Starbucks' Recent Roadblocks Present a Buy Opportunity

Mar.19.07 | About: Starbucks Corporation (SBUX)

Sometimes you have to capitalize on short term unpleasantness and consider purchasing shares of a great, but always expensive, business. As Goldman Sachs noted, on Friday investors may currently find that opportunity with Starbucks' (NASDAQ:SBUX).

Over the last several months, the company's stock price has suffered because of several concerns. Slower sales in the early months of 2007, increased store opening expenses, and uncertainty regarding their heated food/breakfast rollout have combined to pressure its shares. Some other issues include expansion concerns in China, McDonald's (NYSE:MCD) introduction of premium coffee and subsequent praise in Consumer Reports, and press coverage of Dunkin Donuts' expansion push.

The company also experienced difficulty managing customer wait times, with its labor intensive Frappuccinos causing slower service and pushing consumers to avoid some locations. Most importantly, Chairman/Founder Howard Schultz wrote a surprising internal memo to SBUX execs, lamenting the possible deterioration of the SBUX culture and customer experience.

However, these issues have given investors an opportunity to own a premier global business at a reasonable price. A good deal of growth remains for SBUX in the next decade. While the company may have seemingly saturated the US with locations, many potential infill sites exist in major cities, on interstates, and in places of business that do not cannibalize nearby stores but capture valuable real estate and further mind-share of its customer base. It can likely achieve its goal of 40K locations globally - from 13K this year - at a pace of 2500-3000/yr, leading to a more-than-doubling of sales and an increase in earnings leverage.

SBUX recently purchased 90% ownership in its China operations, and although some native Chinese have protested SBUX presence in certain locations, the company and its products have accelerated in popularity. It possesses no long term debt, $400M in cash/securities, growing strength in Europe, and can maximize the ability to repurchase its own stock at lower prices.

Lines at stores still remain long, but SBUX has improved the average wait for service and will continue to attract customers that will endure lines for its seasonal and specialty offerings. It also maintains good relationships with its suppliers and manages raw material costs through hedging potential future price increases in its coffee beans.

Why has MCD's new premium coffee resonated with the public? MCD has more locations in the US, 13,700 versus 9,300 for SBUX - it simply has more points-of-presence and can leverage its significant customer flow at different meal times to promote its "premium" product. MCD dominates the breakfast market, and any improvement compared to their former coffee offering pushes consumers to reconsider it. MCD customers can also use the drive thru to order, capitalizing on an advantage in time and convenience. Also, its coffee remains cheaper by 20-40 cents, and many older consumers receive discounts.

SBUX can quickly counter these potential roadblocks. The firm has begun to increase breakfast sales which almost always include a coffee purchase. Also, SBUX announced recently that it will aggressively open drive thru locations, and many of its existing California drive thru's are frequently busy. We've discussed its expansion plans, enabling the firm to closely match MCD's overall presence, and its beverage sales will occur at higher price points than MCD.

Moreover, I think that Dunkin will encounter difficulty expanding its brand nationally. Its coffee remains expensive and significantly trails SBUX and MCD in consumer preference, and the company may need to fight for remaining store locations on both coasts.

I would also consider MCD as an investment, with an earnings multiple in the mid-teens, strength in Europe, expansion potential in China, an increasing dividend and stock buyback plans, and further real estate value to unlock. But I would like to focus on SBUX today, and the chance to purchase its shares at these levels won't last long.

SBUX 1-yr chart: