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Starbucks' Valuation More Vulnerable Than Its Brand

Stocks in this article: SBUX CMG MCD DNKN PEET

Since the financial crisis, the Starbucks story has been marked by strong execution and industry-leading earnings growth, as the company invested in the high-margin packaged goods businesses and single serve Via and K-Cup coffee drinks, which are now a lever of top and bottom line growth.

Now, in talking boldly about relatively small recent deals -- a $100 million June acquisition of bakery La Boulange and the $30 million purchase of juices specialist Evolution Fresh in late 2011 -- Schultz is dismissing past struggles to grow the nation's largest coffee company, banking on the consumer packaged goods (CPG) venture as a new model to grow shares and store offerings.

Schultz appears to be making two points: he wants to reinforce that Starbucks sells a core differentiated product -- the best coffee that can organically grow in profitability over the years. Second, the company can expand from that core to grow sales without diluting existing offerings or profit margins. In the past, Starbucks has seen diminishing returns from store-led growth initiatives.

With this year's La Boulange bakery deal, Starbucks said it will sell breads in existing stores and expand the California-based chain nationally, at once adding to its in-store food proposition, while growing non-Starbucks branded stores.

The bakery deal is just the latest example of Schultz's comment from November, " We've cracked the code on growth plans." When buying specialty juice chain Evolution Fresh last year, Schultz said Starbucks will sell new juices in its coffee-selling chains outlets, and by the end of 2012, it will use the deal to introduce a new health and wellness line of stores.

According to Bloomberg data, Starbucks trades at an enterprise value that is the third highest premium to one-year trailing and estimated forward earnings figures within the restaurants sector. Only Dunkin Brands (DNKN) and Chipotle trade at higher valuations, the data show.

Investors may be worried that Starbucks is deviating too much from its core competency with simultaneous La Boulange and Evolution Fresh initiatives, notes Hottovy. However, investors have previously predicted that a pullback for Starbucks' valuation and earnings was inevitable, based on disappointment with the CPG model and other initiatives, when in fact Starbucks has remained a growth stock for far-longer than many expected.

"A few years ago, I would have said they are pretty far along in their growth," says Hottovy. "They've really dialed back the clock on that and how big the business can grow," he adds.

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