Rule Breaker Portfolio

Fool To Buy SBUX, Part 2
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.**

Continued from Part One.

Financials & Valuation
It's like a train that's only accelerating, but could it derail?

Management at Starbucks is skilled. You can't look at the numbers since it came public in 1992 and conclude otherwise. The company was founded in 1971 as a specialty bean seller that sold coffee by the pound until 1987, when the current CEO acquired it. Inspired by Italian coffee bars, he began building retail locations. After at least three years of anticipated losses, the company's cash flow and earnings slowly began to build like Rockefeller's pocket change. In the last two years, even while opening hundreds of new stores, the company's annual net operating cash flow has topped $100 million. As a result, recently the company had over $150 million in cash and only $1 million in long-term debt.

Over the past three years, sales at Starbucks have grown from $465 million to $696 million to $966 million, up 39% last year from fiscal 1996. Net income grew 36% last year to $57.4 million.

Sales by category... 

The 1997 sales break out
as follows (from Hoover's):
                        1997 Sales
                        % of total
Coffee beverages                63
Food items                      16
Whole bean coffees              14
Coffee-related products          7
Total                          100


                         1997 Sales
                 $ mil.  % of total
Retail            828.1          86
Specialty sales   117.6          12
Direct mail        21.2           2
Total             966.9         100

Much of the company's sales growth is the result of increased retail locations. The company added 300 new stores during fiscal 1997. Sure, the existing stores are seeing annual increases in revenue of 5% to 7%, but new locations are responsible for a majority of the topline growth. Luckily, Starbucks has enough room for expansion in years ahead to keep its sales rising aggressively, while increases in specialty coffee sales (primarily to corporate accounts) are adding fuel as well, as will supermarket sales. Indeed, put it all together and 34% annual earnings growth per share is expected (by analysts -- who are often wrong) into 2003.

What's arguably more important for the long term, though, is the type of return that Starbucks is able to generate on the investments that it makes in itself. Even after 100 years of being a business, Coca-Cola is able to earn market-beating rates of return on the money that it invests back into its own enterprise. This simple fact is largely behind Coke's market-crushing price-to-earnings valuation. Likewise, if Starbucks can continually invest its capital into initiatives that grow at market-trouncing rates -- by investing in new stores, new distribution channels, and new products -- the market could continue to reward the company a relatively high valuation to earnings.

The business itself...

Investing isn't merely about earnings growth -- at all. It's about the dynamics of a business and the inherent risks involved. Coca-Cola is also granted a premium price because the risk of the company's business -- selling syrup -- is incredibly low, especially in relation to the return on investment that the company achieves. Though currently Starbucks faces more risks than Coca-Cola, its risks are still lower than most other companies, all of which are competing for investment dollars. If you're selling semiconductor stocks due to turmoil in Asia, where might you invest the money?

In Asia, Starbucks has seen record sales despite the currency crisis crippling much of the economy. Starbucks has the benefit of selling an inexpensive repeat-purchase product (the most popular in the world after water). New technology isn't going to displace it. Coffee has been enjoyed for centuries. The Venetians first introduced coffee to Europe in 1615. By 1632, coffee houses began to flourish throughout the continent, becoming centers of social activity. The popularity of the commodity has only increased since then. In the past three centuries, over 90% of all people living in the western world have switched from drinking primarily tea, to coffee. Coffee is even more likely to be a constant than is a sugary drink like Coca-Cola.

For now, suffice it to say that Starbucks is in a business with a long history, is financially strong, and is -- in North America -- the dominant niche player. Its ability to reinvest the cash that it generates back into its business (mainly, now, the international business) and achieve market-beating returns is, along with earnings growth, what will drive the stock price. While a lower risk factor can mean a valuation premium.

Margins, and that mysterious enigma called "fair value"...

Another major factor in how the stock will be valued in the future is the company's ability to grow profit margins. For the past three years, Starbucks has had gross margins of about 56%, operating margins of 9%, and profit margins of nearly 6%. Though this is far from horrible (and actually quite good for what it does), they could improve. Selling in grocery chains (without the overhead and fixed costs of leasing and staffing a store) could increase margins, as could more sales through catalogs and online. But even current retail sales are far from unprofitable. There's a joke that Barnes & Noble achieves its highest margin on the coffee that Starbucks sells in-house, rather than on books. This actually might be true.

