We've written a great deal about Starbucks
I did so with a bit of nervousness. I had seen a Starbucks, but I was not a coffee drinker at the time, and I worried about competition. I didn't grow up with KrispyKreme
Everything about Starbucks from seven years ago remains true today. Just, well, larger. Starbucks is still growing like gangbusters, carries negligible debt, funds expansion from cash flow (more on this below), and trades at a premium P/E. The only exception now versus when I bought my shares in 1998 is that the P/E was in the 30s instead of the 50s.
All good things come to an end eventually. The question for today is: Given Starbucks' valuation and growth prospects, is that time soon or perhaps now?
The strong get stronger.
There have been a few small changes at Starbucks the last few years that are worth noting. Last year was a subtle but important turning point for the purveyor of all things coffee. In recent years the company had large capital expenditures, not only for opening stores but also for building out an infrastructure to support future store openings. According to the company's filings, the bulk of this investment is complete and the business is seeing increased profitability, or economies of scale if you want to be fancy. A quick look at a few important ratios confirms this with improvement in operating margins and net margins.
Starbucks' 2002-2004 ROE, ROA, & Margins
|Return on Equity||17.11%||14.07%||13.15%|
|Return on Assets||12.90%||10.90%||10.50%|
More interesting to me than the margin improvement is the increasing return on equity. With so much money over the years being poured into assets, such as the aforementioned store openings and infrastructure, the return on equity was always double-digit good, but not knock-your-socks-off impressive. To peer a little bit deeper and see what is driving the improvement in ROE I used a method for decomposing ROE highlighted by Bill Mann last year.
Starbucks' ROE Composition
|Op Profit Margin||0.12||0.10||0.10|
|Interest Expense Rate||0.00||0.00||0.00|
|Tax Retention Rate||0.63||0.61||0.63|
With ROE broken down into its components it becomes more clear that asset turnover and operating margin improvements are driving the improvement in ROE. The Return on Assets calculation in the first table is another confirming data point. To wrap up, if you're curious about the calculations used to break ROE into its components please refer to Bill's commentary here or shoot me an e-mail using the link at the end of this commentary.
Finally, let's not overlook the value of the prepaid value cards floating around. They don't count as revenue until used, but the money is much like float in that the cash comes in earlier than it needs to be paid out -- if ever.Almost time to pay up
About a year ago Mathew Emmert wrote a great two-part series on companies that can and should start paying out dividends. With almost $1 billion in liquid investments, you can make a case that Starbucks should start to pay out a dividend. However, the company does have certain obligations that it is responsible for and needs to meet minimum liquidity levels to remain in compliance. That said, I think Starbucks is nearing the point where total new store openings will level off a bit. Add this leveling-off to the improving margins, and the free cash flow generation should really start to pick up. This is pure speculation on my part, but with so much cash coming in I would be surprised if Starbucks did not begin paying some form of a dividend in the next three to five years.
A look at valuation -- is it time to sell?
Normally, I like to use the enterprise value-to-free cash flow method of valuing companies. By estimating future operating cash flow over a period of years and backing out estimates of capital expenditures this provides a fairly clear picture of a company's earnings capability. But for fast-growing retailers or restaurants like Starbucks, free cash flow calculations like this can often be disappointing because all of the store growth shows up in the capital expenditures and eats up the would-be free cash flow.
For some companies you can get slightly more fancy and take a look at just expansion capital expenditures, but Starbucks does not provide such a split, so instead I'll turn to a more traditional tool: the P/E ratio. Taking special charges into account (if any), the first thing I check for is whether the P/E is substantially above its historical range or its growth rate. In Starbucks' case the P/E is at the top end of its historical range, which also puts it above its growth rate.
Then I do a similar exercise comparing the ROE to the P/E. Generally if you can find an investment with a growth rate and ROE that are greater than the P/E you have an interesting candidate. In Starbucks' case the ROE is quite less than the P/E and the growth rate, but it is improving, and an ROE of 17% with almost no leverage is very good.
So, is Starbucks a sell? Not at these levels, unless you have such a large portion of your portfolio in Starbucks that it troubles you. Otherwise, I consider Starbucks a hold. The company still has a long way to go in store growth, and it seems that operationally the company could slowly continue to improve from here as well. In short there is much to look forward to, and if prices were to dip under $45, I'd consider adding to my position.
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