Show Me the Money: What I Want to Hear From Starbucks

When I started to buy Starbucks (SBUX) shares, I started based on relative valuation techniques. The argument for investing in Starbucks has always been that the stock has not traded at this P/E in its history, and hence is a good bargain. Analysts also cite its brand, overseas opportunities etc to justify the buy recommendation - SP a strong buy, and Morningstar gives five stars for this stock.

It is easy to get carried away by the store count, international presence and the company's brand image. I got carried away too and started investing in it once it hit its 52-week low of 28 last year. I have been averaging down, and now own stock at the average price of 23. After yesterday's revised outlook by the company and the stock's severe beating, I again checked the analyst reports and they continue their five-star recommendations.

I then decided to dig in deeper and analyze the stock based on the discounting free cash flow it generates. When I started to look at the free cash flow (Cash Flow from Operations – Capital Expenditures), something struck me.

For 2007 I got the following information from the 10-K:

"For the 52 weeks ended September 30, 2007, net cash flow from operating activities totaled $1.3 billion, compared to $1.1 billion in the same period a year ago. Capital expenditures for fiscal year 2007 were $1.1 billion, of which approximately 80 percent was used to fund new store openings and existing store remodels"

This works out to about $880 Million. The company has opened 1,342 new company operated retail stores in last 12 months. This works out to about $655,000 per new store it opened.

For 2008 the company plans to open about 1,200 (900 in US and 300 International) stores. We all know real estate in US is in major slump and this includes commercial real estate. Even if there is no decrease in the lease rates for 2008, the company should be spending about $590 Million for new store openings, and assuming that this consumes 80% of their cash flow, their Capital Expenditure should be about $737 Million as opposed to $1.1 Billion in 2007.

In its annual report, the company stated that it expects the capital expenditure to be in line with 2007 numbers, which is $1.1 Billion.

Here is my question: If the company opens 11% fewer stores and considering the fact that in US the company should be able to get a very good lease rates (due to real estate slump) and the company's majority of new stores is in US, why is the capital expenditure forecasted to be same?

If the company is trying to be conservative in its estimates, that is very good, because a saving of $400 Million would be twice as its 2007 free cash flow. This means the free cash flow for 2008 could potentially be triple 2007 levels.

I have also heard Howard Schultz say in an interview that from 2009, the company will be opening more stores internationally than in the US. The majority of international stores is licensed for Starbucks. If Starbucks slows down its US Operated stores growth and concentrates on international "licensed" store growth, there could be continuing increase in its free cash flow growth and that would change the valuation model for Starbucks.

One last question for the chairman: Why is Starbucks so much stuck on opening its own stores in the US rather than licensing, as this could preserve the cash that is being drained as capital expenditures? Why would Starbucks not focus on building its brand image and focusing more on their Consumer Products division and license its stores rather than opening so many of them themselves?

This could be something the company should consider very seriously, if it has to restore some faith in investors.

Lastly, I wish the analysts covering this stock would ask important questions like this in its conference calls next week, rather than again and again asking superficial questions.

Comments

[Bretts02]

I agree completely i've bought down to 17.01 and feel quite comfortable with it. Its fallen out of favor, and will remain so for the next few months but once people see the overraction its got plenty of room to rise.

[David Tsao]

The company already has a problem maintaining a consistent level of customer service through their US owned stores. They shut down all their stores a few weeks ago to retrain their staff on mixing/serving coffee. Unfortunately, I haven't seen any difference except for the brown cups.

Licensing more stores would only complicate matters with respect to maintaing high levels of customer service. With their massive store count it was only a matter of time before service started to slide.

I'm not sure what type of re-training they provided, but if anyone that works at Starbucks reads this, please help me understand why you need to mark up the cups with my order when I am the only customer in the store? I just want my coffee, serve it, and let me get out of there. This has happened to me at 2 SBUX locations. I don't understand it. Is it supposed to make me feel all warm and fuzzy that there are sharpie marker writings on the cup? or did you suddently forget my order that you need to write it down?

[kiki80]

I bought SBUX today @ $15.55. We haven't seen Starbuck's at this level since Oct 2004! Everyone has been in a panic lately, but they will "wake up and smell the coffee soon"! Starbuck's has consistently been a strong company for years and will no doubt continue to be despite the recent downturn in our economy.

[Big Larry]

I would not consider purchasing this stock until it was in the $10-12 range based on this past week's earnings numbers.

[mkreisel]

People who ignore history will always suffer!

SBUX in 2006 was very much like MCD in 1972: exorbitant valuation, slowing growth, economic stagflation.

MCD dropped 70% from peak to bottom during that episode. If SBUX were suffer the same fate, the -70% price point would be 12 or 14 times the latest earning forecast.

[Trader T]

SBUX became intoxicated with its 'brand' and stopped focusing on the retail aspects of the business - delivering a consistent high quality product across all outlets at a profit to the bottom line. They've cut back on the movie ventures and other nonsense but still have not yet put a laser focus back on the business basics. I'd like to see the marketing rationale behind opening more stores in the U.S.. There is diminishing returns on opening too many locations for any top-shelf product.

[Greg Harris]

Your post has flaws:
1) Lease rates are operating leases. Not a capital expense -- is an operating expense. Improvements are capital expenses and those won't change and the real estate problems -- so far, have been housing, not commercial. SBUX can't make estimates on what hasn't happened yet.

From the Same Press Release you call a 10-K, of which I know, because you're quoted section isn't found anywhere in the 10-K:

"The company has adjusted its new store opening target to approximately 2,500 net new stores on a global basis in fiscal 2008; approximately 900 company-operated locations and 700 licensed locations in the U.S., and approximately 300 company-operated stores and 600 licensed stores in international markets;

That is around 1200 company operated stores, which is equivalent to almost $800 million at the $655k rate you suggest, which is within spitting distance of that $880 million figure you have and can be needed/used for various reasons.