As long as Starbucks operates its own locations, though, it will never see Coca-Cola type profit margins (23%), but it might -- given economies of scale, favorable coffee prices, and whatnot -- someday raise its profit margins north of 8%, a very respectable level. That such a young and rapidly expanding company already earns nearly 6% on each sales dollar makes one hopeful for an even more profitable future, especially considering that nearly all of the current sales are from retail outlets that Starbucks operates alone (shouldering all costs alone).

So what about the stock's valuation? The company currently trades at over 3.8 times sales, which isn't bad for a profitable, brand-leading retailer growing as quickly as Starbucks. For comparison, Coca-Cola, the ideal business, trades at 11 times sales. Starbucks trades at over 60 times earnings and 40 times earnings estimates for the year ending in September of 1999. The company is expected to grow earnings 33% next year, so the 40 multiple is a modest premium to the growth rate and to the long-term 34% growth rate anticipated. The YPEG values the stock at about $42 per share on earnings alone. The problem with the YPEG is that it doesn't consider brand name and market leadership, nor the risks involved (high or low), nor a company's ability to generate market-beating returns on the money that it generates and reinvests.

Many Fools probably think that Starbucks is overpriced -- and it very well might be. It trades at over 6 times the book value of $8.50 per share. However, being long-term investors, the current valuation is less important to us than what the valuation might be just two years from now. Sometimes you can foresee having to wait a few years before expecting a return. With Starbucks, based on projected earnings growth, we might begin to expect returns in as little as one year from September. Who knows. We aren't taking this position with anything less than a three to five year outlook. Over that period, we think that we have a good chance of beating the market with this investment.

If the company grows earnings 25% annually for the four years following 1999 (rather than 34% as projected), it could see over $3.00 in earnings per share in five year's time. The stock trades at about 15 times this more "conservative" estimate. Give Starbucks a 30 P/E multiple (a 5 point premium above the 25% growth rate) and we have a stock that would double in five year's time. That would almost certainly beat ye old market. But this is guesswork. What matters long term is the business and its ability to grow, and we like the prospects.

Criticisms? Yep, at Least One
The company's conference call policy could be substantially warmer

There is at least one thing that needs to change if the Fool is going to remain a happy investor in Starbucks for years to come. Namely, the company's conference call policy. Investor's Business Daily reported over a year ago that Starbucks doesn't allow individual investors to listen to its conference calls -- it's analysts only. How come? Because, according to management, "Individual investors can't understand its business." We find that humorous.

Individual investors are able to understand the business of Intel, a semiconductor maker, but can't quite grasp that of a coffee retailer? Okay. If we can't understand the business, though, isn't that all the more reason to allow us to hear the conference call, so that we -- loyal shareholders -- can begin to understand the difficult, complicated world of coffee, and thus become even better shareholders?

This is an issue that we'll address most effectively as shareholders. Amazon.com, being a new company, didn't have a system in place for individual investors regarding its conference calls either, but beginning next quarter it will at least offer a replay number. We're certain that Starbucks can improve its policy as well.

The Risks
Retail stocks can be taxing investments: same-store sales growth is important, consumer tastes change, coffee prices fluctuate, the valuation granted SBUX is generous and, finally, the earth might spin off its axis...

In the end,no matter what Starbucks is selling or how good it smells, the stock represents a retail business, and retail often makes for a tough investment.

There are some stand-out companies in this industry over the past decade or two (Home Depot, Gap, Starbucks, McDonald's, Sears), but for every restaurant or retailer that flourishes, ten or more languish for longer than a deadbeat relative with nowhere to go. The industry is difficult because consumer tastes can be fickle and competition is, or eventually becomes, intense. As a result, retail businesses are typically low margin. Every time you hear the cash register ring in the checkout lane, the company is usually only making a few pennies on each dollar spent.

That said, being a lower-margin business isn't horrible as long as inventory turnover is steady and high. It's the amount of dollars that a company brings to the bottom line that truly matters. Plus, Starbucks has better profit margins than many retail outlets, and they stand to continue improving as the company reaches greater efficiencies of scale and increasingly diversifies revenue streams. The majority of its sales will derive from retail stores, though, and as the company adds 1000 locations or more by the year 2003, this will become increasingly true.

