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When CNBC asked me to take the bear case in a “Stock Brawl” on Star­bucks (SBUX) last Thurs­day (9/28/11), I said sure — I can do that again.

Sim­i­lar to my prior inter­views on SBUX, I found it easy to make the bear case for a stock that is as expen­sive as Star­bucks (SBUX). As my reg­u­lar read­ers know, when I say “expen­sive”, I back that up with details such as: to jus­tify its $40 stock price (clos­ing price from the prior day), SBUX had to grow prof­its at 10% com­pounded annu­ally for more than 25 years. If you believe in faster growth (as did my stock-brawl oppo­nent), then the stock price implied 15% com­pounded annual profit growth for about 13 years.

No mat­ter how you slice the future cash flow require­ments, the stock is expensive.

My stock-brawl oppo­nent said SBUX was cheap based on com­par­ing the cur­rent P/E to its his­tor­i­cal P/E. Ah, the always pop­u­lar and manip­u­la­ble P/E ratio… but I digress.

Sug­gest­ing that SBUX is cheap for any rea­son when its P/E is over 23x makes me scratch my head. True, SBUX has had a higher P/E in the past…and, soon after­ward, the stock tanked. Argu­ing that the stock should get more expen­sive just because it has been “more” expen­sive in the past is not convincing.

With all the cheap stocks in the mar­ket (e.g. Most Attrac­tive Stocks), why would any investor want to place a bet that SBUX future profit growth would be bet­ter than what is already baked into the cur­rent stock price.

It is not as if SBUX has a monop­oly on sell­ing cof­fee. It has a lot of com­pe­ti­tion, which means mar­gins are slim and will stay slim. Profit will be hard to come by as there are lots of com­pa­nies fight­ing for the same pool of rev­enues. When I review the list of publicly-traded com­pa­nies in the coffee-selling busi­ness, I think “wow, the cof­fee busi­ness is in boom times at a time when noth­ing else is boom­ing. Investors in these stocks should be care­ful.” Here is a quick list of publicly-traded com­pa­nies that focus on sell­ing coffee.

  1. Green Moun­tain Cof­fee (GMCR) -Dan­ger­ous rat­ing
  2. Cari­bou Cof­fee (CBOU) - Neu­tral rat­ing)
  3. Peet’s Cof­fee & Tea (PEET) Dan­ger­ous rating
  4. Ein­stein Noah (BAGL) Neu­tral rat­ing
  5. Dunkin Donuts (DNKN) Not covered

Note that this list does not include three other major sources of coffee-selling com­pe­ti­tion: (a) home-made cof­fee, (b) local, pri­vate cof­fee shops, many of which offer excel­lent “atmos­phere” and (c ) stores that sell cof­fee along with a host of other things, the best exam­ple of which is McDon­alds (MCD).

Regard­ing the expec­ta­tion that the price of cof­fee might fall — it is naive to assume that a drop in the price of the com­mod­ity on which one’s busi­ness is based will trans­late into prof­its for any mean­ing­ful period of time. When the price of the com­mod­ity drops, the cost of the end prod­uct tends to fall with it. In other words, when the price of cof­fee falls, cof­fee ven­dors will drop the price of cof­fee to entice more cus­tomers to buy more cof­fee, such is the com­pet­i­tive nature of business.

The only con­ceiv­able way that a drop in cof­fee prices results in a sus­tain­able improve­ment in prof­its for SBUX is if SBUX con­vinces all the other cof­fee ven­dors to keep their prices unchanged — as if the price of cof­fee never fell. In which case, the profit mar­gins of all the exist­ing cof­fee ven­dors stays higher. In short order, those higher profit mar­gins will soon be under attack by new entrants to the cof­fee busi­ness, who see an oppor­tu­nity to sell cof­fee (and still make a profit) cheaper than the exist­ing competitors.

Not low­er­ing prices in step with the drop in the under­ly­ing com­mod­ity only invites price com­pe­ti­tion from exist­ing or new competitors.

The poten­tial drop in the price of cof­fee should not trans­late into expec­ta­tions for higher profit mar­gins. Instead, it trans­lates into cheaper cof­fee for con­sumers and, per­haps, more cof­fee sales.

