During the beginning of the last decade, I wanted to add Starbucks (SBUX) to my portfolio in a meaningful way. I understood the economics and the value proposition well, yet I did not want to overpay for the privilege of owning this very popular, fast growing coffee retailer.
Finally, during the Christmas season of 2007, I bought my first scoop of shares at an average price of $20. I remember standing in my local Starbucks at the time and doing the price/cash flow math in my head. The stock hadn't been below $20 in 3 years and then suddenly it was. At 8-10x EV/FCF (depending on how one adjusted the maintenance and growth capital expenditures), the stock still wasn't cheap, but it was a fair deal for a business with compelling economics.
At the time, I knew Starbucks essentially was selling a branded addiction, with pricing power, and it had a business with relatively high returns on capital (ROIC of 18%+, excluding capitalized retail store leases, which exclusion is one point where I respectfully disagree with Aswath Damodaran.)
Starbuck's business was easy to understand as was their annual report on file with the SEC. This business was not subject to disruption by new technologies, as so many other businesses are, and Starbucks did not need to re-invent its product every year just to maintain its market position. Maybe one day, I thought, I could really buy a lot of this stock, but due to its price, SBUX remained out of my value-oriented reach.
Then came the financial crisis and the subsequent, slow-moving market meltdown. Starbucks was doubly hammered as McDonald's (MCD) threatened to compete directly against Starbucks and steal its loyal customers. This added to the pain of Starbucks' prior over-expansion in the USA as its growth slowed and its non-performing stores weighed heavily on its overall profits. This was bad news, and the stock (and the sky) was falling.
I still remember the day in mid-July 2008 that Starbucks released its store closing list, which I hastily, if not hesitantly, devoured. Were stores near me closing? Were many of the stores in Manhattan, where they were on every other block, also closing? The answer was a resounding "no." As became apparent, most of the store closures were located in small, rural markets. The list seemed correlated with an inability to profitably manage and/or penetrate smaller and more remote districts. This was not the over-saturation issue that I had expected, but in fact was nearly its opposite.
Howard Schultz, the firm's entrepreneurial founder, had rejoined the company as CEO at the beginning of 2008, and he was in the process of turning the company around. I thought about Howard's track record; it was stellar, but nobody else seemed to believe in him (the old "What does the founder know?" investor syndrome).
Starbucks traded below $10 per share for a period of 6 months from October 2008 to April 2009, during the height of the financial panic, no doubt due in part to forced and/or panicked selling of equities in general. This wasn't just a Starbucks problem, yet SBUX was catching the full force of the storm. At an enterprise value / cash flow of 5-6x, Starbucks now was a compelling opportunity and one not directly involved in the banking crisis on Wall Street.
However, I first needed to determine two things: (1) Was this business going to survive the financial storm in the short run, and (2) were customers going to defect en masse to McDonald's for lower prices over the long run? The market was pricing both with negative outcomes.
For me, the answer to the first question took 5 minutes. Starbucks in 2007 had net cash flow from operations equal to its net debt, and that felt very safe to me, that is, for a business providing a branded addiction. In fact, Starbucks in 2007 spent nearly its entire operating cash flow of $1 billion on capex on new store buildouts, remodelings and infrastructure improvements.
Crisis? What crisis? This was not a bank like Bank of America (BAC) or Citi (C) or even General Electric (GE), all with "who-knows-what" lurking on their balance sheet, nor was this a business with structural problems and disappearing revenues such as that faced by General Motors (GM). In contrast Starbuck's operations were simple, its balance sheet strong, and I believed there was no chance of it going bankrupt no matter how bad the financial storm became, that is, provided the USA continued to function.
The next question required a few weeks of consideration, but one thing seemed certain immediately: if customers were going to abandon Starbucks, that was not going to happen at any of the Starbucks stores near me.
All I saw at local Starbucks stores were lines of people paying $2, $3 and more for cups of their favorite, highly-customized frothy beverage. These customers, in their office attire and yoga stretchies, groups of students and retirees, moms and dads and young and old - many lounging, tapping on laptops or poking brand new Apple (AAPL) iPhones while others double parked - were not moving to McDonald's.
So I went to McDonald's, but nobody there seemed to be ordering premium coffee as a standalone drink. McDonald's customers also didn't resemble the Starbucks' demographic (judging by, among other things, the food items that they were ordering in addition to their coffee). I concluded that two could win at this game; there was room for both Starbucks and McDonald's in the coffee business, just as there was room for Dunkin' Donuts (DNKN) and Wawa and Panera Bread (PNRA).
