High Conviction: Starbucks Has Its Buzz Back

| About: Starbucks Corporation (SBUX)

Editor's note: Starbucks (NASDAQ: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 chartSBUX 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 (NYSE: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 (NASDAQ:CBOU) has estimated earnings of $0.43 for 2010, which gives it a similar earnings multiple.

Green Mountain Coffee Roasters (NASDAQ: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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