Sales growth at both new and old stores...

This brings us to the "same-store sales" risk. When unfavorable, the same-store sales results for any given period (and Starbucks reports these every month) can send a retail stock down faster than a cowboy who loses his horse. Investors get nervous when sales slow at stores that have been in operation for one year or longer because it means slowing profits -- at least eventually. Even if a company is adding dozens of new locations per month, if sales at older locations are slowing, investors perceive a flashing red warning light and eject from the cockpit. Even if the plane doesn't hit the ground, it will take time to stabilize and finally begin to climb again. Perhaps years.

To date, Starbucks has seen same-store sales increase 5% to 7% year-over-year at locations that have been open one year or longer. This strong performance is the result of new products, increased market share, some pricing power, and lower coffee prices -- over certain time periods. In order for Starbucks to continue growing same-store sales, it will need to continue to offer new drinks and get more and more customers in the door. As addressed, the company's CEO believes that Starbucks needs to continually reinvent itself, so new drinks and products are always in the making.

This is important not only for same-store sales growth, but for sales growth overall, which represents another risk. Sales and earnings growth are risk factors that we can cover with three simple points: 1) Both growth rates will slow as the company matures, and even earnings growth of 34% annually for the next five years, as analysts project, sounds mighty aggressive to us. 2) We'll accept it if Starbucks can grow earnings per share only 20% annually a few years from now, but how well will the market accept it? 3) The company has years worth of expansion remaining, but eventually growth from new location openings will slow and it will be up to management to keep sales rising with a more constant number of stores.

Those risks considered, we do think that Starbucks is in a good position to become the McDonald's of coffee -- and if it does, it could mean years of market-beating performance even as it slows domestic retail openings.

One final point to make before we move on: Starbucks has found that putting stores closer together leads to greater efficiency in operating costs as well as in advertising returns -- much like McDonald's. In the right cities, numerous locations benefit the company rather than cannibalizing sales -- though of course a new location a few blocks from an existing one will steal sales from the older store. This could lower same-store sales results in certain areas. This type of business approach needs to be considered when same-store sales numbers are reported, though it won't be. Chalk this potential risk up to "the market's lack of understanding."

Coffee ain't free, even to Starbucks...

Coffee bean prices are a less controllable factor. If bean prices rise substantially, Starbucks will need to pass the costs onto consumers and more expensive prices could lower sales. And if bean prices rise only moderately, Starbucks might keep prices for the consumer steady, but this would eat into profit margins. The price of coffee is arguably one of the largest, least predictable risks that we face. If the volatile country of Colombia burns to the ground or is bought by Disney and turned into Disney South America, coffee prices will soar. As a matter of fact, Farmers Brothers had flat sales last year because storms (El Nino again, of all things) damaged crops and increased coffee prices.

Being long-term investors mitigates some of the short-term price fluctuations that we'll face with this commodity product, but face them we will. Brazil and Colombia produce nearly 50% of the world's coffee and prices do fluctuate. Coffee is the number two commodity in the world, second only to petroleum.

Coffee, though sold in vacuum packs, isn't sold in a vacuum...

Eventually we have to believe that more serious competition will cause Starbucks to sweat -- at least a little. In grocery stores, Starbucks coffee is up against several leading brands (Maxwell House, Folgers, etc), and on the retail outlet front competition could eventually increase (Virgin Coffee? Why not?) and possibly drive margins lower in the process. It won't be easy, though. Starbucks has the early lead and advantages similar to those that McDonald's has had for years, and any potential competitors have already seen other companies attempt and fail (as discussed in the section on competitors). What Starbucks is building isn't something that's easily toppled by anyone at this point, at least not in current markets.

But whether it be Brothers Gourmet Coffee, Green Mountain, Dunkin Donuts, or what have you, there will be other companies that will and do compete with Starbucks. In the end, coffee is a fairly easily duplicated product -- though many Fools argue that Starbucks makes the best mocha, or iced coffees, or teas, and so forth. But tell that to the Italians. Italy has over 200,000 coffee bars already. It'll be interesting to see how Starbucks is accepted in that country. Generally, young Italians like American "items," but... we'll see.

