Rule Breaker Portfolio

Fool To Buy SBUX
July 01, 1998


**This trade is being made under the regular portfolio policy, namely, once The Fool announces an intention to trade, that trade will be made within the next WEEK, as opposed to the next day. For more detail, please read the "New Trades" section of the Fool Portfolio.**

Buying Starbucks Corp.
Nasdaq: SBUX
Type: Mid-Cap, High-Growth World Beater
Closing prices: $52 9/16 bid, $52 5/8 ask
http://www.occ.com/starbucks/

Market Cap: $4.59 billion
Trailing 12-month sales: $1.119 billion
Price-to-sales: 3.85
Trailing 12-month earnings per share (eps): $0.83
Price/Earnings: 62

Next quarter reported: Q3 '98 (June), in mid-July
Consensus EPS for third quarter: $0.24e
Consensus EPS for fiscal year '98 ended Sept: $0.93e
Consensus EPS for fiscal year '99: $1.24 (+33%)
P/E on far estimate: 42
Five-year estimated growth rate: 34%
Implied YPEG value: $42.16
(more on this in the valuation area)

Cash and equivalents (3/29/98): $152 million
Long-term debt: $1 million (for good measure?)

Trade: Buying $13,000 worth of shares

Overview
It's been right under our noses since 1992 -- a steaming hot world beater...

If you'd come by and toured Fool Global HQ at any point over the past year or so, you might have seen this one coming.

Alongside Coca-Cola cans, Amazon.com packages, and smiling jesters, one can't help notice Starbucks coffee cups sitting atop one desk or another (or another next to that). Yep, there's a Starbucks across the street from our Fool HQ in Alexandria, Virginia, though proximity isn't the only reason we find ourselves slurping its products every day. The real draw is that Starbucks is just plain hard to beat.

Embodied in the logo and brand name of Starbucks is consistent quality, dependably quick service, and an interesting and ever-growing variety of products (this summer will pass by a bit cooler thanks to the company's iced drinks). The variety of tasty beverages at Starbucks alongside aggressive store expansion has resulted in a wide and growing customer base -- one that becomes loyal as each Fool (err, Starbucks customer) discovers her favorite Starbucks product and returns again and again. The increasingly wide variety of products is also one reason that you see Baby Boomers lounging next to teenagers in these tiny coffee-scented stores every time you stroll by. (Of course, now that we're shareholders, we Fools will never just stroll by again. New Rule: Every time we walk by a Starbucks, we enter and buy!)

Regarding Starbucks these days, one's experience can range anywhere from a simple, comfortable, Old World cup of coffee and a scone (perhaps enjoyed with Grandmother), to a new, hip, and refreshingly boppy iced Frappuccino (perhaps enjoyed while using your 3Com PalmPilot at the coffee bar -- and will more of us please buy these things? 3Com's stock is foundering!). By design, Starbucks has made drinking coffee and tea pleasurable cultural experiences in the U.S. again -- akin to the refreshing and invigorating experience of pouring down a Coca-Cola on a hot day.

The company has been public for six years, so what took us so long? For all the "buy what you are" teaching that the Fool has prescribed, Starbucks should be one of the most widely held stocks in the country, shouldn't it, perhaps alongside AOL? (Nearly 5% of the country's households subscribe to AOL, but far fewer own the stock.) The old saying, "It was right under our nose," is especially true with Starbucks. Silly as we are, we simply didn't consider it until that fateful day when Fool Port co-manager Jeff Fischer hit himself in the head, leaned over his desk, and whispered to David Gardner: "Hey, what about Starbucks?"

A larger company than our usual fare...

What about it, indeed? This used to be a much smaller company, the ideal size we prefer when purchasing stocks to complement our Foolish Four giants. Now, having grown, Starbucks is a mid-cap selection, only the third that the Fool Port has bought, the first being Gap and the next being 3Com. (Though KLA-Tencor and Applied Materials were no midgets, either.)

So, Starbucks doesn't much fit the Foolish Eight criteria that we use for smaller companies like 3Dfx, Ride Snowboard, Innovex, Medicis, and even Iomega, AOL, and Amazon.com when they were first bought. And other than our Fool Four stocks, we usually like to find small companies that fit the Foolish Eight criteria in order to really juice up the portfolio's performance (or take it on the chin, as the case may be). But we're making an exception with this purchase for a few reasons.

