Will Howard Schultz Put the Buzz Back into Starbucks?

Maybe it was the going to the doctor for a check up or maybe it was the chocolate chip cookie I ate just before bed (guess the doctor's advice about my diet didn't last too long...) but regardless the cause, I dreamed of Starbucks last night.

In my dream, I was tasting a delightful muffin kind of thingee, when I decided I wanted to try another kind of pastry I saw (no calorie limits in dreams!) in the display window. I had not finished muffin #1 when I ordered pastry #2. When I realized that the server had taken away muffin #1 before I was finished, I told him I wanted it back. What I got instead was a curt remark that it was company policy that I could not get it back.

This made me angry and I went behind the counter to confront him about this. He obviously did not care about my views and basically told me to take up the matter with "the corporation." Within a few minutes, I was watching a video on a small television (I guess this was supposed to be the way the "corporation" dealt with customer complaints) that was spouting meaningless Dilbert-esque platitudes about company policies and how I should have read the provisos and customer agreements on the menu before ordering my muffin.

Luckily, the alarm clock ended this nightmare before I went postal on the espresso machine.

SBUX is a stock that I used to know very well and have recommended to clients successfully over the years. Mark Kalinowski, who used to be Smith Barney's restaurant analyst, helped me greatly in understanding this company. Back in 2002 and 2003 when Mark and I were discussing this stock on a regular basis (and when the stock was trading around $10), the thesis was quite simple. The company had 5,000 shops at that time and was going to eventually open up 30,000. This six-fold increase in sales would have positive implications on earnings and so on any kind of longish time frame one could make tons of money in the stock.

During this time, he showed me a book from the 1970s which talked about how when McDonalds (MCD) hit the 5,000 shop level, people back then were talking about market saturation and slowing growth (the same kind of stuff we were hearing about SBUX) and how the company continued to confound the consensus and grew basically six-fold.

From the stock's lows in 2002 to the peaks in 2006, SBUX  has quadrupled, and I think this was largely in line with Mark's expectation. Sometime before the peak, I had stopped looking at the stock closely (I was doing Japanese stocks then) and really don't know what happened to the company.

From what I can tell, after a quick look at it today, the company seems to have strayed from what made it great. It seems they are selling too much stuff besides coffee in the stores and to use a tech metaphor, have "split the arrowhead." There also seems to be more competition.

I understand that the founder, Howard Schultz, is back at the helm and seems determined to get the company back on track. The company recently announced several strategic initiatives to help it grow. The response from many of the bloggers has been less than optimistic.

The stock seems so beat up that I wanted to take a closer look at it. My usual historical valuation analysis yielded me very little. The stock (intra-day price of $18.39) is trading at 19.2x the consensus '08 EPS estimate and 16.2x the numbers for '09. This is the lowest valuation in many years, if not ever. The market has re-rated the valuation from a classic growth story (P/Es used to range over 40x) to perhaps a value stock. I say "perhaps" because there could be a lot of uncertainty in the forward looking numbers. Other measures showed a similar trend, but it's very hard for me to quantify the upside.

All I know for sure is that I have never seen the stock looking this cheap. Will Mr. Schultz be able to turn the company around? Not sure. Maybe he's like Steve Jobs. Maybe he's like Michael Dell. I have no way of knowing, but I do know that I have never seen the stock this cheap before.

I probably won't buy the stock here (for non-investment-related reasons), but I am wondering aloud how long the market will let this once great growth story (the company still seems to have enormous international growth potential) be valued like this.

I think that much of the thinking about the stock boils down to this quote I found on a financial blog today, "When Howard Shultz shows results, then I would consider a position." I would submit that by the time the results are clearly shown, a good deal of the upside might be behind us. Successful contrarian investing requires one to take a few steps into the darkness...

Disclosure -- I do not own SBUX.