My colleague and I agree that Starbucks (NASDAQ:SBUX) shares are expensive, but judging by Rich's wording in his opening bear argument, he thinks Starbucks is due to fall by 40% or more. Comparing Starbucks' current valuation to the bubble valuations of General Electric (NYSE:GE) and Intel (NYSE:INTC) simply doesn't hold water, nor does a straight free cash flow valuation do Starbucks, or any fast-growing restaurant or retail concept, justice.
I'll tackle the bubble comparison first, because it requires less math and effort, and it's the effort Rich led with. The problem here is size. At the time that GE and Intel sported P/Es in the 40s, they were valued at more than $400 billion and more than $200 billion, respectively. Investors back in the bubble days were paying 40 times earnings for a behemoth like GE, which optimistically could only be expected to grow about 12% a year. That's a game investors always lose.
Today, Starbucks is valued at $22 billion, which is an order of magnitude smaller than GE or Intel, making it much easier to fathom that Starbucks can continue growing earnings at its stated goal of 20% to 25% year. Still, 20% to 25% growth doesn't justify a trailing P/E in the high 40s. The P/E is higher because there is another factor at work with Starbucks -- free cash flow. I'm certainly glad my colleague brought this up in his opening argument.
There are a number of ways to evaluate free cash flow. In his opening argument, Rich looked at the good old-fashioned textbook version of free cash flow, which is operating cash flow minus capital expenditures. On this measure, Starbucks doesn't look so hot. Having only delivered $334.1 million of free cash flow against $474.9 million in net income, Starbucks looks even more expensive on a free cash flow basis. But this method of looking at free cash flow doesn't go deep enough, because the costs of opening around 700 company-owned stores and more than 1,600 in total is included in those numbers.
Getting a little bit of perspective on the underlying free cash flow of the existing business requires separating out the capital expenditures that are for growth (new stores) from those that are for the existing stores (replacement fixtures). I've looked at quite a few fast-growing restaurants, and it's not uncommon for the growth capital expenditures to be as large as 70% or 80% of the total capital expenditures. Unfortunately, Starbucks doesn't provide this breakout in its annual filings, but looking at the trends in depreciation and in what its property, plant, and equipment is worth on the balance sheet, I think a pretty conservative estimate is that 60% of Starbucks' capital expenditures are for growth, and I wouldn't argue with numbers as high as 70%. Adjusting Starbucks' capital expenditures for 60% going toward growth delivers free cash flow of about $670 million, or a price-to-free cash flow ratio of 34.
There is one large note of caution in using this method. If you're backing out the growth capital expenditures, you also have to bring growth estimates way down, too, because removing the growth capital expenditures eliminates the fuel going into the business for growth. For Starbucks, this leaves only the growth that could be achieved by same-store sales and price increases. This method helps shine some light on why Starbucks is perpetually valued with a P/E of 35 to 50: There are gobs of cash flowing through this business, but the company is plowing it all into opening what appears to be as many stores as possible with cash still left over. You can see an even more pronounced example of this in play at BJ'sRestaurants (NASDAQ:BJRI) and Cheesecake Factory (NASDAQ:CAKE).
A price-to-free cash flow of 34 is still pretty rich, but I think my argument for why Starbucks starts getting attractive at prices 15% lower than where they are today should make a bit more sense now. My colleague's argument that the company is due for a GE- or Intel-like fall is a bit amusing to me, but I'd take that 50% to 75% hit to my long-term gains if the market were kind enough to offer me such an amazing opportunity for multibagger returns.
But, wait! You're not done. This is just a quarter of the Duel! Don't miss Rich's bearish beginning, the bullish view, and Rich's rebuttal. When you're done, you're still not done. You can vote and let us know who you think won this Duel.
Nathan Parmelee owns shares in Starbucks and has for quite some time. He has no financial stake in any of the other companies mentioned. The Motley Fool has an ironclad disclosure policy.
