate - but so does a glass of water. At almost $1 per serving, it is more expensive than purchasing Starbucks' traditional coffee and brewing it in a drip machine. Via may be a good thing to bring on a camping trip, or the next time you have the yen to climb a mountain and have a Starbucks at the summit - yet another way to have the Starbucks experience.

Instant coffee is more popular overseas than in the U.S., and the Via line is part of Starbucks' emphasis on more aggressive global growth. Starbucks has continued to be inventive and produce new products.

What could go wrong with your Starbucks holding?

The growth of coffee shops has been extraordinary for almost two decades, and the growth rate will have to slow. If it slows too much, Starbucks will of course be negatively impacted. Also, Starbucks' profitability is sensitive to commodities prices, such as milk and coffee.

And commodities volatility might affect the company's re-examination of value pricing?

Starbucks recently modified its pricing architecture with an emphasis on lowering the price for the lowest-cost basic coffee drinks. Volatility in supply chain pricing could impact Starbucks' profitability and potentially require them to realign prices if costs change dramatically. Should there be a double-dip recession, this would also have a negative impact.

Also, barriers to entry are low in this business, and Starbucks is constantly being challenged by coffee shops, coffee kiosks, doughnut shops, and fast-food chains. None of its competitors have come close to building a large chain with anything even approaching Starbucks' brand awareness. Starbucks was not immune to the downturn and their stock was hit hard, dropping below $8 in November 2008, which turned out to be an outstanding buying opportunity.

One change I would like to see Starbucks make is with its usage of Wi-Fi policy in its stores. Presently, customers have to purchase Internet access or already have AT&T Wi-Fi service to utilize the Net. Smaller competitors are nipping at Starbucks' heels by offering free wireless to their customers. Starbucks could easily make free temporary Internet access available to its customers like so many other shops do.

Thanks, Steven, for sharing your thesis with us.

Disclosure: Active Asset Management is long SBUX

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Comments

[Paul Price]

Nothing like a new 18-month high to make a stock especially atttractive, right?

Mar 24 08:03 AM

[Tony Abbate]

SBUX is a wonderfully run company. They have just north of $800 million in next cash on their balance sheet. They bought back their stock aggressively when it was trading at about half of its current stock price. They are in a class of their own as I think the quality of their product is second to none. They have a wonderful business and franchise. Whenever I am on the road I am constantly looking for one because I know that I will get a very high quality product.

This stock is not a screaming buy as it is not cheap. It trades at an EV/EBITDA of 11.5. At most this company is worth an EV/EBITDA of 14 or $31/share. The company traded just below a 5 EV/EBITDA multiple in November 2008 or $7.06/share. The stock has more than tripled off its financial crisis low. I like to buy stocks when they trade at 50 to 65 cents on the dollar. SBUX trades at 82 cents on the dollar. There is no margin of safety at the current price.

Another item I find interesting is if you take a cue from management, they do not view the stock as cheap. From 12/31/04 to 12/31/2007 diluted shares outstanding shrunk from 805.6 mil to 727.6 mil through stock buybacks. From 12/31/2007 to 12/31/2009 shares outstanding increased from 727.6 mil to 762.9 mil.

Any idea on why the share count increased so much? Is it stock issued to management or have they resold the shares they repurchased in the mid-2000s?

What are their growth prospects? Based on the fact that they closed a bunch of stores a year ago or so, this stock is priced for growth. However, given the anemic economic backdrop, I think they are going to have a hard time generating much growth.

SBUX is a great company. However, the stock is not undervalued and I would pass.

Mar 24 11:01 AM

[Steven Benharris]

Hi Tony,
Thanks for your reply, all good points. When I selected SBUX as my pick and started writing the article, the stock was cheaper, it ran about 10% from that time through publication. Also, the market has rallied so much in the past year that it has become difficult again to find undervalued stocks, which were in abundance a year ago.
I don't maintain positions in a static fashion. I step in and out and trade a bit around positions. I will lighten up a holding and/or reaccumulate based on price movement, which is what I have been doing and will continue to do with SBUX. I share your thoughts on how well run a company SBUX is and like you, go out of my way to patronize a SBUX when on the road.

