Whole Foods and Starbucks: Great Companies, Lousy Stock

As I write on Independence Day about two true American icons that are both open on this national holiday, I can only chuckle as I prepare to be attacked by their fans. When I wrote a detailed analysis of Whole Foods (WFMI) (38.21, $5.4 billion) in mid-March, I generated more feedback than on any other article I have submitted to Seeking Alpha. What the readers don’t know is that I received some rather unfriendly responses by email as well. While I am a big fan and customer of both WFMI and Starbucks (SBUX) (26.36, $19.7 billion), I am not a fan of their stocks at all, despite the drubbing that both have taken. Besides being my two favorite suppliers of coffee (WFMI beans and SBUX brewed), the two stocks have a lot in common.

Same Valuation

We live in a 24x7 world. So do SBUX and WFMI, which both trade at 24.7X their September 2008 earnings estimates. How strange is that?

Similar Price Action

Both stocks peaked in early 2006 and have fallen substantially. SBUX put in a double-top near 40, the first of which was on May 5th (and the second was November 16th) and is now down about 35%, while WFMI earned its highest valuation on 12/28/05 and is down a bit more than 50% from that 79.90 top. Ironically, both stocks proved to be 10-baggers almost to the penny from their late 1998 lows. Even more ironically, both of these stocks were 1992 IPOs. For those who are curious. SBUX has been the better investment, though both rank among the best stocks to have bought that year.

Both Benefited from “Affordable Luxury” Theme

What drove the earnings of these companies and their PE valuations over the past decade to lead to such stunning appreciation? Both companies were able to provide high-quality experiences to the masses and create incredible brand values. One has to wonder as the housing bubble deflates, with consumers no longer able to use their homes as ATM so easily, if these premium experiences at a premium price can sustain the growth.

Both Companies Face Threats from Below

I previously addressed and the company has discussed the competitive issues for WFMI. Traditional grocery stores, large discounters and new entrants, like Trader Joe’s and Tesco, are mimicking WFMI’s product array and service offering. The press has made a big deal out of Dunkin Donuts and, more recently, McDonald’s (MCD) offering better coffee at better prices than SBUX. In any event, given the competitive environments and the potential for weakening macroeconomic factors, neither of these companies is in a position to raise prices.

Both Companies Have Seen Peak Margins

Both of these companies are extremely profitable for their industries, but are in a position that they need to constrain prices and reduce expenses. Cutting expenses for companies offering a superior customer experience can be tricky. In both cases, growth is coming more from square footage expansion rather than store productivity.

My Outlook

Both stocks are making 52-week lows and are oversold, and either could bounce from here. My outlook for the longer-term, though, is neutral at best for both stocks, primarily a function of their premium valuations still. From what I read, it seems that a lot of new-style value investors see bargains in the pair. In March, I predicted that WFMI would reach 38, which I see as an area of support. I don’t expect 38 to be the ultimate low, but it could serve as a near-term low. The competitive situation for the company is a bigger problem than for SBUX. The Wild Oats (OATS) merger looked like a sign of desperation to me. EPS estimates continue to fall, with the FY08 estimate now down 22% over the past year. While I could see a rally to as high as 45 now, especially if the OATS deal clears the FTC, it is likely to tread water for quite some time. I believe that a generous valuation a year from now is 22X the one-year out estimate (currently about 1.75), which yields a price target of 39. A more realistic valuation of 18X would yield a target of 31.50. For those looking to short, a break of 38 or a failure at 42 would provide good entry points.

SBUX is a bit tougher to call in my opinion. It has penetrated a trading range 23-28 that existed for most of 2005, and it has clearly taken out prior support of 29-30. EPS estimates, unlike those for WFMI, have been very stable, and projected growth over the next couple of years is much higher. With that said, though, the 2008 estimate has actually ticked down just a bit. Is this noise, or is it the beginning of a move by analysts to lower their growth projections? I think that as the fiscal year end wraps up this quarter, there is a risk of more concern surrounding the growth outlook. I have read lately about the wisdom of having a store on all four corners, but it begs the question of what’s next. True, SBUX (and WFMI, for that matter) has a lot of international expansion potential. I think, though, that it is much safer to buy a growth stock that has a better balance between new stores and growth in existing stores. Near-term, I would be surprised if the stock doesn’t test 23. There are several analysts with ridiculous targets on the stock, and the overall analyst ratings are pretty positive still despite the deterioration of the stock. So, while I think that SBUX is less broken than WFMI and can more easily attain international growth, I expect longer-term to see PE compression. I would expect that the year-out valuation will be roughly 21X or 26, about where the stock trades now. In both cases, high-PE stocks making 52-week lows and with declining EPS estimates in the out-year require you to be much smarter than the market. I prefer to be late rather than early.

Final thoughts

I expect to hear an argument that SBUX is relatively immune from any domestic economic slowdown, but I disagree. While its price points are low, I truly believe that a lot of their clientele will be cutting down on $4 coffee concoctions as the adjustable-rate mortgages reset higher in coming years

I think that both of these stocks offer great lessons in the need to understand the differences between great companies and great stocks. I also think that the price action of late should serve as a case-study against buying “falling knives”. What is value? A lower price than yesterday isn’t necessarily a better price. Do you recall how bullish investors were on Tech stocks even in 2001 at significant price discounts to the peak? My advice, for what it is worth, is to stay away from these icons for now and focus on finding tomorrow’s winners rather than yesterday’s.

Disclosure: I don’t own either of these stocks, but I am a customer of both.