Starbucks: Value or Value Trap?

There's been a lot of talk about Starbucks (Nasdaq: SBUX) being a value stock, but I'm not so sure that's true.

The arguments frequently made by Starbucks bulls are, more or less:

• Starbucks' historical P/E average is around 50 times -- at 20 times, it's a steal!
• Starbucks has very little long-term debt, so it's well positioned to survive a down market.
• Starbucks' coffee is immune to macroeconomic factors -- it's an affordable luxury.
• Howard Schultz will save the day!

Unfortunately, each of these statements has flaws. One by one ...

If you liked me at 50 times ...
In 2006, Starbucks' average P/E ratio was about 50 -- today it's less than half of that. If Starbucks could only convince the market it's worth 50 times its earnings again, it would be an easy double at current prices.

In my mind, however, Starbucks deserves its current valuation, and I think it'll have a hard time regaining its former glory as a go-go growth stock.

Back in 2006, the market still believed that Starbucks could deliver outsized earnings growth, rendering its lofty valuation reasonable over the long run. Fast-forward two years, and the situation looks a lot grimmer.

For one, Starbucks has lost most of its competitive advantages. In coffee quality, competitors such as Dunkin' Donuts, McDonald's (NYSE: MCD), Panera Bread (Nasdaq: PNRA), and even local coffee houses have ramped up their quality and selection -- often at lower prices. Green Mountain Coffee Roasters (Nasdaq: GMCR) has even shown that quality coffee can be made one cup at a time, thus reducing the need to go out for a caffeine jolt.

In terms of the "third place" atmosphere, Starbucks' rapid store expansion left many newer stores feeling "sterile" (Howard Schultz's words, not mine) and a bit more like caffeine-refueling stations. The couches, sizeable tables, and fireplaces that gave the original Starbucks stores a homey feel are gone. Moreover, with about 4,000 licensed Starbucks stores in places like Target (NYSE: TGT) and Safeway (NYSE: SWY) grocery stores, a consistent Starbucks service experience is harder to come by.

So with the combination of increased competition, indistinct products, and uninspired stores, it's difficult to see Starbucks' competitive advantage on those fronts. Without growth potential or a wide moat, there's little chance that the market will give Starbucks shares a high price tag.

What you see is what you get
For nine years, the company avoided significant long-term debt, but Starbucks now has $550 million of it on the books. According to the 2007 annual report, proceeds of the 6.25% senior notes due in 2017 "were primarily used to repay short-term borrowings and fund additional share repurchases."

But a quick look at Starbucks' cash flow statement shows that the company generated nearly $400 million in free cash flow for the year -- its eighth consecutive year of positive free cash flow. Why, then, with all that extra cash, did Starbucks need to issue long-term debt to repay short-term borrowings (which in itself sounds questionable)?

For the answer, we need to look off the balance sheet and turn to the report's footnotes, particularly its operating lease liabilities:

Starbucks' stores are accounted for as operating leases, which, to make a long story short, means they are rented, not owned. As such, they are kept off the balance sheet, and they don't always give investors a clear picture of the company's true debt exposure.

To get a better idea of the true debt picture, we can value these lease commitments using Starbucks' pre-tax cost of borrowing (6.25%). What we find is a bit unnerving -- an additional $3.8 billion non-cancelable debt liability.

So much for the argument that Starbucks has little debt exposure ...

Cut back on the lattes
Personal finance gurus frequently recommend that their readers cut back on expensive daily coffee drinks to save money. In the past, this didn't hurt Starbucks that much, because most of the stores were in wealthy suburban and urban communities, where a $5 latte didn't exactly break the bank for yuppie consumers.

Today, however, Starbucks' U.S. stores stretch across the country, at interstate rest stops and inside discount retailers. This has increased the company's exposure to American consumers, who will need to find cheaper alternatives for their morning joe if the economy goes sour. We saw this phenomenon last month, when domestic same-store sales declined 1%. In other words, macroeconomics now matter.

The company's saving grace at the moment is its foreign operations, where it generates nearly 20% of its revenue -- but even those posted only 5% same-store sales growth in February. Despite the sluggish international sales growth, Starbucks plans to open 975 new international stores in 2008, which should keep companywide sales treading water for the year.

But how long will that last? Foreign competitors will eventually catch on there, too, if Starbucks proves successful. Barriers to entry in the coffee-retailing industry aren't very high, after all.

Save us, Howard!
Starbucks is a well-known brand name, but the things it should be known for -- a symbol of status, and a great cup of coffee -- is a bit weak these days. That's what returning founder and CEO Howard Schultz plans to change -- and what Starbucks bulls are banking on.

The thing is, Schultz never really stepped away from the company. He's always been the chairman of the board, and he served as the chief global strategist from 2000 to 2005, so it's hard to argue that he had no hand in shaping Starbucks' current state.

As CEO once again, however, Schultz is charged with cleaning up the mess he helped create. In this role, he needs to focus on improving coffee quality, store experience, and, above all, differentiate Starbucks products from competitors.

This will be a challenging task and one that investors would be wise to consider fully before taking a leap into Starbucks shares.

But, hey, this is just one opinion. Consider related Foolishness for more information:

• Dueling Fools: Starbucks
• Starbucks for a Buck?
• Keep an Eye on Starbucks