The Ultimate Rule Maker: Starbucks

Editor's note: An earlier version of this story mistakenly identified Hugo Chavez, president of Venezuela, as the leader of Chile. Michelle Bachelet is the president of Chile. The Fool regrets the error.

Of all the stocks in this contest, only one has customers who loudly and proudly proclaim themselves addicts. You may even be one. That's the nature of Starbucks (Nasdaq: SBUX  ) . One taste of a triple-shot no-foam mocchachino, and you're hooked like a bass in a fishing tournament.

Yet Starbucks isn't even within spitting distance of its growth potential. For example, though Norway's 4.5 million people were the largest per-capita consumers of coffee in 2005 -- they imbibed 8.8 kilos per person -- there isn't a Starbucks anywhere in the North Country.

No sobs for coffee snobs
What? You don't think Starbucks will ever be welcomed in Scandinavia? Perhaps. But I'll bet you'd have said the same about Austria just a few years ago. Today, Starbucks has 11 locations in Vienna, where coffee might as well be the official beverage.

Then there's Chile. Starbucks has a foothold there with -- count 'em -- 17 stores in the city of Santiago.

Together, these world capitals boast roughly 7.2 million people, or one store for every 257,000 residents. New York City, by contrast, has 178 Starbucks stores serving 8 million people. That's one coffeehouse for every 45,000 people. Clearly, there's still room for global growth.

Brewing a Rule Maker
But this debate is about whether Starbucks is the best Rule Maker. I'll not bore you by explaining exactly what that means. (Though you may find a detailed overview here.)

For now, what you need to know is that, on the whole, Rule Makers tend to:

  • Have excellent management.
  • Dominate an industry.
  • Produce lots of cash flow and high returns on capital.

How has Starbucks fared? Here's the most recent head-to-head tally versus competitors Caribou Coffee (Nasdaq: CBOU  ) , Peet's (Nasdaq: PEET  ) , and Green Mountain Coffee Roasters (Nasdaq: GMCR  ) :

Metric*

Starbucks

Caribou

Peet's

Green Mountain

Free cash flow

$306.7 million

($29.0 million)

Not avail.

$0.0 million

Cash and investments

$684.7 million

$14.8 million

$33.2 million

$3.7 million

Total debt

$367.5 million

$0.0 million

$0.0 million

$99.6 million

EBIT margin

11.4%

(3.6%)

6.7%

7.7%

Return on capital

22.7%

(4.6%)

7.0%

9.4%

Return on equity

26.2%

(7.7%)

6.2%

10.9%

Source: Capital IQ, a division of Standard & Poor's.
*Data from the trailing 12 months.

See? Starbucks is far and away the operational leader.

I'm less inclined to give an edge in management because Green Mountain's Robert Stiller is a founder who still owns nearly 30% of the business. He's also been a force in his industry as a long-term proponent of fair-trade coffee.

Yet Starbucks' Howard Schultz is also a force to be reckoned with. Ask anyone on the receiving end of his recent memo, in which he accused Starbucks of losing its soul.

That this document went public is a testament to Schultz's influence. Shareholders should be grateful for his audacity -- it virtually ensures that executives won't get lazy as they seek new growth.

Caffeinated growth, decaf expectations
But the best argument for Starbucks is investor pessimism. Have a look at what the amateur and professional stock-pickers participating in our Motley Fool CAPS investor-intelligence database think:

Metric

Starbucks

Stars (5 max)

**

Total ratings

2,643

Bullish ratings

2,285

Bull ratio

86.5%

Bearish ratings

358

Bear ratio

13.5%

Bullish pitches

572

Bearish pitches

97

Data current as of March 13, 2007.

A two-star stock? Ouch. The good news here is that, when investors are skeptical, unexpected business improvements are more likely to occur. And that's when the greatest growth kicks in.

Then there's history. Starbucks' stock has traded for a premium for years. So, while today's trailing multiple of 45 times earnings seems like a lot, it is, in fact, the lowest P/E that investors have seen since the end of 2003. Look what's happened since.

What's a Rule Maker? It's a company run by excellent managers, dominant in its industry, and producing generous free cash flow and high returns on capital. That smells like Starbucks to me. Mix in a reasonably priced if not cheap stock, and you have every reason to name this sweet-tasting coffee king the best of the biggest.

Now go back and read about the other contenders for the best Rule Maker. For more stock ideas, visit Motley Fool Inside Value,  where we identify industry leaders trading for bargain prices. Try Inside Value free for 30 days.

Starbucks is a recommendation of the Motley Fool Stock Advisor stock-picking service.

Fool contributor Tim Beyers will have a decaf venti latte with a splash of cinnamon, please. Tim didn't own shares of any of the stocks mentioned in this article at the time of publication. The Motley Fool's disclosure policy is heading to Starbucks for an afternoon pick-me-up. Need anything?


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