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Starbucks (NASDAQ:SBUX) had dropped 11% following the news of a guidance cut triggered by the prevalent economic scenario. This drop makes the stock all the more attractive. The company has posted solid same store sales despite low consumer traffic. Profitability showed double digit growth despite higher coffee costs. The company's rapid expansion, especially in China and Asia Pacific, will continue to drive future growth. We are bullish on Starbucks based on its long term potential and solid fundamentals.

Business Overview:

Starbucks is a specialty coffee retailer that buys and roasts whole bean coffees, and then sells it through its own or licensed stores. Food items are also available at stores in addition to beverages. Packaged coffee is also sold through grocery and wholesale stores. The company has a presence in more than 50 countries, and has strong brand equity. Apart from the Starbucks brand, the company has Seattle's Best Coffee, Tazo Tea, and Starbucks VIA Ready Brew in its portfolio.

By product, beverages constituted 75% of 2011 revenues, followed by food at 19% and whole bean and soluble coffees at 4%. The rest comes in from coffee-related equipment like brewers. International growth has been the driving force behind revenues. The international segment grew from 19.6% as a percentage of total revenues in 2009 to 22.4% in 2011. The consumer products segment grew by 0.5 percentage points over the same period.

Q3 Results and Outlook:

Starbucks reported its fiscal Q3 results at the end of July. Profit and revenue exceeded the results from the same quarter last year, but missed analyst estimates. The company also revised its Q4 guidance downwards. The shares dropped 11% on the news, but have since recovered, and are 2.5% less than the pre-earnings release price. Below are more details:

  • Net income was up 19% on a YoY basis. But the reported $0.43/share was less than the consensus EPS estimate of $0.45/share. The company also had expected earnings of $0.44-$0.45/share. The company cited economic worries, and the resultant lesser traffic in the U.S. and Europe.
  • Sales were up 13% over last year, driven by China, the Americas and Asia Pacific sales. In 2011, the sales growth was 12.3% (YoY).
  • Same store sales were up 6%, despite economic headwinds. This compares with 8% in Q3 last year.
  • Rapid expansion continued with 231 new stores (net). For the full year, the company had guided to 1,000 new stores (net) in Q2 results. 1,200 are to be added in 2013. A focus on China and Asia Pacific is proving fruitful for the company with a 31% revenue jump. It is expected to become Starbuck's second largest market by 2014.
  • Higher coffee prices affected the margin of the consumer product segment this quarter, although it witnessed a 45% revenue growth. The effect is expected to reduce from Q4 onwards. Coffee prices are down 15% since mid-July with a record crop in Brazil being harvested. Last year, SBUX had predicted a 5% EPS growth due to high coffee cost, but it has managed 18% and 19% in the last two quarters.
  • SBUX has a 22% market share for premium single cup, which has positive chances of growth due to the upcoming launch of Starbuck's Single cup machine, along with a partnership with Green Mountain (NASDAQ:GMCR), which will entail the latter using Starbucks-branded packs for its coffee machines.
  • Cash flow from operations is $1.61 billion (trailing twelve months). This can easily cover the $1 billion CAPEX expected next year, along with a dividend yield of 1.4%. The company has total debt of only $550 million.
  • Q4 outlook was cut by 2 cents/share due to an unfavorable economic environment. Analysts expect almost the same (45 cents/share). Revenue will grow by 10%-12% as compared to the previous guidance of low teen growth.
  • Analysts now expect EPS of $2.13/share for the next fiscal year, while the company guided on to EPS of $2.04-$2.14/share (15%-20% growth).

New Initiatives:

Previously, Starbucks customers could pay through a popular mobile app that involved loading money onto phones and then produced barcodes for scanning. Now Starbucks takes this feature further with the Pay with Square app to be released later this year. This app features an ability to pay through an account linked to a consumer's credit cards, without actual cards or signatures. Read this article for details regarding the whole process. Not only will it add to the convenience of the customer and improve efficiency in store operations, but it will also save Starbucks some credit card processing fee, which is great news for operating margin. Square CEO said, "They can offer lower processing fee than other networks. However, consumer adoption of the new service at some 7,000 stores will be the real test for this new app."

Starbucks announced an agreement with Coinstar (CSTR) for its Seattle's Best Coffee brand. Some 500 kiosks (Rubi™ coffee kiosks) will be set up by the year end, which will add significantly to Starbucks' network of selling locations.

Valuation and Recommendation:

The company is trading 26% below its 52-week high value.

The forward P/E ratio for SBUX is 23x as compared to Time Horton (NYSE:THI)'s 17x, Dunkin' Brands Group (NASDAQ:DNKN)'s 19x, Green Mountain Coffee Roasters 's 10x and Peet's Coffee & Tea (NASDAQ:PEET)'s 32x. Over the last 5 years, the P/E has ranged from its highest of 38x to its lowest of 21x.

Below is the valuation for Starbucks, based on the forward P/E of 23x, the last 5-year average P/E of 25x, and the last 10-year average P/E of 30x. At a 23x multiple, there is an upside of 17% at a price of $58. The 52-week high value is $62.

(2014 EPS is calculated by applying a long term growth rate of 19% on 2013 EPS)

The only thing that keeps us from being outright bullish on SBUX at the moment is the economic situation in the U.S. and Europe, since Starbucks coffee is counted among discretionary consumer products. Over the long term, we have confidence in Starbucks, as the economy recovers, and the company stands to benefit from its rapid expansion into fast growing Chinese and Asia Pacific markets. The company has sound financials with a long term earnings growth rate of 19%. The recent drop in share price due to the guidance cut makes it all the more attractive.

Source: Starbucks: Recent Correction Makes This Coffee Stock A Buy