Back in October, I said Starbucks (SBUX) was not what I would call cheap, but that I would consider the stock cheap if it went down another 15% to $22.50.

Suffice to say, $22.50 came and went. The stock isn’t down 15% from the point I wrote the article – it is down almost 30%. I figure I owe it to readers to revisit the name and either concede defeat or put my money where my mouth is (figuratively at least – I have owned Starbucks shares for several years and neither sold at the top nor am I likely to buy more as it is a large position for me.)

With the drop in stock price last year, you would think the company has been missing earnings targets left and right, and that the outlook has plummeted. And that is true, to a point.

While the company has met its earnings targets in each of the last four quarters, most on the Street consider merely “meeting” estimates as disappointing – especially for a former high-flyer like the ‘Bucks. And estimates for the fiscal years ending in September 2008 and 2009 have also come down – a bit.

At the time I wrote the article, the consensus expectation was that Starbucks would earn $1.06 in FY08 and $1.27 in FY09. Now those estimates stand at $1.03 and $1.22, respectively. Since the stock decline has been much greater than the earnings decline, the P/E ratio on 2008 earnings has shrunk from 25x in October to less than 19x today.

What’s the Problem?

The big reasons cited for the share price declines are typically slowing consumer spending and increased competition from the likes of Dunkin Donuts and McDonalds (MCD - Annual Report). These reasons seem somewhat wispy to me, given that the 4% same-store sales growth Starbucks reported last quarter is still twice that of the average retailer. And while there may be some people who go out of their way to get a cup of Dunkin instead of Starbucks, there are many who will continue to make the choice based either on convenience or a preference for Starbucks.

In addition to increasing sales at existing stores, Starbucks continues to open new stores at a blistering pace – adding 1,342 company-owned outlets in 2007. There are now more than 8,500 company-owned stores. Total sales and earnings per share grew about 20% in 2007 and are expected to run at nearly 18% in each of the next two years. While Starbucks may be a story of slowing growth, it is hardly a broken brand.

Where I see the problem for Starbucks is in the licensed stores, which are typically located inside other retailers such as Safeway. These stores account for nearly half the total number of Starbucks locations, but the licensing fees contribute just 7% to the top line. While the licensing fees are higher margin revenue, I don’t think the difference makes up for the lower relative sales contribution and the potential brand dilution.

I don’t mind picking up a cup of Starbucks while walking the aisles at Safeway. But when I do so, I am not enjoying what the company calls the “Starbucks experience.” I’m having a cup of coffee.

Valuation

The 19% P/E ratio, in line with the growth rate, seems reasonable enough. But I prefer valuations based on cash flow. In 2007, Starbucks generated $1.33 billion in cash from operating activities, and used $1.08 billion for capital expenditures. That leaves a free cash flow of $250 million, and a paltry 1.7% free cash flow yield on the current $15 billion enterprise value.

However, the free cash flow is growing. Cash from operations is growing at a similar pace to revenues, and the capex is likely to stabilize as the company matures and the number of store openings levels off (or declines, as the company now expects for 2008.) I gathered some information from the Starbucks 2007 10K to figure out how that may play out.

Source: Company reports, estimates by William A. Trent

If one considers the depreciation expense to represent the cost of maintaining existing stores, the difference between capex and depreciation should approximate the cost of opening new stores. The ratio has been fairly consistent over the last three years, which I think may validate this line of thought. By my estimates, opening a new store costs about $450,000.

If the spending on opening new stores in 2007 was $589 million, it suggests the free cash flow from existing stores was along the lines of $840 million ($250 + $589). On this basis, the free cash flow yield would be 5.6% if the company decided to stop growing today. Throw in some more growth over the next couple of years and that starts to look pretty attractive.

I also think an options play is worth considering. For example, the July $20 puts are selling for more than $2.00 – offering a 10% 6-month yield if the stock recovers and an effective purchase price of $18 if the shares continue to drop. At $18, the free cash flow yield from current stores would be more than 6%.

Alternately, the January 2009 $17.50 puts were going for $1.65 as I was writing this. That offers a one-year return of 9.4% if the stock recovers and an effective purchase price of $15.85 (6.8% existing-store free cash flow yield) if it doesn’t.

Nobody ever wants to catch a falling knife, but I think there are plenty of ways for patient investors to capitalize on a Starbucks investment based on the current valuation levels.

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

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.