Next, let’s dis­cuss the “K-Cups” strat­egy. I fully agree that get­ting into the pack­aged food busi­ness and mov­ing away from the stand­alone store busi­ness is an intel­li­gent move. It shows intel­li­gent cap­i­tal allo­ca­tion as returns on invest­ment tend to he higher when licens­ing one’s brand to be on a pack­aged good sold by another firm com­pared to pro­duc­ing, dis­trib­ut­ing and sell­ing that good oneself.

How­ever, pack­aged goods have been around for a while. Star­bucks does not have a monop­oly on the K-Cups mar­ket. In fact, bar­ri­ers to the entry of other brands of cof­fee that could be sold in K-Cups are even lower than the bar­ri­ers to entry in Star­bucks’ core busi­ness. Accord­ingly, the head­line on the K-Cups web­site states that there are “over 200 vari­eties”. It is naive to expect that Star­bucks can gen­er­ate a lot of profit in another mar­ket where com­pe­ti­tion will keep mar­gins slim.

At the same time, I think K-Cups is the best and most excit­ing part of SBUX’s busi­ness right now and rep­re­sents the most prof­itable way for the com­pany to cash in on the impres­sive brand that it has built.

Lastly, let’s dis­cuss Starbuck’s inter­na­tional strat­egy. It seems to me that investors love to hear “inter­na­tional strat­egy” and take for granted that any busi­ness that has been suc­cess­ful in the United States will be equally or more suc­cess­ful in for­eign lands. Wrong. Maybe that was true a quar­ter cen­tury ago, but no longer. Almost every major busi­ness has an inter­na­tional strat­egy so the advan­tage afforded the com­pa­nies that pio­neered inter­na­tional growth strate­gies has long been com­peted away.

I think Star­bucks biggest strength is its brand and that will not trans­late well into other coun­tries where com­peti­tors like McDonald’s have a huge head start in their inter­na­tional oper­a­tions. In a lit­tle more than the time it took Star­bucks to announce its inter­na­tional growth plans, McDonald’s had the capa­bil­ity to add mul­ti­ple cof­fee drinks to its inter­na­tional menus and be sell­ing cof­fee for months before Star­bucks opened a sin­gle inter­na­tional store. In the United States, Star­bucks ben­e­fited from first-mover advan­tage in the coffee-selling busi­ness, which enabled it to build the best coffee-store brand in the United States. Now, how­ever, the word is out. Build­ing a prof­itable brand in other coun­tries will be much more difficult.

Read­ers may be sur­prised to see me write that Star­bucks has the best coffee-selling brand in the United States because of all my bear­ish com­ments. I am very impressed with the brand and stock val­u­a­tion that Howard Shultz has built around a com­mod­ity busi­ness. I find it amaz­ing that he has con­vinced so many peo­ple of the poten­tial prof­its to be won from sell­ing cof­fee. I think he sur­prised lots of people.

Indeed, once he had the stock mar­ket wind was at his back, the stock enjoyed the back­ing of the many momen­tum traders and spec­u­la­tors that have come to dom­i­nate much of the dia­logue on stocks these days. His suc­cess was, in at least one way, his undo­ing as it encour­aged many other com­pa­nies to enter the mar­ket and com­pete with Starbucks.

The say­ing “live by the sword, die by the sword” applies to SBUX and Mr. Schultz. As we enter a bear mar­ket, SBUX will be one of the many stocks with val­u­a­tions dri­ven to spec­u­la­tive heights by momen­tum traders that falls back to earth.

I feel sim­i­larly about the five publicly-traded cof­fee com­pa­nies listed above. All of them are over-priced and poised for correction.

My argu­ments above apply to all of the cof­fee stocks.

I rec­om­mend investors get out now before the stocks fall fur­ther. SBUX has already dropped roughly 10% since my stock-brawl interview.

McDonald’s, with New Con­structs’ “very attrac­tive” rat­ing, is the only stock I rec­om­mend buy­ing out of this group.

I rec­om­mend sell­ing the fol­low­ing ETFs that hold SBUX.

  1. Rydex S&P 500 Pure Growth ETF (RPG)
  2. iShares Rus­sell 1000 Growth (IWF)
  3. Van­guard Growth ETF (VUG)
  4. Con­sumer Dis­cre­tionary Select Sec­tor SPDR (XLY)
  5. iShares Rus­sell Top 200 Growth Index Fund (IWY)
Source: Starbucks Is A Sell: Overpriced, Poised For Correction