Archive: October, 2007

Semiconductor Environment Continues to Improve

For the second consecutive month, worldwide sales of semiconductors rose sharply in September, the Semiconductor Industry Association (SIA) reported. Global microchip sales in September were $22.6 billion, an increase of 5.9 percent from September 2006 when sales were $21.3 billion.

5.9% probably doesn’t sound like stellar growth, and it isn’t much special. However, compared to the growth in industry capacity it is strong. And since price is a function of both supply and demand, sales growth that exceeds capacity growth should ultimately have a positive impact on pricing.

semidata.jpg

Disclosure: William Trent holds long positions in the Semiconductor Holdrs (SMH) and put options related to shares of Lam Research (LRCX).

William Trent currently owns put options against the shares of Lam Research (LRCX).

Topics: Lam Research (LRCX), Semiconductor HOLDRS (SMH), Semiconductors | No Comments

Office Depot Delays Earnings Release

Office Depot (NYSE:ODP) announced that it has delayed its third-quarter earnings release, previously scheduled to take place on October 30, 2007. The delay is due to an independent review by the Audit Committee of the Company’s vendor program funds. The review relates principally to the timing of the recognition of certain vendor program funds.

A little over a month ago I said an investment in Office Depot will require patience and possibly a strong stomach, as things are likely to get worse before they get better. The stock, of course, started rallying almost immediately. Today’s news may test investor’s stomachs.

Disclosure: William Trent has written naked put options against shares of Office Depot (ODP).

William Trent currently has a short position in put options related to Office Depot (ODP).

Topics: Office Depot (ODP), Retail (Specialty) | No Comments

Cash Flowing Through Industrial Valves

Last month I showed how investors can generate investment ideas by using the Producer Price Index (PPI) report prepared monthly by the Bureau of Labor Statistics. The idea is that industries where prices are rising may contain companies where revenue will grow faster and/or margins will improve.

Of course, like any initial screen the PPI report is only a starting place. It is useful to generate ideas, but further research is needed to determine whether they are good ideas. This month, I do some of that further research.

One industry where the price increases have been flowing is industrial valves. Although the increases have been flattening out somewhat, the 8.3% year/year gain in September is still pretty sweet.

As I mentioned last month, some of the industrial valve makers include Flowserve (FLS), Crane (CR) and Curtiss Wright (CW - Annual Report). Let’s see how they are doing.

According to Flowserve, the PPI indicator is right on the money. Flowserve noted in its latest earnings report that its Flow Control Division’s “gross margin of 35.6% for the second quarter of 2007 was substantially higher than the second quarter of 2006, up 140 basis points. This increase was principally due to improved absorption on higher sales, the implementation of various Continuous Improvement Programs and cost reduction initiatives and improved pricing.” With sales up 13%, bookings up 15%, and pricing remaining strong it looks like the trends could continue for some time.

Crane is also doing well. Crane’s Fluid Handling segment saw a 13% gain in sales and a 30% increase in backlog in the latest quarter. However, “Margins remained at 12% reflecting more price competitive project work and investments in new products and systems to support future growth.” That “price competition” isn’t doing any damage yet, but it could. It may be especially important to watch the PPI reports on a continuing basis to find the right time to get out of a position before the eventual loss of pricing power is picked up in an earnings report three months later.

For Curtiss Wright’s Flow Control division, “Sales for the second quarter of 2007 were $163.2 million, up 26% over the comparable period last year due to solid organic growth and the contribution from the 2006 and 2007 acquisitions. Sales from the base businesses increased 14% in the second quarter of 2007 as compared to the prior year period.” Profitability declined primarily due to cost overruns on a Navy project, but the company noted that margins were also impacted by “labor inefficiencies, business consolidation costs, and higher material costs experienced within our oil and gas market.” The stock has rallied on strong results and increased guidance from its other divisions, however.

After taking a closer look at the three valve makers, I think Flowserve may be the best way to play the PPI report. For one thing, valves and related products make up a larger part of its revenue. As a purer play, the pricing information conveyed from valve PPI is more relevant. It’s true that the better performance has not gone unnoticed by the stock market, which has boosted FLS shares more than those of CW or CR in the last couple of years. However, based on the continued strong pricing environment it looks like that strong performance could be sustained.

Topics: Crane (CR), Curtiss Wright (CW), Flowserve (FLS) | No Comments

SLGN: Silgan Beats, Raises Guidance on Strong Pricing

The pricing strength indicated by the PPI report seems to have been validated by Silgan’s (SLGN - Annual Report) earnings report today.