On August 20, 2007, Starbucks Corporation entered into an underwriting agreement with Goldman, Sachs & Co., Banc of America Securities LLC and Citigroup Global Markets Inc., acting on behalf of themselves and the other underwriters named therein (the “Underwriters”), for the public offering of $550,000,000 aggregate principal amount of its 6.25% Senior Notes due August 15, 2017.

So, does this dent on its otherwise pristine balance sheet mark the beginning of the end for Starbucks? I don’t think so. First of all, raising financing at 6.25% in the middle of a credit crunch is, if anything, a confirmation of the company’s strong financial position. Secondly, the company generated more than twice that amount in cash flow from operating activities last year – suggesting the company will have no problem paying it off should they choose, let alone meeting their interest obligation.

It is that interest obligation, in fact, that I think is the best part of the deal. On an after tax basis, it comes out to just 4.6% or so. That is pretty cheap financing for whatever the company chooses to do with it. Up until now, they have been able to open thousands of stores annually using only internally generated cash flow. Adding debt could allow them to grow twice as fast, should they choose.

Alternatively, the company could use the debt to “restructure” their balance sheet by buying back stock. At the current stock price, the $550 million proceeds could take in approximately 2.7% of the total shares outstanding. On the basis of earnings per share, doing this wouldn’t make much difference by my calculations. (Subscribers can download my spreadsheet.) Using the full year ended October 2006 it would have reduced earnings by a penny. The effect is probably less on the current earnings and share base.

[pay]Starbucks pro-forma [/pay]

But the larger impact comes from reducing the total cost of capital to the firm. As I noted when I compared the Starbucks valuation to that of McDonald’s (MCD - Annual Report):

SBUX is more efficient than MCD, which is reflected in a 20.8% ROE for SBUX compared to 17.7% for MCD. And MCD has debt funding which boosts its ROE. As growth slows at SBUX it too could add some debt to its mix to generate better returns for equity holders. But at any rate, the 3 per cent differential in ROE says that SBUX should be more valuable than MCD when it finally tops out. Looking up the fundamental P/E calculation on p. 192 of Analysis of Equity Investments: Valuation, we can get a good starting point. If we adjust the payout ratio to give us the same implied growth rate and required return for Starbucks as we currently have for MCD, we find that SBUX would deserve a 23.2x P/E multiple rather than the 17.3x that MCD has today. And assuming further that SBUX achieves the same debt/equity mix it could justify a $66.5 billion enterprise value. If we get there the average annual return would be more like 8.5 per cent, which is a good deal better but still may not justify the price now unless one is willing to bet that SBUX can, indeed, grow to a larger size than McDonalds (or if one assumes the average return on other investments will be less than that.)

Since that analysis, McDonald’s enterprise value has risen and that of Starbucks has fallen, which makes the comparison more favorable.  But even using that original $66.5 billion estimated future enterprise value is sufficient to merit a 12% annual return before any incremental debt contributions.

In other words, I think Starbucks is doing exactly what I thought they should be doing when I wrote the original post, and the valuation has come down to a point from which I think it can do better than most stocks.

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

To round off, we will assume the company can open 2,000 new stores annually in order to reach 30,000 stores in approximately 10 years. Taking just the simple McDonald’s comparison, SBUX should be able to grow its enterprise value from $29 billion today to $49 billion in 10 years. That gives an uninspiring 5.5% growth rate over those 10 years.

However, as we pointed out, SBUX is more efficient than MCD, which is reflected in a 20.8% ROE for SBUX compared to 17.7% for MCD. And MCD has debt funding which boosts its ROE. As growth slows at SBUX it too could add some debt to its mix to generate better returns for equity holders. But at any rate, the 3 per cent differential in ROE says that SBUX should be more valuable than MCD when it finally tops out. Looking up the fundamental P/E calculation on p. 192 of Analysis of Equity Investments: Valuation, we can get a good starting point. If we adjust the payout ratio to give us the same implied growth rate and required return for Starbucks as we currently have for MCD, we find that SBUX would deserve a 23.2x P/E multiple rather than the 17.3x that MCD has today. And assuming further that SBUX achieves the same debt/equity mix it could justify a $66.5 billion enterprise value. If we get there the average annual return would be more like 8.5 per cent, which is a good deal better but still may not justify the price now unless one is willing to bet that SBUX can, indeed, grow to a larger size than McDonalds (or if one assumes the average return on other investments will be less than that.)