First and foremost is the company's dominant position -- it's a world-beater. Ask yourself this question: Who would you name as number two in its niche? If you've even managed to name another company, how far behind Starbucks is it in sales? Yep, we thought so. Next, consider the impressive growth potential of Starbucks going forward. Analysts forecast 34% annualized gains in earnings per share over the next five years... a rate one expects more from a small-cap than a mid-cap. Third -- or at least somewhere on the list of why we like this stock -- is that this isn't a technology investment. It's good to have the Fool Port invested in something other than networks, wires, and ether. Now we're investing in beans... and a consumer experience that involves drinking and eating rather than surfing the Web and saving data to a disk.

Starbucks shares have returned 32% annually the past five years, compared to 22% for the S&P 500 (including dividends), but we believe that we're far from too late with our purchase. Thinking Foolishly five and especially ten years ahead, we expect further good times lie ahead for Starbucks. Indeed, the company claims that it hasn't even finished chapter 3 of its 11 chapter story.

The Biz
Make it refreshing, make it stand out, make it consistently good, make it omnipresent, keep it affordable, and -- oh yeah -- if it's slightly addicting that's not bad either.

Starbucks presently operates nearly 1,700 locations, but within weeks of this writing that number will be outdated. The company typically opens a few locations per day. (The record was five locations in a single day in a single Canadian city.) The idea is to maintain a constant presence in peoples' minds and, much like Coca-Cola, be attainable in every place that people work, play, visit, live, and Fool around. Alongside this, though, Starbucks is conscious of the need to remain a specialty item retailer and not become an over-exposed bean seller. It sells premium stuff -- only really good stuff -- and it needs to maintain an air of exclusive quality while being omnipresent. The balance is delicate.

The majority of Starbucks are located in North America, though over 50 locations hug the Pacific Rim and, just recently, the company acquired 61 locations in the U.K. after buying the Seattle Coffee Company -- you could ask a question about them over at the Fool U.K. message boards, if you like.

Starbucks sells more than just beans, though. It sells various items through several growing and new markets. The retail outlets are meant to provide a daily consumer experience that is specialized, but the quality of Starbucks coffee means a potential for strong bean sales in grocery chains, too, as well as branching into other branded products such as ice cream, for example. Or even food and coffee cafes. Let's take a closer look.

Products and distribution channels...

Thousands of retail locations will always be Starbucks' Trump card. (We mean that in a good way.) Coffee is the most popular beverage in the world after water, and conveniently placed stores around the country have helped Starbucks capture and maintain the mindshare of the coffee buying public while spending very little money on marketing (Starbucks has spent less than $10 million on advertising!). The constant presence of Starbucks alone leads to market share, while the now familiar Starbucks name leads to increased market share -- people will walk the extra block to buy Starbucks over a no-name coffee retailer. Once the public knows a company, management can branch into other venues of sale and vary its product offerings and still meet continued success if its quality is consistent.

Consider Coca-Cola. It began to sell its single product in the 1890s much like Starbucks began in the 1990s. At first, Coca-Cola was sold only through fountain vendors at drug stores and food delis. Later the company began selling its product in bottles packaged for retail stores. The Italian-style coffee bars of Starbucks are much like fountain vendors, and now Starbucks is moving into other distribution channels and (as Coca-Cola has done) into other related products.

From coffee, to ice cream, to beer, to jazz, to Cafe Starbucks, to Tiazzi Blended Juice Tea? What?

Through a 1996 agreement with Dreyers and Edy's, Starbucks offers ice cream in grocery stores. How has it done? Already Starbucks is the leading premium coffee ice cream seller in the country. In 1996 the company also began selling a bottled coffee drink, Frappuccio, with PepsiCo. The new drink has met with tremendous success -- demand is outstripping supply.

This year the company began selling whole-bean and ground coffee in grocery stores and supermarkets. After successful test marketing in Chicago and Portland, Starbucks began selling in ten other major cities this April, including Denver and Los Angeles. Starbucks coffee will be sold in 3,500 supermarkets before the year ends. The company wants to capture at least 20% of the $1 billion in annual retail sales of specialty-coffee. Starbucks is first selling a House Blend, a Decaf House Blend, Colombia, Espresso Roast, and a French Roast. How well might this go over? Can you name a specialty coffee seller in grocery stores that you'd prefer? In our case, when we see Starbucks next to competitors on the shelf, we know what we'll be grabbing.