Valuation risks: How would you price 2,000 small green stores that sell beans in a cup?

Investors place high valuation premiums on brand-name industry leaders, especially those on the consumer level. Coca-Cola, McDonald's, Pepsi, Starbucks -- all of these usually trade at premiums to their respective growth rates. Starbucks, being the youngest and fastest growing of the bunch, trades at more of a premium than these others (well, except for Coca-Cola, which is a high-margin monster). The type of valuation that Starbucks is granted in the future will depend on how quickly it can continue to grow and how same-store sales performance is viewed by the market. As discussed, the stock trades at over 60 times earnings and about 40 times 1999 estimates.

That's actually not much above the 33% earnings per share growth expected in 1999. But it's still a high multiple for a retailer, and expectations of 34% earnings growth for the coming years is built into the stock price. Yet, current market conditions involve low interest rates inflating the P/Es of premium companies, and given this, we still feel we're getting a good deal. If Starbucks can execute, by 2000 we could have a stock trading at a multiple below its growth rate with ensuing appreciation essentially on par with earnings growth. ($52 divided by $1.64 EPS in 2000 = 31 P/E). That should be market-beating growth going forward, we're hoping -- but the risks at this valuation and in how the market will value Starbucks long term are very present and very unpredictable.

The great unknowns... and a final warning...

Last but not least, Starbucks is soon trying a Cafe Starbucks concept in one test market. While it's great that the company tests concepts before diving in, there is still the possibility that the test goes well but the eventual concept fails -- and fails big. Any new market is an unknown. Let's clump in here the real estate market as well. Because Starbucks leases its locations, it is at the whim of real estate rental prices, even if leases are long term to begin with. A final unknown is wage costs. With thousands of lower-wage employees, national minimum wage adjustments could impact Starbucks.

As always, you should only invest in individual stocks if you have a diversified portfolio. Please read the 13 Steps to Investing Foolishly if you're new to the Fool. For us, Starbucks will represent only 5% of the Fool Portfolio's total value when we take our $13,000 position. If it goes to zero, we'll share a good laugh, learn some lessons, and have a whopper of a story to tell the grandkids.

Conclusion
Nobody here is claiming to be an "early genius" for finding this one

The market's treatment of this stock proves that we're not early to the ballgame. We've arrived, perhaps, in the top of the third inning and the Braves are already ahead by seven. The valuation granted Starbucks proves that the market recognizes its dominant position and its potential. The stock trades at a premium, but for many reasons. As long as the business performs, the stock will probably continue to trade at a premium price and will continue to look expensive relative to the market. Our only hope is that we can beat the S&P 500 with Starbucks. We invest in individual stocks with this purpose, and as we're getting the money for this investment from the sale of our S&P 500 shares, the desire to beat the S&P is even stronger than usual.

Starbucks is expected to grow earnings 34% annually for the next five years. It has grown earnings 46% annually for the past five years. 34% is over three times the average return of the S&P this century (11%). If Starbucks can grow earnings just 22% per year over the next, say, seven years, and the stock price mirrors 2/3rds of that growth, we'll have a handy market-beater on our hands. But the stock is trading at a premium price and in order to keep this sort of valuation management needs to continue to perform. Same-store sales results in the coming years might represent just one needle that could pop this balloon.

This report has outlined both the potential and the risks. It's not meant to persuade anyone to buy shares, or not buy them, but instead it's meant to show how a few Fools might find a stock, analyze it, and then decide whether or not to invest. In our case, we've decided to put 5% of the portfolio into this idea. In many cases, investors might decide the stock is too pricey. Or they might not like coffee to begin with. Foolishness is about making your own decisions. We use the Foolish community around us as a resource -- that's how we found Iomega -- but the decisions made are always our own.

To close, we'd be foolin' ya if we didn't admit that we like the Starbucks name for its literary connotations. Being book lovers (and early Amazon.com investors), we love that Starbucks is reportedly named after a character in the immortal Moby Dick. This seems appropriate, seeing how coffee and books go so well together. Maybe Amazon.com and the coming Starbucks.com can strike a deal. Of course, there is that current Barnes & Noble/Starbucks relationship in the way... shucks!

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