RealMoney Silver - Warm Up With a Nice Cup of SBUX

Warm Up With a Nice Cup of SBUX
By Bill Trent
RealMoney.com Contributor
1/3/2008 10:07 AM EST

Back in October, I said Starbucks (SBUX) was not what I would call cheap, but that I would consider the stock cheap if it went down another 15% to $22.50.

Suffice it to say that $22.50 came and went. The stock isn't down 15% from the point I wrote the article -- it is down almost 30%. I figure I owe it to readers to revisit the name and either concede defeat or put my money where my mouth is (figuratively at least -- I have owned Starbucks shares for several years and neither sold at the top nor am I likely to buy more, as it is a large position for me).

With the drop in stock price last year, you would think the company has been missing earnings targets left and right, and that the outlook has plummeted. And that is true, to a point.

While the company has met its earnings targets in each of the last four quarters, most pundits on the Street consider merely "meeting" estimates as disappointing -- especially for a former highflier like the 'Bucks. And estimates for the fiscal years ending in September 2008 and 2009 have also come down -- a bit.

At the time I wrote the article, the consensus expectation was that Starbucks would earn $1.06 in fiscal 2008 and $1.27 in fiscal 2009. Now those estimates stand at $1.03 and $1.22, respectively. Since the stock decline has been much greater than the earnings decline, the P/E ratio on 2008 earnings has shrunk from 25 times in October to less than 19 times today.

What's the Problem?

The big reasons typically cited for the share price declines are slowing consumer spending and increased competition from the likes of Dunkin Donuts and McDonald's (MCD) . These reasons seem somewhat wispy to me, given that the 4% same-store sales growth Starbucks reported last quarter is still twice that of the average retailer. And while there may be some people who go out of their way to get a cup of Dunkin instead of Starbucks, there are many who will continue to make the choice based either on convenience or a preference for Starbucks.

In addition to increasing sales at existing stores, Starbucks continues to open new stores at a blistering pace -- it added 1,342 company-owned outlets in 2007. There are now more than 8,500 company-owned stores. Total sales and earnings per share grew about 20% in 2007 and are expected to run at nearly 18% in each of the next two years. While Starbucks may be a story of slowing growth, it is hardly a broken brand.

Where I see the problem for Starbucks is in the licensed stores, which are typically located inside other retailers, such as Safeway (SWY) . These stores account for nearly half the total number of Starbucks locations, but the licensing fees contribute just 7% to the top line. While the licensing fees are higher-margin revenue, I don't think the difference makes up for the lower relative sales contribution and the potential brand dilution.

I don't mind picking up a cup of Starbucks while walking the aisles at Safeway. But when I do so, I am not enjoying what the company calls the "Starbucks experience." I'm having a cup of coffee.

Valuation

The 19% P/E ratio, in line with the growth rate, seems reasonable enough. But I prefer valuations based on cash flow. In 2007, Starbucks generated $1.33 billion in cash from operating activities, and used $1.08 billion for capital expenditures. That leaves a free cash flow of $250 million, and a paltry 1.7% free cash flow yield on the current $15 billion enterprise value.

However, the free cash flow is growing. Cash from operations is growing at a similar pace to revenue, and the capex is likely to stabilize as the company matures and the number of store openings levels off (or declines, as the company now expects for 2008). I gathered some information from the Starbucks 2007 10K to figure out how that may play out.

	2007	2006	2005
New stores	1,342	1,043	751
Depreciation	$491	$412	$367
Capex	$1,080	$771	$643
Capex-Depreciation	$589	$359	$276
New stores/(Capex-Depreciation)	2.28	2.91	2.72
Cost per new store	$438.9	$344.2	$367.51
Source: Company reports; estimates by William A. Trent Dollar figures are in millions

If one considers the depreciation expense to represent the cost of maintaining existing stores, the difference between capex and depreciation should approximate the cost of opening new stores. The ratio has been fairly consistent over the last three years, which I think may validate this line of thought. By my estimates, opening a new store costs about $450,000.

If the spending on opening new stores in 2007 was $589 million, it suggests the free cash flow from existing stores was along the lines of $840 million ($250 million + $589 million). On this basis, the free cash flow yield would be 5.6% if the company decided to stop growing today. Throw in some more growth over the next couple of years and that starts to look pretty attractive.

I also think an options play is worth considering. For example, the July $20 puts are selling for more than $2.00, offering a 10% six-month yield if the stock recovers and an effective purchase price of $18 if the shares continue to drop. At $18, the free cash flow yield from current stores would be more than 6%.

Alternately, the January 2009 $17.50 puts are going for $1.65 as I write this. That offers a one-year return of 9.4% if the stock recovers and an effective purchase price of $15.85 (6.8% existing-store free cash flow yield) if it doesn't.

Nobody ever wants to catch a falling knife, but I think there are plenty of ways for patient investors to capitalize on a Starbucks investment based on the current valuation levels.