Mar 25 05:17 PM

[Steven Benharris]

Just a follow-up to last month's article. SBUX came out with earnings that beat expectations and raised guidance, and SBUX rallied above $27. I remain a believer in SBUX, however the price has more than tripled in a year and a half, and I acknowledge it's not in the bargain bin like it was a year or two ago.
I also noted that GMCR looked overpriced and the stock is down 10 points since then. I still see GMCR as overvalued based on fundamentals, it's price is likely to remain volatile as 1/6th of it's shares are shorted. I see a lot of potential downside to GMCR, but who knows when with the high short interest?

Apr 28 03:04 PM

[j_remington]

I owned SBUX at $9 sold at $23. CERTAINLY NOT buying now.

Mar 24 11:10 AM

[kinsey]

I have no opinion on the stock, but find the comments on the ambience of the shops not true to my experience. Starbucks cannot compete, in my book, with the small, locally-owned coffee shops for friendliness and atmosphere. We seek out the local shops wherever we travel and usually find the coffee superior. Often the prices are also lower, the edibles more appealing and unique, and the staff more genuinely cheerful (as opposed to trying to project cheerfulness).

Mar 24 01:03 PM

[Steven Benharris]

People are certainly passionate about their coffee and coffee locations. The ambience of a shop is subjective, my perception is based on having been in scores of Starbucks locations throughout the U.S. and many other competing shops. I have found that that there is a tendency amongst the smaller shops to be friendlier with their regulars visitors, less welcoming to unfamiliar customers, particularly older patrons. I have seen several mom & pop shops go out of business, even when they are quite popular. It's a matter of profitability. They may be popular hangouts, but what is their profitability model?
For example, in the shopping district nearby me, there is a Coffee Bean, Peets, and Starbucks within a 100 yards or so of each other. The Coffee Bean did a brisk business when it first opened, but now you could ride a motorcycle through the store blindfolded and not hit anyone. Peets does better than the Bean, but nowhere near the Starbucks, which easily does more business than the Bean and Peets combined. While the niche coffee shops may have their cadre of dedicated patrons, my observation is that Starbucks typically appeals to a broader group of people, and after all, this is a business.

Yesterday, while in Starbucks, I observed a Starbucks corporate inspector or manager writing up an employee for leaving the milk on the counter in an environment above 40 degrees in between making drinks....now that's what I call quality control. I have also found Starbucks to be slightly less expensive than their competitors. If you register your Starbucks card, refills are free and you can get free wifi access.

Apr 01 03:26 PM

[Alan Young]

On the "ambience", I agree with Kinsey; maybe the scene in Hermosa Beach is different, but the analyst should at least research a variety of locations before using that as an investment thesis.

I also see the stock as pricey. And if I want expensive coffee, Peet's is much more to my liking.

Mar 24 01:29 PM

[mr clark]

buy high sell higher??

Mar 24 02:37 PM

[Jesse99]

A: There are basically two kinds of coffee shops. One is the grab and go, on the way to work, functional and adequate brew. Dunkin' Donuts, Tim Hortons etc. exemplify this model. These shops also have people who hang out in them, but I think it comes with the comfortableness of their working class aesthetic. I grew up in a poor neighborhood and there is something about florescent lights and formica that just feels right. Needless to say. These businesses make money on volume.

B: Then there is the high brown, boutique coffee experience. Hand brewed individual drip coffee, cappucino with hearts and leaves in the foam etc. Here people (my self included) will pay $3 for a cup of coffee. Why? Because it is good.

Starbucks was instrumental in changing how Americans think about their coffee, opening many people up to the boutique aesthetic. But as the landscape changes, it finds itself in neither A nor B. Its too pricey for the daily grind and too plastic for the boutique experience.

As McDonalds and others (e.g. Tim Horton's) expand aggressively to soak up people looking for coffee shop A. Starbucks same store organic growth has always sucked suggesting that there are limits on how much volume they can achieve.

