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Thursday, July 1, 1999

An Investment Opinion
by Dale Wettlaufer

Starbucks Brew Ha Ha, One Year Later

Since it's been a little less than a year since I addressed Starbucks (Nasdaq: SBUX) in this column, and since it was bashed pretty hard today, and since this company is sort of near and dear to many Fools' hearts, I thought I'd write about it today.

The coffee roaster, retailer, and lifestyle marketer (what the heck, if it's a new age company, I can make up new age descriptions) last night reported that it expects fiscal 1999 EPS results to come in 10% below the mean estimate of $0.60. Starbucks says the difference between the mean estimate and its own estimate of full year EPS of $0.54 "reflects the fact that despite strong Retail performance and a likelihood of even higher year end store count than previously announced, some of the Company's other businesses have not grown as previously anticipated. In addition, the Company has incurred significant additional costs related to its commitment to its Internet strategy."

First, retail performance does look strong, with same-store sales having risen 7% for the five weeks ended June 27 and total sales having risen 30% year-over-year for the same period. When my colleague Yi-Hsin Chang talked with Starbucks CEO Howard Schultz last year, an August same-store sales number of +3% had everyone worried and had knocked the stock down a few pegs. Compared with same-store sales comps of +5% for the first three quarters of fiscal 1999, we can see that condition didn't persist.

Further, invested capital has grown a little more slowly than revenues (not converting operating leases over to the balance sheet), which is at least one sign that the economics of the business haven't changed for the worse. Return on capital hasn't expanded year-over-year and the company is still underperforming its cost of capital by my estimations, but the story here is one of huge growth. Year-over-year, invested capital expanded 23.5% with very little additional equity being contributed to the company while the store base grew 31.2% year-over-year when you include licensed stores as well as company-operated stores.

Those are extremely impressive growth figures. Is that enough, though? At what point do investors want to see the kick in return on investment above the company's cost of capital? Well, you could have asked that for many years at McDonald's (NYSE: MCD), couldn't you? The simple answer is that a relatively mature company, which is decades into its goal of achieving world ubiquity, is going to show a lot better return on book capital characteristics than a company that is decades behind in that goal. The contrast I'm drawing here has to do with the fact that Starbucks is in the midst of taking market share from low-end coffee purveyors, building out a ubiquitous North American store platform, building out widespread retail distribution with its Kraft agreement, and moving on to build out a worldwide retail presence and brand platform. Near-term profits aren't exactly what the company is shooting for.

Nevertheless, it is generating strong growth in operating cash flow and shows free cash flow, the absence of which could be forgiven in the context of its strategic goals. The simple question is this: Do people love the product? Do people prefer the product? Is it a fad? I would say yes, yes, and no, even if I don't spend too much in their retail stores. I'm not going to overlay my preferences over a significant chunk of consumers that have acted in an obviously receptive and loyal fashion to Starbucks' traditional and new products.

The question today is whether the market is acting rationally with the price of Starbucks down $10 5/8 to $26 15/16. Is it the earnings shortfall in the near-term that the market is discounting or is it other strategic initiatives the market doesn't like? After all, investments to build out value-creating projects should be welcomed if they increase the intrinsic value of the company, even if they do knock down 1999 EPS. I would have to say ultimately that the market is not welcoming last night's discussion of Starbucks' "lifestyle portal" plans:

"As part of its innovative Internet strategy, Starbucks Coffee Company announced today that it will create a new lifestyle destination/portal that will include expanded content and commerce offerings within the gourmet/specialty food, kitchen products, and home furnishings categories.

"The new portal will be launched in the form of a unique 'canopy brand' site in time for the 1999 holiday season. It will represent a single destination for customers to purchase both traditional Starbucks core coffee, tea and music offerings as well as complementary products and services from a portfolio of selected online and land-based retailers.

"In conjunction with the portal development, Starbucks plans to announce a major strategic partnership later this summer.

"'Creation of the canopy brand portfolio enables us to extend the leadership we now enjoy as a specialty coffee retailer to new and highly complementary products centered around the lifestyle of our customers,' said Howard Schultz, Starbucks chairman and [CEO]."

Deion Sanders can play two sports and so could Bo Jackson, but even the mighty Michael Jordan couldn't hit breaking balls, Hall of Fame quarterback John Brodie didn't exactly dominate seniors golf, and Carl Lewis certainly couldn't sing too well. Does this "lifestyle portal" thing bring up some risks? Yeah, definitely. I know everyone wants to go after the high disposable income sort of customer and I know it's a temptation to think that since you've got a few things figured out about your customers that you've got their "lifestyle" nailed, but it doesn't mean it's easy to accomplish those things. "Lifestyles" and capturing this intended lifestyle, whatever medium you're using, is NOT a new business. So you've got some stores and you've got a brand. Can you leverage it and increase the value of the company? Why not? But in wanting to do so, the company just introduced some uncertainty into a pretty straightforward and easy-to-understand investing proposition.

Sticking with my valuation of the company last year and assuming intrinsic value has grown about 25% year-over-year, I think the stock is very interesting again at $21 1/4. I would want to see some movement on the Kraft deal, like actually seeing the coffee in some local retail outlets. Until they can cover a straightforward initiative such as that, then I wouldn't be the biggest supporter of this somewhat flaky lifestyles thing. If I saw some action there, I would be willing to believe that there are supernormal returns over 10 years available at this price level.

($ in millions, except per share. EV = enterprise value)

Market Cap.....$5,073.65
Enterprise Value.....$5,064.25
EV/Invested Capital.....5.62
Price/Book Value.....5.70
EV/Net Income.....54.97

A/R Days Sales Outstanding.....9.41
Inventory Turnover.....5.09
Capital Turnover.....1.81
Days in Inventory.....71.99
Days in Payables.....49.52
Days Sales Outstanding.....9.41
Cash Conversion Cycle.....31.88

Current Ratio.....1.95
Quick Ratio.....1.24
LT Debt/Equity.....0.00%

Begin Invested Capital.....$730.04
End Invested Capital.....$901.54
Avg. Invested Capital.....$815.79
YOY IC Growth.....23.49%
Tax Rate.....38.00%

Trailing Revenues.....$1,473.59
Operating Earnings.....$131.27
Net Income.....$92.13
Gross Margin.....55.55%
Operating Margin.....8.91%
Net Margin.....6.25%

Cash & Equivalents.....$165.70
Excess cash.....$9.40
Last year excess cash.....$31.03
Last Yr receivables.....$34.07
Last Yr Inventories.....$128.28
Current Assets.....$357.27
Current Liabilities.....$183.40
Long-Term Debt.....$0.00
Shareholder's Equity.....$889.34
Last Yr Shareholder's Eq.....$744.70
Diluted Sharecount.....188.35
Average receivables.....$36.02
Average inventories.....$128.73
Average share equity.....$817.02

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