“Net sales for the third quarter of 2007 were $904.8 million, an increase of $48.4 million, or 5.7 percent, as compared to $856.4 million for the same period in 2006. This increase was primarily attributable to higher average selling prices resulting from the pass through of inflation in raw material and other manufacturing costs and an improved mix of products sold in the metal food container business, the inclusion of sales from our fourth quarter 2006 and first quarter 2007 acquisitions, the impact of beneficial foreign exchange translation on international revenues and improved volumes across all businesses.”

Topics: Containers and Packaging, Silgan (SLGN) | No Comments

Stocking Up on Storage Plays

This article was originally published at RealMoney on October 17, 2007.

Last month I showed how investors can generate investment ideas by using the Producer Price Index (PPI) report prepared monthly by the Bureau of Labor Statistics. The idea is that industries where prices are rising may contain companies where revenue will grow faster and/or margins will improve.

 

Of course, like any initial screen the PPI report is only a starting place. It is useful to generate ideas, but further research is needed to determine whether they are good ideas. This month, I do some of that further research.

In the technology sector, prices almost never go up. But sometimes they decline at a slower rate than normal, which tends to have the same effect on sales growth and profit margins.

Last month I noted that the year/year price declines for computer storage devices were the lowest they had ever been. Although pricing ticked down in September from that level, it is still one of the strongest readings on record.


Source: Bureau of Labor Statistics

There are plenty of ways to play this one, including Brocade (BRCD), EMC (EMC - Annual Report), Iomega (IOM), Hutchinson (HTCH), Quantum (QTM), SanDisk (SNDK - Annual Report), Seagate (STX - Annual Report) and Western Digital (WDC). It will require a closer look to see which ones seem like the best bets.

Brocade beat earnings estimates last quarter, and although they said the industry remains competitive the competition didn’t seem to be hurting pricing. On their conference call, Brocade noted that “From a pricing perspective, the pricing environment for the past several quarters has been more favorable than historical levels. While we believe ASP declines may eventually return to mid single-digits per quarter, as competitors ramp their new product offerings, our current outlook is for a relatively benign pricing environment in Q4, with ASP declines once again in the low single-digits.”

The competitive environment for storage continues to be mitigated by consolidation. Brocade bought McData, Seagate bought Maxtor and EVault, and Quantum’s purchase of Advanced Digital Information Corp. has since been followed by the Western Digital/Komag merger.

The buzz around EMC has almost entirely been around its holdings of VMWare (VMW), but that is far from all the company has to offer. Compared with the second quarter of 2006, EMC systems revenue increased 18% year-over-year, led by strong revenue growth from the company’s mid-range information storage products. EMC systems revenue represented 43% of total second-quarter revenue. However, on the conference call management said the pricing environment has always been competitive and that they “don’t see any significant sea change here in the pricing environment.”

Iomega saw 46% year/year revenue growth and an increase in gross margins from 16.7% last year to 20.5% this year. That would seem to support the pricing power hypothesis but nobody seemed to notice much. Although the stock rallied ahead of that report it has gone nowhere since.

Hutchinson is one of the disk drive industry’s top suppliers. They actually bucked tech industry norms and raised prices. “Overall average selling price in the fiscal 2007 third quarter was $0.80, compared with $0.79 in the preceding quarter and $0.84 in the fiscal 2006 third quarter. The increase in average selling price compared with the preceding quarter resulted from a higher percentage of newer products in the fiscal 2007 third quarter sales mix. “We expect our average selling price to be flat to slightly up over the next year as our sales mix continues to shift to a higher percentage of newer products,” said [CEO Wayne] Fortun.” How’s that for evidence supporting the PPI report? You wouldn’t guess it from the way the stock has acted over the last year.

Quantum’s GAAP gross margin rate was 31.8 percent, a significant increase over the 27.9 percent rate in the same quarter last year and its best performance in three years. Seagate also beat estimates.

Western Digital raised guidance, and gives credit to improved pricing power. “Western Digital also said its gross margin should hit 17.5%, rebounding from lows in previous quarters and above its prior estimate of 15.5%. The change reflects firmer pricing power after years of price wars with Seagate and Asian rivals like Hitachi.”

The only company that didn’t confirm the PPI result was SanDisk, which operates in a different segment of the storage market. Sandisk’s average price per megabyte sold declined 65% on a year-over-year basis and 26% sequentially.

 

Other than SanDisk, however, the ideas generated from the PPI report seem very fruitful. Depending on whether you like small caps, large caps, value, momentum or low price strategies there is likely a storage name for you.