Meanwhile, those who prefer coffee shop B will leave Starbucks as they become more savvy and local competitors reap the rewards of the lifestyle shift Starbucks has provoked. I agree that free internet and allowing some degree of heterogeneity in store decoration might slow this down. But more importantly, Starbucks coffee is objectively bad. It is oily and often bitter. People drink it because they don't know better or have few alternatives, but over time, smaller boutiques will drive them out of the neighborhoods most willing to pay a premium for good coffee

Mar 24 03:35 PM

[Pro Stock Pickers]

Bottom line the story has been working and the stock is still in solid technical shape. Today's reversal off the highs on heavier volume is negative and wouldn't buy on a day like this but your downside right now isn't too bad especially if SBUX can consolidate at these levels for a couple more weeks. The last solid entry point we took was on March 8 and +10% in 2 weeks is a nice gain. There will be more high probability entry points to take advantage of the Starbucks story. Worrying too much about all the small details and one will never make a trade.

Mar 24 04:19 PM

[najdorf]

Perceptions of SBUX tend to vary wildly based on how good or bad your local Starbucks is. This is one of the problems with the huge expansion they did over the last 10 years - it became impossible to maintain consistent store quality. Some of the B&N locations are really terrible, but the Seattle's Best at the Borders I used to go to was quite good. Some of the NYC locations have totally clueless staff, but others are well-run. In a lot of towns they have some of the best commercial real estate, but in other places they were late on the scene and settled for bad locations or built too close to their own stores and competitors.

These are problems that McDonald's doesn't have, because it expanded more slowly and rationally and knows a lot about herding franchisees - all McDonald's are more or less at the same dubious but tolerable level, and so we all know exactly what going to McDonald's will be like. Also McDonald's is about 1/2 the price, so lower standards are ok. When you charge $4 for a drink you must ensure that the person making it can follow directions and the store is a pleasant place to spend time. Starbucks nails it more than half the time in my experience, but they will continue to feel a drag from underperforming stores until they establish more consistency.

Mar 25 06:26 AM

[Stephen Castellano]

I agree with some people here -- Starbucks is a very well-run company but the stock is not cheap. It is impossible to not be impressed with what management has done over the last year.

But in my opinion, a long-term investment in SBUX at this price only makes sense if one can see estimates moving consistently higher, approaching $1.70 or so for its fiscal year ended September 2011. This compares to the consensus of about $1.25 and a high of about $1.41 right now. Right now, ROIC looks like it could move from ~10% to ~13-14% by next year. That's great, but probably does not justify huge multiple expansion -- the stock price will have to move on anticipated earnings growth. This scenario is not ridiculous at all, but it does require very high conviction.

It also makes sense as a short-term relative value idea -- right now SBUX is one of the best adjusted values of any Discretionary stock. If SBUX remains in a class of its own, it could just move higher due to high demand from investors that focus on relative value.

You can read my report in pdf format here: www.scribd.com/doc/283...

Mar 25 07:01 AM

[guymar]

This article is touching. Makes me think of the famous scene in Wall Street, with Charlie Sheen finally having his meeting with Michael Douglas. Comes with stock idea 1: a dog. Idea 2: a dog. Idea 3: a dog with fleas. It literally reads: buy it as it has been going up, and by the way: they will get competition from McDonalds, they have also decreased operational margin on their run-of-the-mill products (which by the way require also the least man-power to make in all the shops), but yeah management is great and don't forget this is because some other company has gone up. Oh, and this miracle company is down almost a percent with the market up 0,7% ....
Back to the bar trying to get some advice from a friendly 'tender....

Mar 25 03:34 PM

[talld]

The problem Starbucks is going to face, is the same problem Vegas is facing now. They changed their business model to try to wring every dollar possible from people and for a while, people will put up with it, but eventually they will stop going.

The 23 dollar hamburger I got in Vegas and the 5 dollar Latte I got at Starbucks have a lot in common.

However, very short term their stock does appear to have upward pressure.

Mar 27 01:15 PM

[otrtiresupply]

I am glad someone finally mentioned the "Seattle's Best" angle. SBUX has been selling this coffee to independent shoppes for years under this name. All the major food wholesalers carry it as an ordering option.

As to Starbuck's....the coffee is not especially good. It is actually quite bitter. Unless I need a Frappucino, or am desperate for a caffeine buzz via the avenue of burnt coffee, I will stay away.

Mar 29 08:37 AM