Starbucks Still Has Significant Potential

Starbucks Coffee (SBUX)- Discounted Cash Flow Valuation: $23

Starbucks stock has been getting a beat-down for more than a year already, down more than 50% from the $ 40 high reached Nov ’06. In the past few months, SBUX fell from the $ 26-28 range, where it was treading water all summer into the fall. Now, trading around $18, SBUX is still not cheap.

Applying a discounted cash flow model gives a fair value estimate of $23. Even though fair value exceeds current price by a decent amount, the margin of safety is too small, given Starbucks' negative momentum and expected near-term weakness. However, for a long-term investment horizon (10yr+), I believe SBUX can be bought here. Starbucks may have rough times in the near-term.

Last August, I placed a value on SBUX of $35 /share. SBUX announced it is scaling back store additions for the coming year, thus I slashed my sales growth forecast, resulting in the steep drop in valuation. Projected 5 year growth rate assumption decreased from 18% (Aug) to 14%. The other input assumptions really didn’t change, just the revenue growth projection. Read SBUX: Long-term Hold

In the last five years SBUX sales growth averaged 23.5%, fueled primarily by new store additions. Starbucks cut its previous forecast for 2008 new stores from 1,600 to 1,175 (in the US), and mentioned closing 100 or so under performing locations. The company is forecasting ’09 US store additions of less than 1000. Slower/less growth in Starbucks' store count translates into less revenue in future periods.

Fear of slowing growth is the main culprit to Starbucks' stock price slide. Concerns that a slowing economy will materially affect SBUX might be discounted in the share price, but SBUX is well insulated and recessions are short-lived events. Stocks are valued over a long-time horizon, at least 50 years. Worries about McDonald's (MCD) giving SBUX a run for its money are laughable. Yes, MCD may negatively impact Starbucks' growth, but only slightly, if at all. I believe that new store expansion has been too aggressive, causing cannibalization of store traffic. Aware and addressing this issue, Starbucks is scaling back store openings. Read SBUX Face-off

Foot traffic at comparable stores declined (or was flat) for the past several quarters, leading me to suspect sales cannibalization. Some geographies likely became over-saturated, thus a new store takes traffic from an existing, causing weak SSS comparisons. Surely, some customers who constituted the sales at new locations had visited a SBUX in the previous year. Take a person who had 20 store visits last year. This year that customer returned 10 times to that location, but also went to newly opened store on ten other occasions. That’s where the foot traffic is going, to the 1,800 stores opened this year. Read SBUX Cannibalization

Last fall, management maintained that saturation played no part in declining foot traffic as concerns rose. The reduction to planned store openings is an admission that cannibalization is becoming an issue. On the last call, the CEO said they were slowing down store additions to avert sales cannibalization of existing locations. So, it is a problem, the primary problem, not the MCD noise or economy fears.

I think SBUX still has significant growth potential, albeit at a slower pace. SBUX still has some room to grow domestically and plenty of room internationally. Management needs to be more deliberate about expansion, instead of shooting from the hip and putting stores anywhere and everywhere.

Starbucks generates high returns on capital and equity. Usually competition and market forces drive returns down to a more normal rate, yet Starbucks possesses a very strong competitive position that will keep returns above normal for a considerable time. These factors underlie the premium multiple that investors have placed on SBUX.

Examining Starbucks market valuation from the price/earnings vantage point also suggests that shares are fairly-valued. Maybe slightly undervalued, but certainly not undervalued or cheap by any means.

SBUX is trading at 19x Sep FY earnings and 16x next year’s estimate. Using ValueLine and Nasdaq.com for estimates years farther out, I calculated my 5-year growth rate projection of 15%, not 19% analyst consensus estimate. 13-15% growth may not warrant a 19 multiple, but given ROI and the persistence of growth and competitive advantages, SBUX trades at a reasonable multiple. Interest is very low too, making a case for higher P/Es.

One area of concern is the downward trend in revisions to EPS estimates, which may portend even more downward revisions.
Earnings Estimates and Revisions:

Starbucks Historical Data:

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SBUX Valuation: Discounted Cash Flow Model:

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Disclosure: No Position.

Comments

[Walt17:]

The traffic in my local Starbucks began to drop, before the economic downturn. And there are no other Starbucks nearby to siphon off the customers. I believe competition and new stores, are only a contributing factor to their problems. The main problem, as I see it, is an inability to grow their customer base. That is because there are a lot of coffee lovers who hate Starbucks coffee. I know many many people who like coffee. But not one who likes Starbucks coffee. Until they come out with blends that appeal to a wider consumer base they will continue to have problems.

2008 Feb 12 11:09 AM

[My Two Cents:]

Glad to read the comment of User 149821 about Starbucks coffee. I am a coffee lover who always found the Starbucks variety undrinkable and never understood its apparently broad appeal. Now I know I'm not alone.

2008 Feb 26 05:50 PM

[brassia:]

Starbucks, as I am sure many people know is not just about coffee; it is an environment and a second home/office to many people. People seem to sit at a table all day at their computers working. The restrooms are usually clean and free.

In addition to the coffee of the day, served at the counter, Starbucks sells an enormous variety of coffees to prepare at home. They also have the best hot chocolate served in any restaurant that I know of; and many other beverages.

They also serve a variety of healthy tasty foods, as opposed to Macdonalds and other fast food places. One can eat breakfast, lunch and dinner there.

And wherever you go in the world you can usually depend upon getting the same "at home" atmosphere, and quality of beverages and food.

Although I enjoy having a Starbucks along the road, there is no doubt that they have probably extended into areas where they are not appreciated; and Dairy Queen or MacDonalds is the preferred choice.

Starbucks has a very loyal following, and I am sure that an analysis of locations and "tightening the belt" will help their recovery.

2008 Feb 27 04:14 PM