Starbucks: Keeping Its Friends Close and Its Enemies Closer

Anytime I write about Starbucks (NASDAQ: SBUX  ) I only feel it fair to preface my articles by stating that I practically live, eat, and breathe Starbucks coffee. I've been ritualistically ordering the same drip coffee from Starbucks for 17 years without waver, and I do a lot of my research in what is now referred to by the dozen-and-a-half baristas here as my "office." So keep that bias in mind as you read on!

The question I propose to answer today is simple: Is Starbucks a buy at its current levels, given the fact that it's valued at 31 times trailing earnings, and knowing that restaurants and retailers across the board are struggling to bring in customers with a higher payroll tax and delayed tax refunds taking their toll?

To answer this question, I propose to look into the very heart of Starbucks' success -- in essence, at the innovation, emulation, and collaboration that turned it into the leading coffeehouse you now see today.


Source: commons.wikimedia.org

Innovation
I'm not certain there's an investor out there who would question just how valuable CEO Howard Schultz is to the Starbucks franchise. With domestic sales growth floundering in the late 2000s, the reappointment of Schultz to the CEO role was precisely the spark Starbucks needed.

Schultz's plan encompassed numerous key points to help get Starbucks back on track. These included remodeling and refreshing the inside of many of its retail locations; expanding into high-growth overseas markets like China; and refocusing its menu to include more health-conscious options.

The results have been utterly phenomenal. Starbucks' free wireless Internet offerings and its mobile payment partnership with Square, as well as its fresh look, have encouraged patrons to stay in its stores longer, occasionally leading to secondary purchases that the company would not have made if that same customer had come and gone just years prior.

In terms of overseas growth, Starbucks is aiming at having 1,500 stores open across 70 cities in China by 2015. Even with China's GDP below its 30-year average, the growth in the country's burgeoning middle class is enough to merit a big international push.

Finally, Starbucks has firmly embraced the move toward supplying more nutritious food and drink options. Starbucks was one of the first coffeehouses to make this move -- relying heavily on local growers to supply its all-natural selection -- and realized that consumers will pay a premium for healthier food and drink options if those options are perceived to be more nutritious.

Emulation
Starbucks' innovation is second-to-none in the food service industry... but even it can't invent everything.

Take Green Mountain Coffee Roasters (NASDAQ: GMCR  ) , for example. The company behind the Keurig single-brew coffee system and individual serving K-Cups bet big on the single-serve market in 2006 when it purchased the remaining 65% stake of Keurig that it didn't already own for $104.3 million -- a hefty price for a still unknown company at the time. That bet, as we'd later find out, returned better odds for investors than a roulette table! The popularity of the Keurig single-brew system and K-Cups exploded, with the company itself selling 4.6 million Keurig brewers alone in its fiscal first-quarter.

I could make a similar case for Whole Foods Market (NASDAQ: WFM  ) , which actually took the organic and natural phenomenon to heart and based its entire food and drink selection on pricier but more nutritious offerings. As traditional grocers have struggled to regain their footing since the recession, with consumers expecting lower prices in these stores, Whole Foods, where consumers have the expectation of paying more for more nutritious locally grown and all-natural products, has excelled.

In both cases, Starbucks has taken the bull by the horns and corralled it in its favor. Last year Starbucks introduced its very own single-serve brewing system known as the Verismo -- its own unique take on the Keurig single-brew system that was also capable of making lattes and espresso -- and also beefed up its salad and panini line with fresh new offerings. If you look at a Starbucks pastry and food casen you aren't going to see much that'd be considered "cheap" by many; but you will get, in many instances, a healthier variety of food than most coffeehouses offer.

Collaboration
Between Starbucks' innovation and emulation, it's learned to keep its partners close, and its enemies even closer.

Without question, the two biggest threats facing Starbucks are Green Mountain's Keurig single-brew system and its K-Cups, which could keep people from leaving their house for coffee, and the rapidly expanding Dunkin' Brands (NASDAQ: DNKN  ) , which earlier this year announced its plans to expand into Southern California by opening 150 stores beginning in 2015. Basically any company that's originated its own signature line of coffee is a threat to Starbucks -- even Krispy Kreme Doughnuts (NYSE: KKD  ) , which reported 7.5% same-store sales growth in the fourth quarter, of which a good chunk is attributable to strong Signature coffee sales.

When Dunkin' Brands announced a partnership with Green Mountain Coffee Roasters in February 2011, Starbucks did the only thing it could do: form a partnership with Green Mountain itself just three weeks later. With the hybrid Keurig Vue single-brew system, developed out of this partnership, Green Mountain can deliver its brewing technology in combination with Starbucks' Vue single-serve coffee packs. It's a symbiotic partnership of enemies at its finest!

Is Starbucks a buy?
I'd say that you could throw the kitchen sink at Starbucks right now and it probably wouldn't flinch. Its valuation isn't the most enticing it's ever been, that's for certain; however, the plan of action to grow the business is practically perfect. Krispy Kreme and Green Mountain just don't offer the stability of cash flow you can get from Starbucks, and Dunkin' Brands is even more expensive on a trailing-12-month basis and has very little emerging-market exposure. I'd say that Starbucks still looks like it's brewing the perfect roast for the long-term investor.

Should Green Mountain investors fear the Verismo?
With Green Mountain as cheap as it's ever been, many investors are wondering whether this is the end of the former market darling, or the perfect entry point for an enormous rebound. You can find our recommendation for how to play the company in our premium research report. In it you'll find everything you need to know about Green Mountain, including whether it's a buy at today's prices. Click here for instant access.


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