Starbucks Corporation (SBUX) operates and licenses coffee stores with a strong focus in North America and Europe. The company is listed in the S&P 500 and has a market capitalization of $41 billion.
I have followed Starbucks for a while as a prospective wealth management client introduced the stock to me and was quite intrigued by it. The investor community also seems, for the most part, to have a favorable opinion about the stock.
I want to address the main bull points head on: Starbucks trades at 31x trailing earnings and 23.3x forward earnings which is way out of touch with fundamentals. Investors might want to look for reasons justifying a premium multiple. So far I could not find them. It seems to me that Starbucks is everybody's darling with investors chasing the stock without paying attention to the underlying fundamentals. Bulls place too much value on the acquisition of La Boulange and past improvement of margins. The underlying key performance indicators (margins, return on book value, growth rates) do not justify the current overly optimistic valuation. Even Microsoft (MSFT), though a totally different industry, with a very high return on equity of 39%, gross margins of 77% and 25% of market capitalization in cash, only trades at 10x earnings. Given the choice between Microsoft or Starbucks, the pick is pretty straightforward.
Investors might disagree with me, certainly, as to the comparability of Microsoft and Starbucks. My point is to illustrate the market valuation of company metrics. Let's look at some of them.
In addition to out of proportion earnings multiples, Starbucks posts only a 26% gross margin, a 11% net profit margin and cash represents about 6% of SBUX's market cap. These metrics do not convince me to assign a multiple above 20, or 15 as a matter of fact.
Analyst estimates of 2013 EPS stand at $2.29. The earnings estimate for Starbucks are scattered in a very narrow EPS range of between $2.19-2.42 and, hence, should be very precise. From a year ago, EPS is set to increase 25% which is not sustainable due to competitive pressures. Also, with a certain size, operations are subject to diminishing returns on capital and will not be able to post double digit EPS growth rates consistently. Investors mistakenly extrapolate extreme levels of EPS growth which will eventually run into constraints. I estimate a 2013 EPS based on a DCF model (capital costs 11%, earnings growth 7%, same cost structure and expense ratios) of $2.25. With a multiple of 15, which reflects more realistically the economic success of Starbucks, the intrinsic value stands at $33.75. Having almost 40% downside potential based on my model, I rate Starbucks a strong sell and advise my clients not to open long-positions in short- or long-term portfolios. The already rich multiple, however, suggests an overvaluation that can not be justified on neither current company fundamentals nor growth prospects.
On a technical level, holding the $53 would be crucial for bulls to justify their positive thesis. A break of the $55 resistance level would give bulls temporarily more reason to go long.