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.

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One Comment on “SBUX: Consider Your Options When Considering a Starbucks Investment”

  1. Turley.Muller

    Great article. I wrote a piece addressing the same aspect of SBUX. Take a look a let me know your thoughts if you have the time.
    http://financial-alchemist.blogspot.com/2007/10/starbucks-coffee-sbux-smartmoney-face.html

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