 

Topics: Brocade (BRCD), Computer Storage Devices, EMC Corp. (EMC), Hutchinson (HTCH), Iomega (IOM), Quantum (QTM), Sandisk (SNDK), Seagate (STX), Technology, VMWare (VMW), WDC | No Comments

Dancing the Pricing Power Can Can With Canners

This article was originally published at RealMoney on October 15, 2007.

Last month I showed how investors can generate investment ideas by using the Producer Price Index (PPI) report prepared monthly by the Bureau of Labor Statistics. The idea is that industries where prices are rising may contain companies where revenue will grow faster and/or margins will improve.

Of course, like any initial screen the PPI report is only a starting place. It is useful to generate ideas, but further research is needed to determine whether they are good ideas. This month, I do some of that further research.

The first industry I mentioned last month was fruit and vegetable canning. Year/year price increases for the industry have been well above average, and although they have come down a bit from a peak earlier this year the trend still appears to be upward and last month inflation ticked up to 5.5% from 5.3% in August.

Year/Year Price Increases for Fruit and Vegetable Canning Industry


Source: Bureau of Labor Statistics

As I noted last month, possible plays on this industry include packaging companies (can makers) such as Ball Corp. (BLL), Crown Holdings CCK - Annual Report) or Silgan (SLGN - Annual Report). Or you can go to the food processors such as Campbell Soup (CPB), Del Monte (DLM - Annual Report), Hain Celestial (HAIN) or H.J. Heinz (HNZ).

Let’s start with Ball. When Ball released second-quarter results, they said they would be increasing capital spending “related in part to 2008 capacity additions for Europe, where we are essentially sold out this year and next.” President and CEO R. David Hoover called the first six months of 2007 the best half-year in Ball Corporation’s 127-year history in terms of sales and earnings. The strong first half supports the initial PPI reading, and the continued strength in pricing power suggests more good news to come.

However, Crown Holdings noted in its earnings report that raw materials prices were also rising. Passing through cost increases benefits sales growth, but may not help profit margins. Crown may be more exposed than others in the industry, suggesting greater caution on the name and an eye on raw material costs if any investments are made.

Silgan also commented on raw material costs, but reports that the pass-through works on a lag. “Operating margin increased to 7.6 percent from 5.4 percent [due in part to] the lagged contractual pass through beginning in the latter part of 2006 of significant inflation in other manufacturing costs.” Silgan looks like a good bet, as the lag effect will mitigate the impact of future cost increases and also help margins even more the next time raw materials prices head south.                                                                    

Moving to the food processors, Campbell’s Soup said “Gross margin increased to 41.9 percent from 41.8 percent… primarily due to productivity gains and higher selling prices, partially offset by cost inflation.” Rising prices also contributed 2% of the 7% total sales growth for the year. With the stock not yet reflecting these results, investors may want to take a good look.

For Del Monte, however, the rising prices are hurting more than they are helping. “The Company now expects fiscal 2008 diluted EPS from continuing operations to be at the low end of its previous guidance of $0.70 to $0.74” due primarily to cost increases in excess of what it can pass through. Given the better apparent prospects from other names that passed the screen, it is hard to argue in favor of Del Monte.

No so for Hain, which reportedgross margin of 27.9% in the fourth quarter, compared to 26.5% in the prior year fourth quarter. Margin improvements achieved through productivity gains and price increases were offset by the challenges at Celestial Seasonings.” Hain has had a good year, though, suggesting that investors may have already picked up on the positive news.

Finally, Heinz increased its sales and earnings guidance, saying on the conference call that “We are seeing positive net pricing and productivity offset these cost headwinds.”

In conclusion, on further review the initial positive read from the PPI report seems to be confirmed in five out of seven cases. In a few of the cases (Ball, Silgan and Hain) the stock price has followed the pricing trends, which bode well for continued strong performance. For Campbell’s and Heinz, the stocks have been stuck in neutral and (pardon the pun) may be ready for one of Cramer’s “ketchup” plays.

Topics: Ball Corp. (BLL), Campbell Soup (CPB), Containers and Packaging, Crown Holdings (CCK), Del Monte Foods (DLM), Food Processing, HJ Heinz (HNZ), Hain Celestial (HAIN), Silgan (SLGN) | 1 Comment

SAP: SAP Should Follow Oracle’s Lead

 This article was originally published for RealMoney on October 11, 2007

There has been plenty of hot air expelled this week over whether SAP’s (SAP - Annual Report) acquisition of Business Objects (BOBJ) is a sign that it is adopting Oracle’s (ORCL - Annual Report) big acquisition strategy or whether it is a simply a larger part of SAP’s existing strategy of using small “tuck-in” acquisitions. I’ll leave others to bloviate on those issues.

