My latest column is up at RealMoney.

I dissect the jobs report to see which industries are showing the best/worst growth in new hiring, on the thesis that companies in these industries may present investment opportunities.

The fastest growing industries are restaurants, hospitals, mine services, machinery, and oil & gas extraction. The worst were transportation equipment and a plethora of housing-related sectors.

Disclosure: At time of publication, William Trent owns shares of Starbucks (SBUX).

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

Starbucks launches chocolate line:

Starbucks Coffee Co. (SBUX) has launched a line of chocolates laced with the flavors of its coffees and teas, such as Milk Chocolate Caramel Macchiato Truffles, and milk and dark chocolate infused with Tazo brand teas.The chocolates, which are made by The Hershey Company (HSY), were launched this month at grocers and other retailers nationwide. For now, however, the chocolates are not available at Starbucks coffee shops.

When I wrote about Hershey’s, I said “at this point, even if Hershey’s problems don’t go away, merely not getting worse should be enough to get the shares back on track.”

One of Hershey’s problems has been market share loss to premium chocolates. A difficulty in fighting this is that Hershey’s own brand will not attract premium customers. Enter Starbucks, who has exactly the right kind of brand for the task at hand.

I’ve also said that the problem for Starbucks is in the licensed stores, which are typically located inside other retailers such as Safewa. These stores dilute the brand by failing to provide the “Starbucks experience.” Licensed products, on the other hand, can fit into the premium brand (if done right.)

That said, it seems clear to me that this partnership offers more to Hershey’s, whose $5 billion in annual sales come from chocolate products sold primarily at grocers and other retailers, than to Starbucks, whose $10 billion in annual sales come primarily through coffee products sold in its own coffee shops.

Disclosure: At time of publication, William Trent owns shares of Starbucks (SBUX)

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

photo credit: Zesmerelda

This article is a reprint of my February 25, 2008 RealMoney column

What is wrong with Dean Foods (DF)? After all with everyone from Starbucks (SBUX) to Hershey’s (HSY) getting hurt by rising milk costs, I would expect the “largest processor and distributor of milk and various other dairy products in the United States” to be living in the land of milk and honey.

Yet somehow, Dean has managed to get itself on the wrong side of every dairy-related position (so much for Peter Lynch’s invest in what you know theory.) For example, the company describes the current dairy environment in its latest 10Q: “As a consequence of higher raw milk costs, we have seen a related increase in shrink costs and reduced profits from excess cream sales. At the same time, sales volumes in the Dairy Group have softened as consumers react to the higher retail prices. We are also seeing a shift from our branded fluid milk products to private label products resulting in reduced gross profit. In our White Wave segment, results continue to be negatively impacted by the oversupply of organic milk.”

High commodity costs during a period of oversupply? It is as if the law of supply and demand has been overturned. And Dean doesn’t expect to see much improvement. “As we look beyond the first quarter, we find it difficult to have much confidence in current dairy commodity forecasts given these unprecedented levels of dairy commodity market instability,” management warned.

As a result of this lack of confidence, the consensus earnings estimate for 2008 has dropped from $1.45 to $1.33 over the last month. The Zacks rank, a measure of earnings momentum, has fallen two points to the worst level of five. That rank puts Dean among the worst 5% of companies followed on the basis of earnings momentum. Yet still the estimates are well above management’s own guidance for “at least $1.20 per share.”

If there is a bright side to Dean’s horrible earnings outlook, it is that the quality of earnings remains relatively sound. The accrual ratio, which represents the difference between cash earnings and accounting earnings, should ideally hover around zero. That is more or less what Dean’s has done.

Source: Zacks Research Wizard, compiled by William Trent

So, with the earnings quality indicating that the lousy earnings are at least trustworthy, I have to ask whether the current “50% off” share price reflects all the bad news. Unfortunately, no matter how I look at it it’s hard for me to think that it does.

The P/E of 20x management’s guidance is above the company’s five-year average of 17.5x. And even being willing to look way ahead, assuming the current consensus estimate of $1.76 for 2009 doesn’t get cut and that investors are willing to pay the average multiple for them, the target price would be about $30. The potential 25% gain over 1-2 years curdles when it has to be based on so many assumptions.

The consensus five-year growth rate of 11.5% also seems incredibly optimistic, given that the same analysts are expecting a 5% sales increase this year to be followed by a modest decline next year. And even assuming the 11.5% growth occurs due to margin expansion, I’d expect much of it to be eroded by a contracting valuation given Dean’s outlandish 63x price/book ratio. Considering that total return is a function of growth and the change in valuation, I think the two would offset each other in this case, perhaps resulting in annual total return in the mid single digits.

Finally, my favorite measure is the free cash flow yield, and Dean looks far from attractive on this basis. On either a free cash flow to equity or a free cash flow to enterprise basis, the yield comes to about 4%. True, it is better than the current yield on 5-year Treasuries. But given the risks involved, I think there are many more attractive opportunities.

In fact, either of the other two victims of milk pricing look far better to me. Starbucks could have a 6% free cash flow yield based on its plans to slow expansion (and related expenditures) while Hershey’s is already at a 6.7% free cash flow yield.

Long story short, I think Dean’s chairman is on the right track by selling shares.

