Friday, August 1, 2008

Starbucks Looks Cheap - Part I

Occasionally, we have guest authors contribute to this blog. The following post was written by Amit Sahasrabudhe, B.A.Sc, MBA. Amit is a Management Consultant at Deloitte.

Starbucks (Nasdaq: SBUX) is probably not the first company that comes to mind when thinking of a value play. As discussed here, small-caps usually offer the best opportunities when it comes to finding stocks trading at discounts to their intrinsic values. With a market cap north of $11B and a large analyst following, one could argue that for Starbucks there is little room for market inefficiency. However, the recent challenges facing Starbucks in today’s weakened economy have likely caused its share price to be unjustifiably over-punished by the markets.

Starbucks has shown an average annual growth in revenues and operating income of 23% and 26%, respectively, since 2003. Meanwhile, over the past year, its stock price has been beaten down from $40 to $15. This relentless fall is usually attributed to its recent challenges: rising food costs, over-saturation of US markets, and new competitors such as McDonald’s and Dunkin’ Donuts entering the premium coffee market.

The harmful effects inflation has on companies is discussed here. For Starbucks, rising prices of milk and other commodities is an issue, but an issue for competitors as well. In a free market, I would expect supply to increase as a result of higher prices, and therefore these high input costs would subside in the long-term eliminating this issue altogether. In the case that high costs sustain for an extended period of time, Starbucks will be forced to find ways to make their menus more cost-effective.

Over-saturation of the US market can be seen with the recent announced closing of up to 600 domestic stores (due to cannibalization of existing store sales). While this news has not had a positive effect on Starbucks’ share price, it is good to see this rationalization taking place sooner than later. With Howard Schultz back in the driver’s seat, he is quickly identifying recently-opened stores that are not making sufficient returns on its invested capital, and therefore not creating long-term shareholder value. Instead, he is redirecting investments towards Starbucks’ growth potential abroad, since only 30% of its current store portfolio is international. Meanwhile, Schultz’s domestic focus will be to increase same-store sales through bringing back the customer experience that has been lost in recent years.

As for the competition, McDonald’s seems to be the current major threat to Starbucks. There is plenty of debate on which coffee tastes better between the two. At the end of the day, I don’t think it matters. What matters is which company has the stronger brand that draws more people to it. McDonald’s will always have customers eating their burgers and breakfast meals. I doubt many people will want to go to McDonald’s solely to have a latte while studying, reading a book, on a date, or on the way to work. At best, better coffee will make McDonald’s a better place to have breakfast. I just don’t see McDonald’s and Starbucks playing in the same ballgame when it comes to the demographic of customers it attracts.

As a result, I see all these challenges being overcome in the long-run, but instead have caused investors to overreact in the short-term. The fears of recession, credit crisis and therefore a weakened consumer have further depressed the stock price.

Starbucks has admittedly grown too fast recently, and is now taking one step back to grow two steps forward in the right direction. Today, Starbucks has some of the most prime locations in the US. It has a strong CEO that has returned to the helm. And finally, it has a superior brand that has become synonymous with coffee. In my recent trip to HK and Tokyo, I saw stores packed with people drinking Starbucks coffee in blistering hot weather; this is the power of branding.

Starbucks’ recent challenges, in conjunction with today’s economy, have resulted in a share price that is definitely near bargain territory, if not already there. The traditional measures of P/E and Market/Book may not meet the criteria of a disciplined value investor as discussed in Graham and Dodd's Security Analysis. However, given its strong earnings power (to be discussed in Part II), Starbucks may be a worthwhile value play.

Disclosure: Author has a long position in SBUX

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