A new product also sold in grocery stores is Starbucks' frozen Frappuccino bars. These are tasty caffeine-enhanced popsicles for adults, although kids probably love them, too (just don't give them too many in one sitting). These sell well alongside the eight ice cream flavors that Starbucks offers, and the Caffe Almond Roast ice cream bars that it sells, too. And for the beer lovers in the audience, Starbucks is working with Redhook Brewery on a coffee-brewed Stout beer. For music lovers, it's working with Capitol Records on a Starbucks-branded Jazz CD. For food lovers (and who isn't?), a prototype Cafe Starbucks is being built. It'll serve eggs and pastries in the morning, sandwiches for lunch, and pastas, salads and entrees for dinner. The first Cafe Starbucks should open in mid-summer.

Oh, and wait. One more thing. This is hot off the press -- yet another new product. The company should soon introduce a new line of fruit juice and tea blended with ice, called Tiazzi Blended Juice Tea. The drink mixes the popularity of tea with fruit juice and adds "a twist of summer fun" (ice?).

If it has a zip code, it should have a Starbucks...

But that is far from all. Starbucks has formed coffee-selling alliances with several corporations, from Barnes & Noble, to Costco, to Nordstrom, to United and Canadian Airlines, to ITT/Sheraton and Westin Hotels, to Horizon. The list is sure to continue growing, as are the number of smaller, ultra-convenient Starbucks locations that you'll find around the world at airports, train stations, bookstores, hotels, and tourist attractions. And wait, there's more.

If your place of employment doesn't serve Starbucks coffee, you have justification to ask, "Why not? Don't we deserve the best?" Because Starbucks and its partners supply Starbucks coffee to corporate offices much like a catering service. You could be drinking a fresh cup of Starbucks every morning when you arrive at your Silicon Valley, Chicago, or New York office. Want to know how? Drop by your local Starbucks for a mailer. But wait. There's still more.

The company also sells coffee and related products through catalogs and online (the SBUX shop is already open on AOL, and soon on the Web). When you think about it, the Internet is the perfect medium for explaining the different nuances of various coffees. Like Amazon.com, it would behoove Starbucks to provide visitors with message boards to host conversations on different coffees of the world. Starbucks should build a community around its website and its different products. The Internet could eventually be a high-margin venue for Starbucks. The company does plan for a "much larger Internet presence." That's all the detail we know.

And, finally -- we promise, last one -- the company sells coffee pots and mugs and all the accessories you could hope for at its Starbucks locations. These are a relatively small part of revenues (7% of 1997's sales), but still a profitable part.

Considering all of that, won't the world get sick of Starbucks?

As for over-exposure, CEO Howard Schultz says, "I don't think we are cannibalizing ourselves as long as we continue to introduce and offer best-of-class products." If history means anything, he'll prove correct. Being conveniently placed around the world while offering superior products has yet to lead to disaster for any profitable company.

Admittedly, though, being "everywhere all the time" can present a challenge when it comes to remaining fresh in the minds of consumers. Coca-Cola defuses this problem by promoting its product as "Classic" -- it's everywhere and it never changes because it's a classic. It can't get any better. Meanwhile, McDonald's would be hard-pressed to call any of its food "classic," so that company is consistently running new promotions.

Starbucks falls between these two extremes. Certain blends of coffee will always be classics and will continuously sell well, but in order to portray an exciting image of constant renewal and to continue generating fresh interest, Starbucks needs to be adept at inventing new products and ways to sell them. The CEO states, "I believe the way to stay on top is to continually reinvent yourself, and that is exactly what Starbucks does with its brand and products."

Starbucks is a creative company (one that should probably break out its research and development numbers for the world to see!). Creativity has catapulted the company to "Best of Class" status in what it already does, while the future should continue to prove interesting. For certain, the Fool Port will share information about any new products or directions from Starbucks as they percolate, and we'll be tasting new products and writing about them, too.

International expansion...

Hopefully we'll also have the opportunity to write about our first cup of coffee at a Starbucks in Prague or Berlin in the near future.

On May 28, 1998, Starbucks announced that it and its licensees plan to open at least 350 locations in North America and 40 new locations in the Pacific Rim during fiscal 1998. (The company owns over 95% of its locations, but some are licensed and many international locations will be licensed.) Also, the company just acquired 61 locations in the U.K., and by 2003, Starbucks plans to have 500 locations throughout Europe and 500 locations in the Pacific Rim. Internationally, aside from the new U.K. stores, the company already has 40 new locations spread over the Philippines, Taiwan, and South Korea, as well as in Japan and Singapore.