I am less interested in whether SAP is following Oracle’s strategy than whether they ought to be. And I think the answer to that question is a resounding “yes.”

For one thing, corporate IT buyers’ main concerns tend to be reducing costs and reducing complexity. Much better to have Oracle and SAP tie together the applications from a number of vendors (by directly integrating them) than to devote in-house IT staff to doing it. Research 2.0 criticizes the Business Objects acquisition for this reason, saying “SAP now faces many of the same incompatible architectural challenges faced by Oracle with its many acquisitions.” I think their customers would rather have SAP deal with the incompatibilities than to have to do it themselves. Since when is making life easier for customers a bad thing?

More importantly, however, there are just too darn many application software manufacturers out there. While consolidation in some industries occurs because the weaker businesses fail, software balance sheets are generally too strong to for this to happen. The only way to fix the problem of too many customers chasing a relatively fixed amount of dollars is for an industry leader to soak up the excess capital by leveraging its own balance sheet to acquire other companies – for cash, not shares. Oracle has been pursuing that fix.

Software companies tend to generate significant cash flow, and Oracle has been able to use this cash flow to fund the acquisitions while both maintaining a healthy balance sheet and avoiding dilution to existing shareholders. As an example, consider its first large acquisition – that of PeopleSoft in January 2005 for $11.1 billion in cash. Prior to the acquisition Oracle held more than $9.5 billion in cash and marketable securities on its balance sheet, and had virtually no debt. The company used this cash and a $7 billion bridge loan to complete the acquisition, and by the end of its fiscal year in May, 2005 it had reduced the loan value to $2.6 billion while still maintaining nearly $5 billion in cash and marketable securities and actually reducing its share count.

By May, 2006 the company had made another $4 billion worth of acquisitions (net of the cash held by the acquired companies) and increased its cash and marketable securities to $7.5 billion while restructuring its debt load to $5.7 billion in long-term debt. Even though the debt was $3 billion more than the prior year, most of that was offset by the increase in cash – meaning that the $4 billion in acquisitions was made possible almost entirely through cash flow from operations.

Speaking of cash flow, in the year ended May 2007 Oracle generated $5.5 billion of it from operating activities, and spent only $320 million of it on capital expenditures. That turns out to be a free cash flow yield of 4.5% from the existing businesses. Most of that continues to be invested in new acquisitions for new growth opportunities. The free cash flow has increased 55% since FY2005.

Meanwhile, SAP is generated approximately $2.0 billion in free cash flow last year, giving it a 3.0% free cash flow yield. Its acquisition avoidance has left the free cash flow essentially unchanged over the last three years (though arguably the change in the Euro/dollar exchange rate is providing growth.)

A higher yield and growing free cash flow compared with a lower, flat one is not much of a choice in my book.

If any doubt remains over which strategy is working better, one need only turn to a price chart. Since Oracle closed the PeopleSoft acquisition in January 2005, its shares are up 70% (mostly driven by rising cash flow), compared to just more than 30% for SAP over the same time. To me, it seems like that is exactly the type of “challenge” SAP would want to adopt.

oracle vs sap price chart

Topics: Business Objects (BOBJ), Oracle (ORCL), SAP (SAP), Software and Programming | No Comments

INTC: Intel Should Beat Estimates

This article was originally published at RealMoney on October 10, 2007.

Intel Corp. (INTC - Annual Report) is scheduled to report earnings today, October 16. The consensus among sell side analysts is that the company will report sales of $9.6 billion (up 10% year/year) and earnings per share of $0.30. This puts the average analyst daringly close to the precise midpoint of the guidance Intel provided as its mid-quarter update.

According to the Semiconductor Industry Association (SIA), over the last six months the year/year sales growth for the overall semiconductor industry has ranged from 1.7% to 4.8%. For the largest manufacturer to be growing at more than twice the overall industry rate seems at first glance to be somewhat aggressive.

However, the nadir in industry sales was in June, and the growth rate has been picking up steadily since then. Furthermore, the industry as a whole has been more disciplined about adding capacity. After more than a year of ordering more chip producing equipment than was needed to satisfy demand from customers, the last six months have seen orders for new equipment being placed at a far slower rate. In fact, sales of semiconductors in August grew 4.8%, while orders for new equipment saw a 19.4% decline year on year.

