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Thursday, August 03, 2006

Starbucks Revisited

By William Trent, CFA of Stock Market Beat

In what became one of our most popular posts, we compared Starbucks to McDonalds and concluded that the comparison suggested a 10-year average return of approximately 8.5%. That could be good or bad, depending on your outlook for other investment opportunities.

Since that was nine points ago, the valuation looks a little more reasonable today. Instead of an 8.5% return, investors can expect 9.5% (assuming that the long-term forecast is correct.) Our assumptions to reach this expected return are:

To round off, we will assume the company can open 2,000 new stores annually in order to reach 30,000 stores in approximately 10 years. Taking just the simple McDonald’s comparison, SBUX should be able to grow its enterprise value from $29 billion today to $49 billion in 10 years. That gives an uninspiring 5.5% growth rate over those 10 years.

However, as we pointed out, SBUX is more efficient than MCD, which is reflected in a 20.8% ROE for SBUX compared to 17.7% for MCD. And MCD has debt funding which boosts its ROE. As growth slows at SBUX it too could add some debt to its mix to generate better returns for equity holders. But at any rate, the 3 per cent differential in ROE says that SBUX should be more valuable than MCD when it finally tops out. Looking up the fundamental P/E calculation on p. 192 of Analysis of Equity Investments: Valuation, we can get a good starting point. If we adjust the payout ratio to give us the same implied growth rate and required return for Starbucks as we currently have for MCD, we find that SBUX would deserve a 23.2x P/E multiple rather than the 17.3x that MCD has today. And assuming further that SBUX achieves the same debt/equity mix it could justify a $66.5 billion enterprise value. If we get there the average annual return would be more like 8.5 per cent, which is a good deal better but still may not justify the price now unless one is willing to bet that SBUX can, indeed, grow to a larger size than McDonalds (or if one assumes the average return on other investments will be less than that.)

Furthermore, as Starbucks pointed out in their conference call (and Barry Ritholtz provided the photographic evidence shown above) part of the reason for their poor same-store sales growth was that there were too many customers waiting for the icy blended drinks like Frappuchinos that take longer to prepare.

In fact, during our Spring and Summer 2006 promotional periods, we introduced a number of new and exciting blended beverage offerings which have been very well received. In light of the increasing demand for our blended beverages, we have recognized the opportunity to refine and improve our Cold Beverage Station to make drink preparation more efficient and improve service over time but, in retrospect, we did not move aggressively enough.

Currently, we have deployed the Cold Beverage Station to 1,070 locations — about 18% of our company-operated locations in the U.S. and Canada. This is one example of how we are beginning to make progress toward increasing service efficiencies in this category.

What is key here is that blended beverage sales are showing strong growth, but we are experiencing the softest overall comparable transaction growth in stores with the highest blended sales. Because of this, we believe we are losing some espresso business due to longer than normal wait times, in both cafes and drive-thru’s during peak morning hours.

It is also possible that we are not maximizing the blended beverage business due to this capacity constraint.

We believe that our July comparable store sales growth is under pressure because we are challenged to meet customer demand for our Frappuccino beverages.

Now call us crazy, but we think lines around the block are a high class problem to have. It is also a problem that can be rectified next year by little more effort than putting an extra blender or two in each store. So while investors bemoan “weak” same store sales growth of 4% (ask most other retailers how weak that is) and send the shares down 10%, we are starting to smell a buying opportunity.

The author may hold a position in the securities discussed.

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