Considerations for Starbucks as a Long-Term Hold

Starbuck’s shares have been under immense pressure the past few months as the stock has fallen to $26 from the $37 level seen back in January making the stock more attractive on a long-term hold basis. I would be compelled if SBUX share price fell to the low 20’s, but at around $26 shares still offer some value. My Discounted cash flow valuation Models suggest a $35 fair value assuming: 18% sales growth for the next five years and 13% average growth for the next ten years as revenue growth decelerates to a normal long-term rate of 3%. Margins should remain stable with a slght decline in later years. We can make forecasts with some relative degree of confidence given Starbucks’ consistent growth record, strong competitive position, and market potential.

I do not expect any significant catalysts to move the stock in the near-term, but operating with the assumption that markets are efficient in the long-run, SBUX should eventually rise to its intrinsic value. The recent disappointing news really only impacts the short-term picture. Starbucks’ dominance and brand strength should limit competitive pressures as it grows revenue through increased market penetration. Starbucks should be able to generate strong levels of cash flow for a long time period, and cash flows will increase from growth and the eventual decline in required capital investment. I believe Buffett would say that Starbucks has a wide competitive “moat.” As shares represent a reasonable value at $26, any further decline will boost the margin of safety and make SBUX worth considering even more.

Competitive Position:
Coffee, it’s a bean that comes from the ground. Pretty simple. Most every restaurant sells it. Yet, Starbucks is able to sell coffee to more customers at even a higher price. The price premium that the brand commands is direct evidence of the firm’s competitive advantage. Consumers perceive real value in Starbucks’ offerings which is very difficult for competitors to duplicate. People are never going to quit drinking coffee; it’s a daily routine for most people. Additionally, caffeine is addictive according to health experts. When you take a product that a significant portion of the population consume on a frequent basis that they may even be addicted to, you have a very sustainable business. Starbucks’ has superior customer service and product consistency which gives customers confidence that their expectations will be met. In other words, consumers know what they are getting as opposed to other outlets with less product familiarity and consistency. Starbucks has already captured many premium locations as well as surrounding locations that provide convenience leaving little potential for entry by competitors. Current competitors pose a mild threat to eroding Starbucks’ strong consumer base due to already engrained habits. McDonald’s offers premium coffee which has received higher ratings in surveys, yet that doesn’t change the fact that it’s still McDonald’s. MCD has a reputation for mediocre service and product inconsistency and lacks the product breadth of Starbucks. The Starbucks’ brand appears to be much more than just coffee, and this brand strength will assuage risks as the firm continues to grow.

Growth Potential:
Revenue and earnings have grown at roughly 25% annually for the past five years, and should continue at an above-average rate given Starbucks’ competitive position and already proven record. Management is expecting 18% top-line annual growth and 20-22% in the bottom-line for the next several years. Domestic same-store sales have been stabilizing at around 4%, with transactions accounting for 1%. Internationally, same-store sales increased 7% for Q3 driven by 5% transaction growth. International comparable sales growth has been north of 5% every quarter.

Starbucks had 14,396 stores at the end of Q3 and management believes they can ultimately hit 40,000 total stores. International expansion is the key factor in the firm’s long-term growth ability. At the end of Q3, SBUX had 4,000 stores outside the U.S., and the company believes it can achieve 20,000 locations abroad meaning that projected expansion is only 20%. Domestically, SBUX feels it can double in size of its current business.

Valuation:
At $26, SBUX trades at 30x current year estimated EPS of $.87 (Dec 2007) and 25x next year’s $1.06 estimate. That is not exactly cheap, yet analysts are forecasting 5 year annual growth of 22% justifying the high P/E multiple. Aside from just prospective growth, SBUX deserves a higher multiple due to its high return on invested capital. Two primary drivers of ROIC are profit margin and asset utilization: Remaining profit from a $ of sales and the amount of assets needed to generate that $ of sales. Starbucks’ margins have been healthy and trending upward the past 10 years. Brand strength should continue to support pricing power and cost efficiencies will continue to increase from scale benefits spreading fixed costs over a larger revenue base. Requirements for capital asset investment should decline from decelerating growth and because capital investments are made “up front.” Starbucks’ asset utilization (sales/total assets) has trended upward the past ten years along with ROA doubling from 7% to 14% and ROE increasing from 11% to 26%. Each dollar of fixed assets generate $3.50 in sales- very impressive given McDonald’s FA turnover is 1.0x and Panera Bread’s is 2.4x.

Summary:
Starbucks possesses one of the most valuable brands in existence and operates in a space where consumers are habitual users less subject to swings in macro-economic conditions. Starbucks generates healthy operating cash flow but free cash flow is paltry due to the capital expenditures required to support robust growth. When growth normalizes 12-15 years down the road, OCF will be substantial and without capital expenditure needs OCF will roughly equal FCF. SBUX’s price decline is warranted in part, yet it’s likely that the decline has been too drastic. Considering the overall long-term picture, SBUX is not a bad choice at current levels, but any continued pessimism pushing SBUX would make for a great buying opportunity.