FOOL ON THE HILL
Starbucks vs. Outback Steakhouse

What makes a beaten-down Outback Steakhouse look better to Whitney Tilson than a piping-hot Starbucks? Though Tilson likes the coffee company, he prefers to look for solid businesses that have fallen out of favor, grabbing them on discount and riding out the rebound. That's a challenging proposition, particularly for investors who would rather own proven companies that are firing on all cylinders.

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By Whitney Tilson
February 6, 2001

In yesterday's Rule Breaker Portfolio report, Brian Lund argued that he's "tempted to sell" e-tailer Amazon.com (Nasdaq: AMZN) because "its world-changing days seem to be in the past." I agree, but I'll do him one better: I suggest that the managers of the portfolio also consider parting ways with Starbucks (Nasdaq: SBUX).

Before diving into my argument against Starbucks, I should note that as a value-oriented investor, there isn't a single holding of the Rule Breaker Portfolio that I would buy at anything close to today's prices (though I admire many of the businesses). I'm writing about Starbucks in part because I'm quite familiar with it -- I used to own the stock, selling it in 1999 -- and think highly of the company. In addition, Starbucks presents an interesting contrast to a company in the same general industry I think looks quite interesting, Outback Steakhouse (Nasdaq: OSSI).

Outback Steakhouse
Outback Steakhouse operates and licenses casual dining restaurants. As of the end of January, it had 669 Outback Steakhouses and 81 Carrabba's Italian Grills (plus twelve additional restaurants under four other names) in 49 states and 16 countries. The company has grown rapidly since its inception in 1988, compounding its top and bottom lines at 24% and 21%, respectively, over the past five years. Outback has also generated consistent returns on equity of 19-21%, among the highest in the restaurant industry. Despite investing heavily in the growth of the business, the company has plenty of cash, almost no debt, and substantial free cash flows that it is now using to repurchase shares.

So why is the stock trading at 12.6 times trailing earnings and 11.0 times estimates for 2001, both near all-time lows? (The stock has typically traded between 15 and 25 times earnings over the past five years.) Because growth slowed at the end of 2000 and the company announced Jan. 9 that it would miss analysts' estimates for Q4 by 15-18%. Average unit volumes for domestic Outback Steakhouses decreased by 0.4% in December, which the company attributed to "severe weather in the Northeast and Central U.S., where the company has a high concentration of Outback Steakhouses." Exacerbating the revenue shortfall were higher utility costs, "higher than expected start-up costs associated with new restaurant formats," and permitting and construction delays which led to 10 fewer Outback Steakhouse openings than expected during the quarter.

The company believes these issues are temporary, however, and stated "that it does not see any reason to materially alter the guidance it has previously provided regarding the outlook for the business in 2001."  The company reported yesterday that in January, "average unit volumes for all domestic Outback Steakhouses and Carrabba's Italian Grills increased by approximately 7.2% and 14.6%, respectively, compared to the same four-week period in 2000."

Despite these assurances, could this business in fact be materially and permanently impaired? Perhaps. I'm investigating further, and until I'm certain that the answer is no, I won't be buying the stock. It's also not quite cheap enough for me yet -- I'd be much more eager to buy the stock were it trading at, say, 10 times trailing earnings. But it's quite likely that this is a good business (in a lousy industry, sure) that has encountered some temporary difficulties, causing its stock to become attractively priced. That's the sort of situation I like, but I have to be absolutely certain that the market is making a mistake -- a big mistake -- before I'll put my money at risk.

Starbucks
In contrast, I can't understand what mistake investors in Starbucks think the market is making given the stock's rich valuation. At yesterday's closing price of $47.94, Starbucks is trading at 61.5 times trailing earnings per share (excluding the write-offs for Internet investments), substantially above its average P/E multiple that has ranged from 40-50x over the past six years.

That's a steep price -- with tremendous downside risk -- for a company that's very strong, but far from perfect. While Starbucks has a very good business and brand name, there are countless competitors and I see the competitive situation becoming more -- not less -- difficult over time. Similarly, I think there is lots of room for Starbucks to grow, but with $2.3 billion in revenues and 3,817 stores, Starbucks is no longer a small company that is likely to continue growing on a percentage basis at the high rates of the past. Conversely, the only question is when and how rapidly growth will decelerate.

Starbucks' net margin was 7.3% last quarter, up from 6.6% year-over-year. That's solid -- it's certainly higher than the 5% median for the S&P 500 -- but hardly noteworthy. Finally, return on equity was a mediocre 13% in FY 00 -- and that's the highest it's ever been.

Let me be clear: I like Starbucks, but liking the company and liking the stock are two very different things. I've warned many times in previous columns about the dangers of owning stocks that are priced for perfection, and Starbucks is no exception. I suppose it's possible that the company could grow into the stock's nose-bleed valuation -- after all, Starbucks grew its earnings 41% year-over-year last quarter -- but what are the odds? Not very good, in my opinion.

The last point I'd like to make about Starbucks is that return on equity and margins are quite a bit lower -- and the P/E multiple is quite a bit higher -- than the figures I've cited because the company issues huge quantities of stock options to nearly all employees. In his book, Pour Your Heart Into It, Starbucks' Chairman Howard Schultz explains that the company's stock option plan is the "one thing that makes Starbucks stand out above other companies... With its introduction, we turned every employee of Starbucks into a partner."

I applaud Schultz and Starbucks for implementing their far-reaching stock option plan, and I have no doubt that it has contributed to Starbucks' success. But the cost to shareholders is a sharecount that has risen rapidly, growing by an average of 4.5% annually over the past five years.

That Starbucks is compensating its employees in part via stock options means that its compensation expenses are understated -- and thus margins and profits are overstated. To get a sense of the magnitude, read Starbucks' latest 10K for FY 2000. Under "Note 12: Employee Stock and Benefit Plans," the company reveals that "had compensation costs for the company's stock-based compensation plans been accounted for using the fair value method of accounting described by SFAS No. 123, the Company's net earnings and earnings per share" in FY 2000 would have been $66.2 million and $0.35 per share vs. reported figures of $94.6 million and $0.49 per share. In other words, EPS would have been $0.14 lower than reported.

This, in my mind, means Starbucks is trading at a P/E multiple of 74.9, not the 61.5 noted above. (For comparison, the effect of Outback's stock option plan was a reduction in FY 2000 earnings from $1.59 per share to $1.55 per share.)

Conclusion
It's easy to follow the crowd and buy the stocks of popular companies -- like Starbucks -- that are firing on all cylinders. But this often means paying a very high price that leaves no room for any stumbles, and how many companies never stumble? I would suggest that a more profitable and less risky course is to instead look for solid companies whose stocks have become undervalued due to what are likely to be short-term problems... perhaps like Outback.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of the companies mentioned in this article at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com.