At the time, Starbucks shares were trading at $39, and though I didn’t sell the shares I have owned for years I did take a couple of opportunities to write call options against them, pocketing a nice premium each time. Now that it is trading much lower, many investors are starting to wonder whether it is time to buy, according to Reuters.com:

Starbucks Corp. shares hit their lowest level since late 2005 on Tuesday as investor concerns about slower sales and profit growth continued to chip away at the once high-flying stock.Some on Wall Street said the free fall — including a 20 percent decline in 2007 — represents the best buying opportunity for Starbucks shares in years as sales comparisons against year-ago results get easier later this year.

One of the advantages of the long-term type of analysis I did a year ago is that unless something dramatic changes the same analysis can apply for a long time. Indeed, over that year I would argue that about the only thing that changed substantially is the share price of each company. Looking at the current enterprise value of $22 billion, and reducing the long-term horizon by a year to count for the one that passed, I calculate that the company would return 9.3% annually to the lower estimate and 13.1% annually to the higher one. Those numbers are a good deal “more like it,” and that doesn’t even take into consideration the rise in McDonald’s – which itself is now trading at $69 billion. Going the extra step and adjusting the prior estimates by the rise in McDonald’s value yields a 9-year potential valuation of $69 – $92 billion and annualized potential returns of 13.4% -17.3%. Realistically, investors should look at other scenarios as well, including the potential valuation had McDonalds lost value rather than gained.
No valuation method is perfect, and according to the Reuters article some analysts still think the price is steep.

Arun Daniel, senior consumer analyst at ING Investments, said Starbucks shares would be a better value carrying a multiple in the low 20s.

I say that’s true, and it would be an even better value with a single-digit multiple. What that type of analysis doesn’t provide, however, is a coherent reason as to why it will trade at the more attractive valuation. Perhaps it will, perhaps it won’t. With my analysis all one needs to do is ask whether a potential return of 9-17% per year justifies the risk. As for me, I’m sure not writing call options at this price.

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

When entering new markets overseas, however, Starbucks often partners with local companies. Sometimes such partnerships are legal requirements for entering a market. Other times they simply reflect a desire to work with people experienced with the ins and outs of running a business in that particular company. Starbucks is usually a significant owner in the joint ventures and often intends to buy out its partners when allowed, as reported in Yahoo! Finance:

Starbucks Corp. said Tuesday it has expanded direct control of its operations in China by buying a Hong Kong company that has operated more than 60 of its coffee houses.

Starting with the local partner helps the company avoid many pitfalls, secure optimal locations, and deal with the unique aspects of operating abroad. Then, once the company has gained that experience itself it can buy out the local partner if desired. That’s good risk management and good business sense.

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

Other news:
McDonald’s Corp. (MCD) on Monday posted preliminary quarterly earnings that topped analysts’ expectations, pushing shares 4.1 percent higher. June sales at stores open-at least 13 months rose a better-than-expected 5.9 percent, with sales in Germany lifted as it hosted the World Cup. The company earned about 67 cents a share for the second quarter, including 10 cents a share in income from the sale of shares in Chipotle Mexican Grill Inc. (CMG) and an expense of 2 cent a share from a tax law change. Excluding one-time items, earnings were 59 cents a share. Analysts, on average, looked for 56 cents a share, according to Reuters Research. Some are reading the McDonald’s earnings surprise as a sign that consumers are shifting to lower-priced goods. Wal-Mart (WMT - Annual Report) may disagree.

Target (TGT) now expects 3 percent to 4 percent growth in July same store sales down from the original forecast of 4 to 6 percent.

However, as we pointed out, SBUX is more efficient than MCD, which is reflected in a 20.8% ROE for SBUX compared to 17.7% for MCD. And MCD has debt funding which boosts its ROE. As growth slows at SBUX it too could add some debt to its mix to generate better returns for equity holders. But at any rate, the 3 per cent differential in ROE says that SBUX should be more valuable than MCD when it finally tops out. Looking up the fundamental P/E calculation on p. 192 of Analysis of Equity Investments: Valuation, we can get a good starting point. If we adjust the payout ratio to give us the same implied growth rate and required return for Starbucks as we currently have for MCD, we find that SBUX would deserve a 23.2x P/E multiple rather than the 17.3x that MCD has today. And assuming further that SBUX achieves the same debt/equity mix it could justify a $66.5 billion enterprise value. If we get there the average annual return would be more like 8.5 per cent, which is a good deal better but still may not justify the price now unless one is willing to bet that SBUX can, indeed, grow to a larger size than McDonalds (or if one assumes the average return on other investments will be less than that.)