Since pricing is determined by supply and demand, when demand is growing at a faster rate than supply it should be good for pricing, margins and the stocks – subject to a lag between the time equipment is ordered and when it is installed. Last month, when the PPI data showed a poor pricing environment for semiconductors (see the chart of year/year price changes below) I said “I happen to believe the worst will soon be over for semiconductors.” The reason for my belief is that this year’s poor pricing environment stemmed from last year’s over-ordering of equipment, so this year’s thriftiness should start to improve pricing sometime soon.


Source: Bureau of Labor Statistics

Furthermore, since Intel and rival Advanced Micro Devices (AMD - Annual Report) were the first companies to over-order, the first to see the damage it did to their margins, and the first to announce cuts to planned expenditures, it should surprise nobody if they are the first to recover as well.

Finally, addressing the issue of whether the guidance is too aggressive, a look at the historical data suggests otherwise. Margins for both AMD and Intel are lower than they have been at any time since the depths of the technology bust. A modest improvement from current levels would still leave them well below the normal range, if there is such a thing.


Source: Zacks Research Wizard

Finally, I looked at inventory levels to see how supply and demand were trending at the company level. For Intel, at least, the inventory levels appear to be drifting back toward normal.


Source: Zacks Research Wizard

Stock performance following the report may come down to the December quarter guidance relative to expectations. There, too, however, the consensus appears beatable. Current estimates call for $10.4 billion in sales, which is just a 7.5% year/year rise. Given the acceleration in industry growth, that rate may well be in line with the overall industry rate despite the aforementioned justification for Intel to lead the group up.

With company inventory levels having peaked, margins potentially having troughed and overall industry health looking likely to improve, I believe Intel’s guidance is not aggressive, and may even be conservative.

Disclosure: William Trent has a long position in SMH.

Topics: Advanced Micro Devices (AMD), Intel (INTC), Semiconductors | No Comments

NTRI: Nutri-System New Years Resolution Rally Play Requires Investor Resolve

This article was originally published at RealMoney on October 4, 2007.

Less than a month after topping Fortune Magazine’s list of the 100 fastest-growing companies, Nutri-System, Inc.’s (NTRI) growth rate came to a screeching halt. The company announced yesterday that while revenue growth will top 20% in the third quarter it will be well below expectations, and earnings per share are expected to be between $0.62 and $0.66 – barely budging from $0.63 last year and well below the $0.82 consensus. With the shares selling off more than 20% in after-hours trading, investors have to figure out whether this stock’s weight loss is permanent or whether, like many of its customers, it could be on a yo-yo.

To start out with, I’m going to lay my cards on the table and admit I didn’t see this coming. I thought investors were being a bit irrational when they sold the shares following a strong earnings report and slightly weak guidance (that has now been revised to really weak.) So when considering anything I say about the name, remember that I have been dead wrong about it to date.

That said, with the after hours sell-off the stock is now trading at just over 10x the trailing 12-month free cash flow. From that multiple, I feel like I can earn an adequate return even if the company doesn’t grow – all it needs to do is maintain its current levels of cash flow.

The problem is, the aforementioned growth has taken the cash flow off the charts. For example, if the growth had been steady I might feel that free cash flow could retract to the $60 million the company posted in 2006, rather than the $108 million it gained in the last half of that year and the first half of 2007. While that would be a sharp cutback, the free cash flow yield would still offer support from which I would hope for growth.

But what if cash flow dropped to 2005 levels? It is surely possible that Nutri-system, a company more than 30 years old, could drop back to the levels seen two years ago, is it not? Well, if it is possible it would be a big problem. In 2005 Nutri-System’s free cash flow was only $12 million. Next to nothing. And I don’t even want to think about 2004.

So, from my point of view Nutri-System doesn’t qualify as a sound investment opportunity right now, despite an apparently cheap valuation. It might, however, be worth a trade.

One guy who did get this story right was Citigroup’s Gregory Badishkanian, who warned last month that sales may suffer in the short term as dieters try out GlaxoSmithKline’s (GSK) new over the counter weight loss drug Alli. He also noted that the comparisons to last year’s third quarter are difficult as that is when Dan Marino joined the company as spokesman. And, of course, October is not known as the time to start a diet.

The tough comparisons are likely to continue, but Badishkanian doesn’t expect dieters to enjoy the digestive side-effects of taking Alli for very long. After we gorge ourselves this holiday season, we are likely to make the same New Year’s resolutions we have often made in the past. And in each of the last three years Nutri-System has enjoyed a strong rally from January through April.

