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Fool On The Hill

Friday, July 2, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

On Investor Expectations


Shareholders in Starbucks (Nasdaq: SBUX) probably still have a headache from yesterday's burn. As you are probably aware, the company announced its long-awaited Internet portal strategy along with the shocking news that earnings estimates for the upcoming two quarters were going to fall 17% below expectations. Was that an overreaction? Is Starbucks now the buy of the month? That depends on your expectations about the future of the company.

I'm not going to be talking that much about the company's strategy. You can get perspectives on that from our message boards or last night's Fool on the Hill column. Instead, I'm going to attempt to provide a financial framework trying to explain part of reason the stock fell so substantially.

Some people reading this article might be wondering, "What? Where did you pull out that 17% number? Didn't Starbucks only reduce earnings expectations by 10% to $0.54 from $0.60?" That's true for the year. But Starbucks' year ends in September. They have already announced results for the first two quarters of that period. The warning only applied to the third and fourth quarter. Prior to the warning, estimates for that period were $0.36. Now, the company is estimating $0.30, a 17% drop. Be sure not to let the "company spin," a 10% drop in estimates for the year, overshadow the reality, a 17% drop in estimates over two quarters.

(It should be noted, in the spirit of full disclosure, that analysts reduced their estimates for the first two quarters of fiscal 2000 by 10%, reducing overall estimates over the next 12 months by 13% to $0.60 from $0.69. History shows, however, that management teams and analysts are often too optimistic about the impact of a performance slowdown on future quarters. Management expects to address problems with a "quick-fix," when the underlying problems are usually more serious. This is the reason that one piece of bad news is often followed by more in future quarters -- consider Gillette (NYSE: G) a textbook example.)

While the drop in earnings estimates for the current year is important, more important is the expectation about future growth. On Wednesday, analysts were expecting the company to post a long-term growth rate of 30%. Today, that estimate has been lowered just a tad to 27%. A seemingly small difference to be sure, but one that ripples through expectations about future profits, as you will see below.


Earnings Per Share Estimates Wednesday Today Difference 1999 $0.60 $0.54 -10% 2000 $0.79 $0.70 -11% 2001 $1.02 $0.85 -17% 2004 $2.24 $1.74 -22% 2009 $8.32 $5.75 -31%
(Estimates for 2004 and 2009 calculated using estimated long-term growth rates.)

The reduction in profit estimates, on a percentage basis, increases over time as the compounding of growth takes its toll. As all investors should know, compounding is an extremely powerful force. Using modest growth rates of 10% (below the long-term historical average for stocks), compounding helps turn $10,000 into $453,000 over 40 years. On the downside, compounding has an equally powerful, but negative impact when future growth rates are reduced. This downside is clearly demonstrated in that a 10% cut in current year earnings projections and a 3 percentage point reduction in growth rate expectations yields 31% shrinkage in a projected 10-year earnings estimate. In that light, the 28% decline in the stock price yesterday doesn't really seem out of whack.

Of course, analysts estimates about earnings and future growth rates are just that -- estimates. What really happens will depend on management moves, the market environment, and the overall economy. Predicting what will happen next year can be tough enough for most people, much less what will happen five, ten, and twenty years from now. The challenges with prognostication create the need for investors to closely evaluate a company's historical performance and management's ability to deliver promised results when considering future growth rates.

Prior to Wednesday, many investors had a high level of confidence that Starbucks would achieve 30% earnings growth. Because of those expectations, they were willing to pay much more for a dollar of Starbucks earnings than for the market at large. In fact, at Wednesday's close, Starbucks was trading at 37x estimates for 2001, which compared to a 28x multiple on 1999 estimates for the Standard & Poors 500 index. Even taking expectations out two years because of its stellar track record, Starbucks' projected earnings were valued more highly than current earnings from the average S&P 500 company.

Using today's closing price, the stock market is indicating a less rosy view towards Starbucks' future. The company is now only trading at 32x the reduced estimates for 2001. That's still well above the multiple of the average S&P 500 company, but noticeably less than the number two days ago. This data reinforces what common sense would suggest: people still believe Starbucks will grow faster than the overall market, but not nearly as much as previously anticipated.

A former boss told me that the biggest rewards an investor earns come from correct, non-consensus views. In other words, your greatest profits will come when you make an investment decision based on a correct evaluation you make that other people in the market don't anticipate. One of the best examples that pops into my mind to demonstrate the validity of this statement is David Gardner's decision to buy America Online (NYSE: AOL) for the Rule Breaker portfolio in 1994, when others thought the Internet was a fad that would quickly pass. That holding is now up over 12,000% in less than five years.

Do you believe Starbucks will be able to post 30%+ earnings growth over the upcoming years? If so, it would seem like the stock might be attractive now that market expectations are lower than that. If you think earnings growth will slow down below 20%-25%, you probably don't want to get close to the stock. Starbucks' stock appears to be trading in a reasonable range if you expect the company to post growth somewhere between those figures. Your decision to invest in this case should rest primarily on how much you believe and want to invest in Howard Schultz's vision for the future.

The news from Starbucks this week did provide a healthy warning to investors. It was a not-so-subtle reminder of the value in keeping abreast of your expectations for a company relative to what the market overall expects. If you bought Starbucks expecting 20%-25% growth, maybe it would have been worthwhile to take some money off the table when expectations started to exceed 30%. While it is preferable to buy and hold a stock forever, you might want to consider taking some of your money off the table if market expectations rise to levels you deem unachievable. From the opposite perspective, you need to be aware when market expectations fall below your own. Those situations may present excellent opportunities for investment.

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