3 Reasons Starbucks Is Still on Fire Heading Into 2014

It is hard to believe that Starbucks (NASDAQ: SBUX  ) traded for less than $10 just five years ago. Today, it trades nearly nine times higher than its financial-crisis low and has charged up 43% in the last year -- besting the S&P 500 index by more than 10 percentage points. Even a multibillion-dollar judgment against the company in an arbitration case with Mondelez International barely put a dent in Starbucks' stock price.

It is impossible to know what the market will do in any given year, but there is a good chance that Starbucks' current growth initiatives will elevate the stock to new highs in 2014.

Starbucks: Not just a coffee shop
Starbucks coffee has more or less run its course in the United States; there are more than 13,000 Starbucks in the Americas, 1 in 5 customers visit every other day, and most locations offer more than 87,000 drink combinations. It is time for Starbucks to branch out a little.

Enter La Boulange, the bakery that is going to make people think great food when they think of Starbucks -- or at least that is management's hope. Starbucks has been slowly introducing La Boulange food -- which includes croissants, scones, and cookies -- to its U.S. stores and plans to complete the rollout to all company-owned stores in the U.S. by mid-2014.

Starbucks' expansion into the food category comes amid increasing competition from fast-casual concepts like Panera Bread (NASDAQ: PNRA  ) . Panera offers baked goods, soups, salads, sandwiches, and custom-roasted coffees. It has more than 1,700 locations in the United States. Like Starbucks, Panera is growing rapidly; just 10 years ago it had less than $370 million in revenue, but it now has nearly $2.3 billion in annual sales. Affluent customers -- Starbucks' core demographic -- frequent fast-casual chains like Panera, so Starbucks' broadened offering is as much about retaining customers as it is about increasing the average ticket price.

In addition to food, Starbucks is expanding its beverage selection. The company bought upscale juice maker Evolution Fresh in 2011 and is ramping up production with a new $70 million factory designed to quadruple output. The world's largest coffee chain is also expanding into teas with its acquisition of Teavana. Although Teavana teas will be sold in some Starbucks locations, the company also plans to roll out Teavana tea bars across the United States. Starbucks CEO Howard Schultz says, "We'll do for tea what we did for coffee." If this initiative is successful, Teavana represents a massive growth opportunity.

Growth in Asia
The China/Asia-Pacific, or CAP, segment represents just 6% of Starbucks' revenue, but it could quickly become a much more important segment. CAP is the company's fastest-growing segment; the company opened its 1,000th Chinese store during the last quarter and plans to open another 750 in 2014.

The best part about Starbucks' expansion in China is the terrific return on investment. It costs $250,000 to open a new store in China that will generate $700,000 in revenue during its first year. The average Chinese store turns 21% of revenue into operating profit. Twenty-one percent of $700,000 is $147,000, so each store should generate about $147,000 in operating profit in the first year. Therefore, Starbucks pays 1.7 times pre-tax earnings to open each new Chinese location. That is insanely profitable -- and the reason that the China growth story is so important to Starbucks' future.

Home brewing
Starbucks has a 13% share of the at-home coffee market, but that will likely grow in 2014 and beyond. Its Verismo brewer may have been a total flop, but Starbucks inked a deal with Green Mountain Coffee Roasters (NASDAQ: GMCR  ) that will deepen its partnership with the maker of Keurig brewers. Under the terms of the agreement, Green Mountain will distribute K-Cups branded with Starbucks, Teavana, Seattle's Best Coffee, Tazo, and other Starbucks-owned brands.

Single-serve coffee is growing nine times faster than the rest of the coffee industry, making it an important source of growth.The segment represents just 9% of Starbucks' revenue, but slowing growth in the Americas and Europe will make it a much more significant part of the company as the years go by.

Bottom line
Starbucks is trading at more than 30 times free cash flow, but its ability to grow earnings via an expanded offering, rapid expansion in Asia, and market leadership in the single-serve segment may justify the high valuation.

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