Keep an Eye on Starbucks

In addition to the return of heralded founder Howard Schultz, Stock Advisor recommendation Starbucks (Nasdaq: SBUX  ) has a lot of other things going for it. However, investors seem to have ignored Starbucks' merits over the past year, which contributed to the stock's nearly 50% plunge. But here are a couple of reasons why investors should still keep a steady eye on the coffee company's shares.

Starbucks sells caffeine
OK, I know, master of the obvious here, but let's be frank: A lot of coffee drinkers need their daily fix. (Loyal customers visit Starbucks 18 times a month.) Luckily, coffee drinkers could probably put on a blindfold, walk in a random direction, and hit a Starbucks within 500 paces.

Selling a product that keeps customers coming back on a daily basis is a pretty sweet gig. A long-term stock chart of Coca-Cola (NYSE: KO  ) or Altria (NYSE: MO  ) is a quick and dirty way to demonstrate that a great brand plus strong distribution equals a happy long-term stockholder. Even better, investing in Starbucks doesn't come with the legal headaches of selling a nicotine-based product.

Lowered expectations
In 1998, satirical newspaper The Onion wrote an article called "New Starbucks Opens in Rest Room of Existing Starbucks."  At the time, it seemed like Starbucks was everywhere. Since that article was written, Starbucks has expanded its store base by nearly 10 times. In fact, every year, Starbucks continues to open more and more stores.

2004

2005

2006

2007

New Stores

1,344

1,672

2,199

2,571

% Store Growth

18.6

19.5

21.5

20.7

Source: Capital IQ.

Will this slow down in the future? Of course, and Starbucks has already announced its plans to slow domestic growth. Trees, even trees hyped up on caffeine, don't grow to the sky.

But Starbucks' stock, at its current levels, doesn't seem to be pricing in the astronomical growth that yesterday's stockholders demanded. According to Capital IQ, analysts expect Starbucks to earn $1.01 per share in 2008, a 16% increase over 2007. Over the past five years, however, Starbucks grew earnings per share at an annualized rate of 26.9%.

Healthy returns on equity
In 1996, Starbucks earned $41.7 million on $451.7 million in shareholder equity, resulting in a 10.9% return on equity. However, this was when the company was just getting started putting capital to work. By 2001, return on equity had increased to 14.3%, and in 2007, return on equity was a blazing 29.8%.

Although it's difficult to break out Starbucks' unit volumes from its consolidated financial statements, one only has to walk into a store to get a sense that returns must be high indeed.

Each Starbucks store is relatively small, as a large number of customers get their drinks to go. This eliminates the need for a large amount of real estate, and thus increased rental expense, that plagues larger sit-down restaurants. I also know from my college days as a barista that making coffee and espressos doesn't require much in the way of equipment, nor is it labor-intensive.

Overblown fears?
Many Starbucks observers fear that fast-food juggernaut McDonald's (NYSE: MCD  ) intends to start serving mochas and lattes. However, not too long ago, Inside Value pick Wal-Mart (NYSE: WMT  ) cut the prices of generic prescriptions to $4, which scared Walgreen (NYSE: WAG  ) and CVS (NYSE: CVS  ) shareholders, but later turned out to be a non-issue. In fact, Walgreens recently stated its market share has actually risen to 17%.

Starbucks has gone decades without a legitimate competitor. Is it possible that McDonald's, with its 14,000 U.S. locations, could put a dent in Starbucks' business? Sure, it's possible, but just as Starbucks' encroachment into breakfast sandwiches didn't really register on McDonald's radar screen, I'm guessing McDonald's move into espressos will ultimately be no more than a slight negative for Starbucks.

In fact, McDonald's could even serve as a gateway for Starbucks, where lower-income McDonald's customers become introduced to McLattes and McCappuccinos, and then trade up to Starbucks.

By traditional metrics, Starbucks shares still aren't cheap. But given its growth prospects, returns on capital, and quality of earnings, I'd definitely put Starbucks on a buy watch list. Shares are now trading at 16 times forward earnings, which is equivalent to a 5% earnings yield, so it's definitely time to start taking a hard look.  

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