Disclosures: William Trent owns shares of Starbucks (SBUX)

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

The following is a reprint of my January 3, 2008 RealMoney column.

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.

Note: Make sure to do a credit card comparison before signing up for a new credit card.

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

Schultz Returns as Starbucks CEO - News & Analysis - Food and Beverage - MCD - SBUX

Howard Schultz will move from his current position as chairman to become chief executive of the java giant, replacing Jim Donald, who is leaving the company….

Shares for Starbucks were jumping 9%, or $1.66, to $20.04 in after-hours trading.

Later this week I will reprint my RealMoney column from last Thursday, in which I said there are plenty of ways for patient investors to capitalize on a Starbucks investment based on the (then) current valuation levels. Even at $20+ I think patient investors will be rewarded.

Note: Look into the facts about debt consolidation and get on top of your own finances!

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

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.

A glance at the most recent balance sheet for Starbucks (SBUX) reveals a company with virtually no debt offsetting its $5 billion in assets and $21 billion market valuation. That, however, is now old news. Today the company disclosed a large debt offering in an SEC 8K Filing:

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.

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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.

With the consumer high on everyone’s mind, I thought it a good time to take a look at some companies exposed to discretionary spending to see what they are saying.

Estee Lauder’s (EL) three percent growth in North America was in line with the total retail sales growth recently reported. A big question is whether they are in the wrong place at the wrong time.

Although our most rapid growth will come from overseas, we are taking action to improve in the largest individual market, the U.S. However, we expect progress to be slow because of continued softness in department stores. We anticipate that the tough retail climate in department stores will last for at least the first half of your fiscal year. However, we remain committed to the channel. Department stores have unique offerings of designers and brands, and we firmly believe they will remain the cornerstone of U.S. prestige distribution.

That said, we also note that we now generate approximately 34% of our net sales in North American prestige department stores down from 46% five years ago.

(Excerpt from full EL conference call transcript)

Starbucks (SBUX) grew significantly faster than the average retailer, but not nearly so fast as its investors have come to expect.

Company-operated U.S. retail revenue growth of 19% was driven by the opening of 1,116 new company-operated stores in the last 12 months. During the third quarter specifically, we opened 285 new company-operated locations.

Turning to comparable store sales growth for the U.S. segment, the third quarter saw trends similar to those in the second quarter. The average value per transaction increased 3% while traffic grew less than 1%, resulting in a 4% comparable store sales growth. During the quarter, sales of our core handcrafted espresso-based beverages and premium food offerings were the primary drivers of the growth in same-store sales.

(Excerpt from full SBUX conference call transcript)

The 3% per-transaction growth, again, was just average for US retail. What is still somewhat impressive is growing store traffic at all (even just 1%) while opening new stores at the rate of 3 or 4 per day. Still, they are noticing some shifts in their customer’s habits.

It’s clear that there is an increased competitive environment. There is an increased pressure on consumers from macroeconomic factors. But in all of those areas, we believe that we have a competitive advantage of being the coffee experts and being able to generate incremental traffic as we go forward, particularly in our core beverages, our core espresso beverages and the things that are uniquely Starbucks.

(Excerpt from full SBUX conference call transcript)

The credit crunch is hitting Nordstrom (JWN).

Approximately $14 million of the bad debt reserve is non-comparable due to the previous mentioned accounting treatment for our co-branded Visa receivables that did not occur in the prior year. The remaining $8 million of the incremental provision resulted from growth in both the Visa and proprietary card receivables ahead of plan and from changes to assumed repayment rates versus last year.

These changes stem from observed increases in early stage delinquencies.

(Excerpt from full JWN conference call transcript)

However, the company expects to gain market share.

Our same-store sales expectation is now 5% to 6% for the year, up from 3% to 4% based on our year-to-date performance combined with our plans for the remaining two quarters of the year.

(Excerpt from full JWN conference call transcript)

I think the general consensus is that consumers are feeling some pressure but not enough to really keep them from spending. These conference calls seem to confirm that consensus opinion.

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

Starbucks Corporation (SBUX) announced financial results for its fiscal third quarter ended July 1, 2007. Consolidated net revenues of $2.4 billion increased 20 percent and were in line with expectations. Net earnings per share of $0.21, compared to $0.18 per share last year and a consensus estimate of $0.21. The company left its guidance for this year unchanged and introduced fiscal 2008 guidance:

— New store openings of approximately 2,600, accelerating International openings by 200 stores

– Comparable store sales growth in the range of three to seven percent

– Total net revenue growth of approximately 18 percent

– Fiscal 2008 earnings per share growth of approximately 20 percent to 22 percent

None of these numbers were particularly surprising, but shares traded up after the announcement anyway. Perhaps the rally at the market close was continuing, perhaps investors were fearing worse, or perhaps there were simply more buyers than sellers.

Whatever the reason, Starbucks continues to post same store sales numbers many other retailers would drool over despite adding new stores at a pace some have called overcaffeinated. As for me, I see little change since I last wrote about the company’s prospects, at which time I estimated potential returns of 9-17% annually for the foreseeable future.  And that is a chance I am willing to take.

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

In a perennially popular posts I wrote almost exactly one year ago, I compared the growth plans for Starbucks (SBUX) to the actual accomplishments of McDonald’s (MCD - Annual Report). I wrote then:

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.