So, I turned to an authority on Starbucks - my wife - the locally well known, SUV wheeling, double fisting iced-coffee soccer mom. Would she consider going to McDonald's to save money - how about up to $500 per year? Her response was simple: "Do we need to sell the house?"
Thinking that I needed to expand my sample size, I called the king of the triple shot, my brother in Washington. I asked him if he was going to convert to McDonald's to save money; he barely had time to insinuate that I was an idiot before changing the topic.
To me, the purchase of Starbucks at this price was a "no-brainer" as the odds seemed clearly stacked in my favor even if the market didn't see it that way.
I took my time dollar-averaging down and loaded my portfolio with thousands of shares at an average price of about $11.50, which average included my earlier purchases made in 2007. I bought some at the lows, and some quite a bit higher. It was a bold, concentrated bet, but one with a "Margin of Safety". Last week, I unloaded most of my shares, and yes, I will be helping to reduce the deficit next April.
Now, I still love and am loyal to Starbucks, and I firmly believe that the business will continue to perform exceptionally well over time. Not only that, but I know full well that the stock could go up another 50-100% in the next year. Why not? Look at the $10 billion enterprise value of Zynga (ZNGA), which barely has any earnings. In the stock market, anything is possible!
There is euphoria surrounding Starbucks and for many good reasons including continued international growth (competence leverage), lower coffee bean prices (margin leverage), an increasingly broad retail strategy based upon its solid existing retail distribution infrastructure including its partnership with Pepsi (PEP) (operating and capability leverage), and a new single serve cup and energy drink business (brand leverage). In fact, at the current price of 30x cash flow, no price seems too high for all of the amazing news coming out of Seattle!
But what makes Starbucks a great business today does not necessarily make it a great stock. There is no question that I got lucky, and I am the beneficiary of some "irrational exuberance" as Starbuck's stock climbs towards $60 per share. However, this was far from a "one-off".
Using these same methods and logic, I have realized many doubles, triples, and home runs in the past few years, especially in other high-end retailers, those with ROICs >20% and possessing rock solid balance sheets. This formula, espoused by Warren Buffett, is so simple that very few care to listen.
Only buy a stock when: (1) You understand the business's long term competitive position, AND (2) it is conservatively financed, AND (3) it has great returns on capital, AND (4) its managers are large shareholders themselves and are not issuing options at the expense of shareholders or selling large blocks of stock, AND (5) the stock is cheap (less than 10x cash flow). Everything else is gambling.
Great deals come along infrequently, usually when there is some sort of panic in the markets as a whole or about a company in particular. You may have to wait a few years, maybe many years, but it makes sense to wait, well, at least in my opinion, it makes sense to wait.
Another important trick is not to listen to anyone talking about stocks because few know any more than you do, and if they do know more than you, then you definitely should not be buying the stock! Especially dangerous to the public's purse are stock recommendations made on popular websites, talk shows and finance channels. In my early days, I lost a small fortune following the "sage wisdom" of well known and trustworthy firms, "gurus," and highly ranked mutual fund managers. As William Goldman says, "Nobody knows Anything," and if they were so certain, then they wouldn't be sharing that stock tip with you!
Instead, buy a diversified index fund at Vanguard - there are few better. Or, if you must, treat yourself and go to Las Vegas, where at least you won't disillusion yourself that indeed you are gambling with your money.
I have kept about 20% of my position in Starbucks just in case I have the opportunity to sell at a higher price to a greater fool, but the good news is fully baked-in, just as back in 2009 when the bad news was fully baked-in.
And should the price run up from here, I will turn to my wife, who was against me selling the stock, and repeat to her what Berkshire Hathaway (BRK.A), (BRK.B) chairman Warren Buffett has often said to his partner Charlie Munger: "Oooops. I did it again."
Investing is most profitable when the odds are heavily and clearly weighted in your favor - when you can do the math in your head, and all things considered, the data and the deal really makes sense.
I lost that edge when Starbucks moved into the zone of approximately 30x cash flow and 20x Ebitda. I would LOVE to own SBUX again, just as I would love to own shares of Chipotle (CMG), too, but at 30x cash flow, neither stock offers (me) compelling upside compared to the downside.
By the way, one of the obvious lessons here is also one frequently repeated by both Warren Buffett and his partner Charlie Munger: bet infrequently, but when that once-in-decade deal comes along, be sure to back up the truck. And whatever you do, don't use margin (debt).
Disclosure: I am long SBUX. I sold 80% of my Starbucks position last week, and if the stock continues to rise, I will sell the remaining 20%.