Is the international expansion working? Does the rest of the adult world wake up every morning, send the kids to school, get in the car, buy a cup of coffee and drink it while traveling to work at 5 miles per hour in highway traffic? Well, in some parts of the world it might be difficult to drink coffee while travelling to work at 30 kilometers per hour on a bike (though Starbucks isn't in China yet), but our friends in international markets have certainly found the time to enjoy Starbucks. International sales hold as much promise as U.S. sales, if not more.

If you need to hear it firsthand, visit our Starbucks message board on the Web, where one Fool recently posted this:

Date: 6/14/98 4:16:27 AM (ET)

Living in Tokyo, I loaded up on SBUX purely for the
reason that the one in my building does so much
business it can probably support the entire company.
Kidding aside, the brand new one in the popular
Roppongi district is crowded all day.

Why is Starbucks receiving such a warm reception on the other side of the planet?

Many of the world's markets lack the quick service and consistent quality offered by a franchise like Starbucks. The ability to fill such a service gap is partially why McDonald's flourishes even in locations with people who generally frown upon its existence (Paris, Florence, Alexandria, VA). A culture might dislike the idea of a Yankee burger and fries, but the service and price is difficult to beat. McDonald's aside, coffee is much more a shared international experience than is Chicken McNuggets. Along with this inherent benefit, Starbucks goes largely uncontested in many international markets when it opens its friendly doors and offers numerous coffee products at reasonable prices.

With plans to open 1,000 locations in Europe and Asia over the next five years, while continuously adding locations in North America, Starbucks could nearly double its current 1,700 store count before the Fool reaches its 10th anniversary in the year 2004.

The competition...

We thought about following this sub-heading with nothing but white space -- empty, blank, nada. Then we thought better of it. We have more to say about competition in a following section about "Risks," so we will keep this section brief for that reason and for the very reason that, to date, Starbucks has been frothing the competition left and right. It's difficult to even determine the number two player behind our numero uno Coffee Guy.

Hoover's Online lists the top three competitors as Au Bon Pain, Nestle, and Southland. Ahem. Au Bon Pain we've patronized a few times. Decent croissants. Not quite the greatest purveyors of coffee. Nestle -- its Hills Brothers, Taster's Choice, and Nescafe products don't quite stack up to the beans that our guy is putting on the shelves. Next! Southland -- sorry, never heard of it. (Oh. Southland operates 7-11s across the country. Now that makes sense. Again, though, it ain't the King of Good Coffee.)

Other listed competitors are Brothers Gourmet Coffee, Burger King (woah, for coffee?), Dairy Queen, Procter & Gamble (Folgers), Green Mountain Coffee, and Farmers Brothers. Let's look at key players.

When considering the competition, you'd think that the retail coffee market was shrinking rather than growing...

First up -- Brothers Gourmet. The company is the leading seller of roasted specialty coffee in grocery stores, but it was spanked in its attempt to enter the retail cafe market (a la Starbucks) with its Gloria Jean's outlets. The company pulled the plug on that biz in 1995. In 1996, Brothers Gourmet formed partnerships with Continental Airlines and Hallmark Cards. That's about all the noise that we could find. Now Starbucks' entry in supermarket sales is threatening Brothers' shelf space and leadership. The company had sales of $70 million last year -- actually down 3.4% -- compared to Starbucks' total 12-month sales of $1.1 billion.

Next up is Green Mountain. It sells good coffee, but it too has begun to close stores in its already small retail chain -- sales last year totaled $47 million and $40 million of that was wholesale. The company appears destined to exit the retail business altogether. Third is Farmers Brothers. This spice, pudding, and coffee company sold $130 million worth of coffee to restaurants, hotels, convenience stores, hospitals and fast-food outlets. Again, this company lacks a retail bar presence.

It's clear that Starbucks has the most warlike competition in the grocery store theatre of war, it's newest front. But even here there's no obvious number one player for Starbucks to attack. Even when you mention the big names of Folgers, Maxwell House, and Taster's Choice, it's difficult to determine which company, if any, is leading the high-end coffee market. Instead, there's a void of leadership that Starbucks -- already number one for specialty coffee sold by the cup -- can fill.

Meanwhile, on the retail outlet front there's decisively no number two. The few specialty coffee stores that were competing with Starbucks in some markets are, if not closing shop and heading for the mountains, not seeing sales growth -- in other words, they're losing market share (To whom? Heh?). The sturdiest cafe competition could be the mom and pop coffee shops that sprinkle every town across the world. If you're looking for a cozy warm feeling while you slurp your beans, these cafes are probably more your ticket. Enjoy! Though in aggregate these stores achieve substantial sales, in the end they're diluted competition, not a unified front.

Part Two: Financials, Criticism, and Risks