Starbucks Is Tier 1

"And, by the way, the bulk of the billions in Berkshire Hathaway has come from the better businesses. … And most of the other people who've made a lot of money have done so in high-quality businesses."
-- Charlie Munger

At Tier 1 Investments, a Motley Fool Real-Money Portfolio, I seek out and invest in elite businesses. These include companies with the most valuable brands, best management, superior products, and strongest competitive advantages. I call these businesses Tier 1 enterprises, and Starbucks (Nasdaq: SBUX  ) fits that description perfectly.

A beloved brand
Starbucks is the dominant brand among coffeehouses in the United States and, increasingly, around the globe. That's great news for Starbucks' shareholders because as Fool co-founder David Gardner wrote in Rule Breakers, Rule Makers, "it's often the power of the brand that can create and sustain [a company's] success." And as money manager Brian Zen has said, "growth often comes from powerful consumer brands spreading all over the globe."

I believe Starbucks is one of those powerful consumer brands that's about to embark on a massive global expansion. After years of closing underperforming stores in the States, Starbucks is once again expanding in select U.S. markets. But even more exciting is Starbucks' international growth opportunity. The company plans to enter the Indian market this year and triple its store count in China by 2015. This is exactly the type of investment opportunity I seek out -- a proven U.S. company with tremendous growth potential in emerging markets. 

Starbucks is also launching new juice bars after acquiring Evolution Fresh, putting Starbucks on the verge of tapping into the $50 billion health and wellness market. And finally, Starbucks plans to roll out Verismo, its single-serve home-brewing machine, this coming holiday season. Starbucks' trusted brand and loyal customer base make the likelihood of success for these new initiatives much more likely.

Outstanding products and strong leadership
Starbucks' beautiful green and white siren tempts you -- she calls out to you to take a moment to enjoy a rich, delicious cup of coffee. And once you enter a Starbucks, the aroma of fresh-brewed coffee, the comfortable couches, the pleasant service, and the artful architecture help lull you into staying a while.

So Starbucks is more than a coffee retailer -- it's an experience.

And now, much to shareholders' delight, the creator and guardian of that experience is firmly back at the helm. Founder Howard Schultz took back the reins as CEO in early 2008, as Starbucks was struggling with overexpansion and with what he called "the commoditization of the Starbucks experience." Schultz immediately went to work rebuilding the brand and closing underperforming stores. After a difficult transition period during the Great Recession, Starbucks is once again on an upward trajectory. Same-store sales have been positive for several quarters, and after a three-year retrenchment, store openings are once again increasing. Revenue and profit are at all-time highs and are growing at double-digit rates.

A wide and expanding moat
Starbucks has numerous competitive advantages. Perhaps the biggest is the massive scale advantages it enjoys thanks to its more than 17,000 coffeehouses worldwide. This gives Starbucks negotiating power over suppliers and a distribution network that its smaller coffeehouse competitors simply cannot mach. What's more, Starbucks' massive retail presence serves as an excellent advertisement for the brand, which allows Starbucks to spend very little on advertising. As David Gardner has said, "the ubiquitous green-and-white cups in the hands of morning commuters do a better job of reinforcing the brand than any ad campaign could."

Even more impressive is the innovative culture that is ingrained in Starbucks. Whether it's creating a new "blonde" light roast or the Verismo single-cup machine for making espresso-based beverages at home, the company is constantly moving forward. Starbucks continues to dominate its core business while at the same time entering and disrupting new markets, thereby displaying the best qualities of both a Rule Maker and Rule Breaker.

Risks and why I'd sell
Starbucks' stock has pulled back more than 20% from its highs since management said European sales are taking a hit from the economic turmoil in that region. If Europe enters into a deep and prolonged recession, and especially if Europe pulls other parts of the global economy down with it, sales of Starbucks' relatively high-priced coffee products will suffer. But Europe will eventually recover, and massive growth opportunities in emerging markets such as China and India should offset sluggish sales in Europe.

Other risks include competition from lower-priced competitors -- the recent focus on coffee at McDonald's  (NYSE: MCD  )  comes to mind -- but competition is nothing new to Starbucks. It's shown an ability to compete and win in its industry for more than a decade. Coffee-bean prices can also be volatile, but Starbucks has years of experience managing its supply chain and has built up strong relationships with its suppliers over the years. It should be difficult for competitors to match that.

Valuation
Many look at Starbucks' $50 stock price, see a coffee retailer trading at nearly 30 times earnings, and jump to the conclusion that shares must be overpriced. But as I've explained, Starbucks is much more than just an average coffeehouse. Companies with dominant brands, visionary leadership, and strong competitive advantages deserve to trade at a premium to the average stock. Understanding what's driving Starbucks' growth now -- and what will drive it in the future -- will serve you much better than focusing solely on crude valuation metrics like P/E multiples. I see tremendous room for expansion in Starbucks' core coffeehouse business in international markets, and also in its new tea and juice product lines. Once you factor in these catalysts, you can begin to see that Starbucks may not be as expensive as it first appears. And while Starbucks' stock is not "cheap," I'm willing to pay for quality. I conservatively value Starbucks at $60 per share and can easily see how shares could be worth much more if Starbucks' new growth initiatives take hold.

The Foolish bottom line
Starbucks is an elite business, and the recent pullback in the share price is giving us an attractive entry point. That's exactly the type of opportunity I seek out, and so tomorrow I will be buying shares for the Tier 1 Real-Money Portfolio.

Next steps:

  • If you'd to like to stay updated on breaking news affecting Starbucks, add Starbucks to your Watchlist. My Watchlist is a free service offered by The Motley Fool to keep you updated on all the news and events as they relate to your favorite companies
  • If you'd like to follow along with Tier 1 Investments as I build out the rest of my portfolio, you can follow me on Twitter, @Tier1Investor.
  • And if you're interested in learning about more dominant U.S.-based businesses with outstanding international growth prospects, grab a free report from The Motley Fool.

Joe Tenebruso manages a real-money portfolio for The Motley Fool and is an analyst on The Motley Fool's Stock Advisor, Supernova, and Fool One premium service teams. You can follow him on Twitter @Tier1Investor. Joe owns no shares in any company mentioned above.

The Motley Fool owns shares of McDonald's and Starbucks. Motley Fool newsletter services have recommended buying shares of Starbucks and McDonald's and writing covered calls on Starbucks. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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