No Coffee Break Here

I just finished listening to Starbucks' (NASDAQ:SBUX) latest earnings release conference call, for the second time. I don't plan to dwell here on the details of the second-quarter sales and earnings results; fellow contributor Jeff Hwang has already covered them in his usual thorough and insightful manner. It's enough here to say they were splendid. What I was struck by is the potential that still lies ahead of this seemingly unstoppable brand.

Now, hold on, I'll get to the brand in a moment. But with all the angst in the market over whether the company's shares are overvalued or undervalued, it might be worthwhile to take a minute to review why the stock has been under pressure in recent months. It all has to do with growth.

First, comparable-store sales are slowing. Technically true, and it didn't help the company's cause much for it to declare in the 2004 annual report that management believes last year's comps of 10% are not sustainable over the long term. But what multi-unit operator, restaurant or retail, can expect to sustain double-digit comps over the long haul?

Starbucks' second-quarter comps of 7% were very much in line with what the company delivered from 2000 through 2003 -- numbers that ranged annually between a low of 6% and a high of 9%. Last year was exceptional, partially helped by a price increase. The company reaffirmed last Wednesday that it expects full-year 2005 comparable sales to be at or above the high end of its previous 3% to 7% guidance.

Second, there's new-store growth, both from a quantity and a quality perspective. Starbucks ended the second quarter with 9,261 stores worldwide, including company-operated and licensed locations. Management's stated goal of a full build-out is 30,000 stores. Without being an insider, it is difficult to judge how reasonable this number is. The only comparable company I know of is McDonald's (NYSE:MCD), which ended 2004 with 30,496 stores and continues to grow, albeit slowly. Let's call this one an unknown quantity, with the caveat that whether the final number is 25,000 or 35,000, Starbucks clearly has several years left to grow new stores at a very rapid pace.

Where to go?
Frankly, I've had more worries about the quality side of new stores. Are the best locations already taken? Will future new stores be in secondary locations that open at lower volumes and won't deliver the stellar margins the company is famous for? Again, something of an unknown for an outsider, but management gave us a clue on the call, when it stated that domestic new stores are opening at higher volumes than in the past. And we should also note that the international segment during the second quarter more than doubled profitability on a revenue increase of just over 30%. The company is leveraging its international investment, and with international second-quarter operating income at 7.2%, less than half of the U.S. level of 15.4%, there is a lot yet for the company to do.

All this leads me to brand extension. The company is expanding its food offerings, with about 35% of U.S. stores offering a lunch menu. Management mentioned on the call that it believes this could grow to as high as 70%. Starbucks continues to expand food service and license products revenue, opening Seattle's Best licensed locations in BordersGroup (NYSE:BGP) stores, and selling Seattle's Best coffee to McDonald's restaurants on the West Coast. As Alyce Lomax reported a few weeks ago, Starbucks is buying the Ethos bottled water company.

The company is moving further into music with the opening of a Hear Music Coffeehouse in Santa Monica, Calif., and the launch of the Hear Music XM Satellite radio channel. Not to mention the collaboration on a Ray Charles CD that reached No. 1 on the R&B charts and sold more in Starbucks stores than in any other retail outlet. Billboard magazine just listed Starbucks as one of the 10 power players in the music industry. The list goes on and on.

About the price
I wonder whether Starbucks has even begun to tap its brand extension potential in the United States, forgetting for now where this might lead it worldwide. On the call, Howard Schultz, Starbucks' chairman and chief global strategist, described the company as a "borderless community." I used to think Wal-Mart (NYSE:WMT) had a highly extendable brand, but on further consideration, I'm becoming convinced that it's hard to extend a brand that stands for low prices. But Starbucks stands for quality and a cozy, inviting atmosphere. As they say in Arkansas, "This dog can hunt."

I don't want to get into a dueling discussion about the multiple that Starbucks is trading at. The market looks pretty choppy, Starbucks is trading at about 46 times trailing 12-month earnings, and in this environment, high-multiple companies can be at risk. No doubt the stock could pull back further, and market timers are waiting for Starbucks to bottom out. Fortunately, The Motley Fool encourages its writers to say what they think. I wrote a week ago that I thought $45 was the right price to buy in. Permit me to update that -- today, I think Starbucks, at 25% off its December high, is a gift.

Coffee lovers may want to indulge their passion at:

• Should You Still Hold Starbucks?
• Starbucks' Coffeehouse Rock
• XM's Subscriber Boom

Starbucks has been breaking all the rules since the day it started. David Gardner's searching for other companies with similar characteristics in his Motley Fool Rule Breakers newsletter. Find out how you can profit from innovative companies by checking out Rule Breakers free for 30 days.

Fool contributor Timothy M. Otte owns stock in Wal-Mart but in none of the other companies mentioned in this article. The Motley Fool is investors writing for investors.