Why Starbucks' Valuation Multiples Could Expand

Jul.31.14 | About: Starbucks Corporation (SBUX)

Summary

Starbucks reported low earnings last year due to a litigation charge.

It is due to bounce back this year and post impressive growth numbers, as is sector peer Chipotle Mexican Grill.

The current valuation gap between the two companies appears to be too wide and we feel that Starbucks could outperform its sector peer going forward.

In this article we're focusing on Starbucks (NASDAQ:SBUX). It's had a fairly lackluster year, with shares in the company being up just 0.3% during the course of 2014 while the S&P 500 has risen by 6% during the same time period. However, we feel that consumer goods companies, such as Starbucks, are an interesting space to focus on right now, with there being question marks over the strength of the US recovery and the resilience of the US consumer.

We're also comparing Starbucks to Chipotle Mexican Grill (NYSE:CMG) because it sits in the same GICS sector as Starbucks (consumer discretionary) and is also in the same GICS sub industry of restaurants. Although they don't serve exactly the same goods, we know that many investors allocate capital based on sectors and sub industries, so we feel it could be a useful comparison in helping investors to allocate capital within this space.

Huge Discounts

One thing that stands out when analyzing the two companies is their valuations. Indeed, both Starbucks and Chipotle trade on extremely high valuations, with Starbucks having a forward P/E of 25 and Chipotle's forward P/E being 39. While both are high, that's a huge difference between the two figures, with Starbucks' P/E being at a discount of 36% to its sector peer.

It's a similar story in terms of the EV/EBITDA ratio, with Starbucks having a ratio of 17.9, while Chipotle's is much higher at 29.1. Again, it equates to a vast discount for Starbucks compared to its peer, with the discount on this occasion being 38%. Furthermore, the two companies' price-to-sales ratios are also very far apart, with Starbucks' ratio being 36% lower than that of Chipotle at 3.7 versus 5.8.

Litigation Charge

A key reason for the stark difference in valuations could be the fact that Starbucks experienced a huge fall in reported profit in 2013. Indeed, its bottom line was hit very hard by a $2.8 billion litigation charge associated with the Kraft arbitration, which left it with only a small amount of profit. Therefore, its profitability was severely hit and could be a major reason why the market is reluctant to give shares a higher rating than at present.

Strong Growth Prospects

However, forecasts for the current year show that Starbucks is all set to bounce back from the disappointment of 2013, with the company expected to post EPS of $2.68 in the current year. This would equate to very healthy returns for shareholders, since the company continues to enjoy a very healthy operating margin of 16%, which is in-line with that of Chipotle. Furthermore, both companies are running low levels of balance sheet risk, with Starbucks having a debt-to-equity ratio of just 41% and Chipotle having no debt. This means that, as interest rates rise, their net margins are unlikely to be hit too hard by added interest expense, which is good news for shareholders.

In terms of future growth, Starbucks again delivers impressive numbers. It is forecast to grow EPS by 17.5% next year and, although this is behind the expected growth rate of Chipotle of 26.9%, is highly attractive nonetheless. Both numbers are well ahead of the market average and show that the restaurant space continues to offer investors very strong growth rates going forward.

However, we feel that the growth rate of Starbucks, while behind that of Chipotle, is not fully reflected in its current valuation. As mentioned earlier, Starbucks trades at huge discounts to Chipotle on a number of valuation metrics and we feel that is undeserved - especially when it is forecast to return to impressive earnings numbers in the full year to the end of September 2014. Therefore, we feel that Starbucks could be mispriced at current levels and could outperform Chipotle going forward.

Conclusion

Although Starbucks' reported earnings were severely hurt in 2013 by a litigation charge, it is forecast to deliver strong earnings numbers in the current year. These are set to be followed by EPS growth of 17.5% next year, which is impressive. Although its growth rate is behind that of Chipotle, we feel that the current gap between the two companies' valuations is too wide. As such, we think that Starbucks could outperform its sector peer, as the market realizes that there is a mispricing and reacts by bidding up the shares of Starbucks going forward.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.