The Average Joe Investor has now weighed in with his take on Starbuck’s valuation. Although he takes a different route to get there, the conclusion is similar:

SBUX trades at 46x the current EPS estimates for 2006 – that’s a nice 2.3x a 20% five year growth rate. And this is after shedding 12% since the first part of May. I think there’s a great company behind the SBUX ticker, but you’re not going to get me to pay that kind of a price for it. My take is that people may be a little too worked up about music and movies (which ‘Bucks is using to enhance customer experience to sell more coffee not necessarily to be a big new source of growth) and letting the fundamentals fly out the window.

I think SBUX has a good amount of room to fall to become interesting in the least, and a heck of a lot of room to fall before it becomes a buying opportunity.

Bottom Line: HOLD

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

The comparison of Starbux (SBUX) to McDonald’s (MCD - Annual Report) when assessing Starbuck’s potential is one we have used often. We were pleased to see the method used by Douglas McIntyre (via SeekingAlpha.) He presents the case well, so definitely read his article for the jist. We will just make a few comments below on certain points. Douglas says:

At the company’s current revenue run rate, with 12,000 stores, the revenue yield per store would be $633,000. McDonald’s (NYSE:MCD) currently has nearly 32,000 stores, up from 23,000 ten years ago. McDonald’s revenue for 2005 was $20.46 billion, or $639,000 per store.

So, it is not unfair to ask if coffee is as popular as hamburgers. The answer may well be yes.

Not unfair indeed. But the correct answer is that coffee is clearly more popular than hamburgers. Most coffee drinkers do so daily, perhaps several times daily. Hamburger eating tends to be less frequent even among regulars. By comparing the revenue per store Douglas is ignoring the fact that Starbucks stores are smaller on average than McDonalds. They are generating the same revenue from a smaller space, which is more efficient. We at Stock Market Beat believe the number of McDonald’s stores is merely a minimum potential penetration level for Starbucks rather than the ultimate goal. Perhaps matching McDonald’s total square footage would be a more appropriate target.

At $38.79, the stock is just shy of its all-time high. It’s market cap is $29.6 billion.

We were a bit surprised to see that Douglas did not continue the McDonald’s analogy here to indicate a potential future value for SBUX, which could then be discounted back to today’s price to estimate the return an investor will see. But first we need to correct one small error Douglas appeared to make.

When the company announced its Q2 earnings (fiscal Q2 ending April 2, 2006; see conference call transcript), it stated that its goal was to open another 1,800 new stores globally by the end of the year. That would get them over 12,000.

Actually, the conference call transcript says that the 1,800 is the full-year goal, rather than what is expected over the remainder of the year. To round off, we will assume the company can open 2,000 new stores annually in order to reach 30,000 stores in approximately 10 years. Taking just the simple McDonald’s comparison, SBUX should be able to grow its enterprise value from $29 billion today to $49 billion in 10 years. That gives an uninspiring 5.5% growth rate over those 10 years.

However, as we pointed out, SBUX is more efficient than MCD, which is reflected in a 20.8% ROE for SBUX compared to 17.7% for MCD. And MCD has debt funding which boosts its ROE. As growth slows at SBUX it too could add some debt to its mix to generate better returns for equity holders. But at any rate, the 3 per cent differential in ROE says that SBUX should be more valuable than MCD when it finally tops out. Looking up the fundamental P/E calculation on p. 192 of Analysis of Equity Investments: Valuation, we can get a good starting point. If we adjust the payout ratio to give us the same implied growth rate and required return for Starbucks as we currently have for MCD, we find that SBUX would deserve a 23.2x P/E multiple rather than the 17.3x that MCD has today. And assuming further that SBUX achieves the same debt/equity mix it could justify a $66.5 billion enterprise value. If we get there the average annual return would be more like 8.5 per cent, which is a good deal better but still may not justify the price now unless one is willing to bet that SBUX can, indeed, grow to a larger size than McDonalds (or if one assumes the average return on other investments will be less than that.)

At any rate, there is no correct answer. We will know 10 years from now, and not a day sooner, what Starbuck’s price will then be. Hopefully, though, this discussion serves as a useful launching point for your research.

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