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.
- Green Mountain Coffee (NASDAQ:GMCR) -Dangerous rating
- Caribou Coffee (NASDAQ:CBOU) - Neutral rating)
- Peet’s Coffee & Tea (NASDAQ:PEET) Dangerous rating
- Einstein Noah (NASDAQ:BAGL) Neutral rating
- Dunkin Donuts (NASDAQ: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 (NYSE: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.
- Rydex S&P 500 Pure Growth ETF (NYSEARCA:RPG)
- iShares Russell 1000 Growth (NYSEARCA:IWF)
- Vanguard Growth ETF (NYSEARCA:VUG)
- Consumer Discretionary Select Sector SPDR (NYSEARCA:XLY)
- iShares Russell Top 200 Growth Index Fund (NYSEARCA:IWY)
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.