Starbucks Still Looks Like a Buy

The Street had high expectations for Starbucks (NASDAQ: SBUX  ) going into its third-quarter earnings release... and it delivered.

With the stock up about 6%, a quick glance at the quarter's key metrics in comparison to last quarter reveals why the market is reacting so positively.

Quarter

Revenue Growth (YOY)

Comparable Store Sales (Global)

Operating Margin

Q2 2013 

11%

6%

15.3%

Q3 2013

13%

8%

16.4%

Source: SEC filings for quarters shown.

The company's growth rates actually accelerated. Meanwhile, its operating margin continues to expand.

As if the quarter's performance wasn't enough to get the Street excited, Starbucks introduced robust guidance for 2014.

Metric

2014 Guidance

Revenue growth

10% to 13%

Net new stores

1,400

Consolidated operating margin improvement

150 to 200 basis points

EPS growth

18% to 22%

Source: Q3 FY13 earnings release.

The "flywheel" effect
Starbucks undoubtedly had a great quarter, but is the company really deserving of a price-to-earnings ratio of 35? Certainly not on the foundation of a great quarter and robust guidance alone.

To merit such a premium, a company should possess both a durable competitive advantage and meaningful momentum. Given these characteristics, projecting sustained high levels of EPS growth for years to come is a realistic assumption, giving credence to Starbucks' price-to-earnings ratio.

Its gross profit margin of 56% is solid evidence of the company's brand-enabled pricing power, supporting the argument for Starbucks' durable competitive advantage. Fifty-six percent is just 4 percentage points short of Buffett's beloved Coca-Cola stock, a classic example of a consumer goods business with a Buffett-like economic moat.

Its operating scale further reinforces the company's economic moat. As Starbucks continues to open new stores and expand its distribution, the company is benefiting from the scale that accompanies volume. Though refranchising in Europe and easing coffee costs can be credited for much of Starbucks' operating margin improvements, some of it is simply the result of a leverageable business. Going forward, management's guidance for 150 to 200 basis points' improvement in operating margin is also reflective of Starbucks' clear scale advantages.

An economic moat alone, however, won't deliver the company from its lofty expectations. Starbucks needs momentum. Though management's plan for 1,400 new stores in 2014 will definitely help, it's Starbucks' ability to diversify its offerings and expand its distribution that is really propelling the company.

"Our more than 19,000 store global footprint, our fast-growing CPG presence and our best-in-class digital, card, loyalty and mobile capabilities are creating a 'flywheel' effect elevating the relevancy of all things Starbucks, and driving profitability," said Schultz in the third quarter earnings release.

Starbucks' massive store presence, its fast-growing consumer packaged goods business, and its successful loyalty card (dollars loaded on Starbucks Cards globally grew 30%, year over year) already makes for an impressive list, but there's more to Starbuck's flywheel effect: expansion to daypart business, revamped in-store food offerings, store redesigns, and expansion of drive-thru formats.

The flywheel effect, an idea popularized by business author Jim Collins, suggests that once companies build positive momentum, it is hard to slow them down. Starbucks' CFO, Troy Alstead, did an excellent job (intentionally or not) making a case for Starbucks' flywheel effect in the company's third-quarter earnings release:

Our ability to grow income at a pace that exceeds revenue growth clearly demonstrates the strategic synergies we generate across our global footprint, which combined with the diversity of our portfolio, enables consistent delivery of excellent results. Looking forward to FY14 and beyond, I am as confident as ever in our ability to continue to deliver strong revenue and earnings growth.

Don't run from Starbucks' valuation
Consistency. Starbucks' ability to consistently deliver excellent results thanks to its economic moat and diversified momentum make the company worthy of its premium valuation.

In the short term, Starbucks' lofty valuation could make for a bumpy ride. But for Foolishly long-term-minded investors, Starbucks seems like a low-risk bet for a sweet gain.

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