Personally I feel like I would benefit more from the product than from the stock at this point. If the shares are still down in late December I may even attempt the seasonal trade, and by the time that is done there may be a little more clarity about the sustainability of free cash flow.

In any case, making the resolution play will require a good deal of resolve for this volatile stock.

Topics: Citigroup (C), GlaxoSmithKline (GSK), Healthcare, Major Drugs, Nutri Systems (NTRI), Personal Services | No Comments

SBUX: Consider Your Options When Considering a Starbucks Investment

This article was originally published at RealMoney on October 2, 2007.

So, after 50 years of selling hot mud, McDonald’s (MCD - Annual Report) continues to awaken to the notion that its customers might enjoy coffee that tastes good. According to Crain’s Chicago Business, “McDonald’s Corp. plans to sell lattes, cappuccinos and other specialty drinks in all of its 14,000 U.S. restaurants next year. McDonald’s predicts the new drinks will add more than $1 billion a year to sales.”

Not surprisingly, the anti-Starbuck’s (SBUX) crowd has latched on to this announcement as proof the company is doomed. 24/7 Wall St. even called it a “coup de grace,” which is defined as a “death blow intended to end the suffering of a wounded creature.” Although Starbuck’s the stock is certainly suffering, down about a third from the high reached earlier this year, it is hard to argue the company is wounded, or in need of a merciful end to its suffering.

It’s time for the doubters to face some facts. First, McDonald’s is not planning to match Starbuck’s “product for product.” In a Bloomberg article published just last month, McDonald’s President Ralph Alvarez said McDonald’s has no plans to offer the breadth of Starbuck’s beverages such as raspberry latte with soy milk and half the caffeine. Instead, they intend to compete for the plain-Jane cappuccino, offering it at about a 25% discount to the equivalent Starbuck’s model.

Secondly, Starbuck’s doesn’t need to concede the future market growth to others. For one thing, McDonald’s is already selling the cappuccinos in two thirds of its stores, according to the Bloomberg article. That potential market share loss has already been baked in, and it doesn’t seem to be hurting too badly. Starbuck’s same store sales growth is running at 4%, below its historical norm but above that of most retailers. If anything, the fact that most of McDonald’s rollout will be complete next year could ease the pressure on comp sales.

If further convincing is necessary, just look at the expected sales numbers. McDonald’s wants specialty drinks in 14,000 stores to add $1 billion to sales. In 2006 Starbucks had an average store count of approximately 6,500 and produced $6.5 billion in sales from them. In other words, they are still selling 14 times as much coffee per store as McDonald’s. The further incursion from the remaining one-third of McDonald’s expansion, even under the generous assumption that 100% of those sales would have otherwise gone to Starbuck’s, amounts to about 4% of Starbuck’s trailing twelve month company-owned retail sales – about one year’s worth of same store sales growth at worst.

Meanwhile, over the last 12 months Starbucks has generated $1.2 billion in cash flow from operating activities, and used just $1 billion to expand those operations by 15%. Assuming that two thirds of the capital expenditures went to open new stores and the rest was routine maintenance, the free cash flow from their existing store base is approximately $700 million per year, for a 3.5% free cash flow yield on the $20 billion enterprise value. It isn’t what I would call cheap, but it is much less like a wounded animal than a healthy tiger pouring its energy into a continued pounce by opening still more stores. At its current expansion rate, in two years the free cash flow yield would exceed that offered by treasuries, and Starbuck’s would still be only halfway through its expansion plans.

I would consider the stock cheap if it went down another 15% to $22.50, or if it just stayed at about the current price for another year. Since neither of those outcomes is certain, Starbuck’s fans will have to pick their own entry point. In the meantime, my favored strategy of writing put options may be worth considering. The April 2008 $27.50 puts are selling for about $2.30 right now. By writing those options you could earn an 8.5% 6-month return if the stock goes up, or buy the stock for an effective price of about $24.25 (which by April would probably meet my “cheap” criteria) if it goes down.

I think it is great that McDonald’s is offering its customers good coffee, and think the two companies can coexist much in the same way that McDonald’s has coexisted with, for example, hamburgers sold at ballparks. The two companies have very different customers and serve different purposes for them throughout the day. As for “coups de grace,” I don’t expect either company will need one any time soon.

Disclosure: Author is long Starbucks (SBUX) at time of publication.

Topics: McDonalds (MCD), Restaurants, Starbucks (SBUX) | 1 Comment