Starbucks Steeped in Froth

Once again, earnings are strong. But will Wall Street stand by when the inevitable slowdown occurs?
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On Wall Street, great success breeds great expectations, and the stock market's reaction to the second-quarter earnings figures released late Wednesday by

Starbucks

(SBUX) - Get Report

serves as a perfect example of the traps that can ensnare investors as a result.

The Seattle-based coffee empire sits atop Wall Street's totem pole of admired companies after bringing its so-called coffee culture to the masses. The company consistently outperforms across the board, defying skeptics, and its recent foray into entertainment channels shows that Starbucks is one of those rare companies that can redefine the boundaries of its brand.

The java giant's second-quarter results were no exception to the growth story. It posted a 27% gain in net income, beating expectations, and raised its earnings targets for 2006. Despite all that, the stock sold off after hours -- probably because the 6% comp-sales growth it posted for April merely matched estimates and didn't top them.

Chances are, most traders will forget all about the 6% figure in a matter of days, but the selling was still a harbinger of what might lie ahead when the inevitable slowdown in Starbucks' exceptional growth arrives.

Even after the 1.3% selloff in Starbucks shares after Wednesday's closing bell, the stock trades at roughly 45 times Wall Street's consensus estimates through 2007.

"I think a lot of the growth is priced into this stock already, and people's expectations are very high for it at this point," says Carl Sibilski, managing director with Oyster Capital Management. "I think there's a lot of potential growth for the company to achieve, but the main question is whether you're paying up for that growth before the company achieves it. If you are, the returns will be fairly low in the end."

Starbucks shares have multiplied roughly 20-fold in value since it went public in 1992, blowing away the market's average return. Sibilski himself was positive on the stock for much of that time, but he warns that the party has gotten too crowded (neither he, nor his hedge fund, has a position in the shares). He advises investors to look for growth stocks that are less popular.

On the other hand, most analysts on Wall Street are still on board with Starbucks.

"Starbucks has always been a high-valuation stock, and many people have missed a great ride because they thought it was expensive in 1992, they though it was expensive in 1997 and they think it's expensive today," says Sharon Zackfia, analyst with William Blair. "The reality is that if earnings estimates keep going up, usually stocks perform well, and I think there's a good case to be made that estimates for Starbucks will keep going up."

The company earned $127 million, or 16 cents a share, for its second quarter ended April 2, up from $100 million, or 12 cents a share, a year earlier. Analysts, on average, expected earnings of 14 cents a share, according to Thomson First Call. Even more impressive, Starbucks' results for this year include the effect of its new practice of expensing stock options, which the company says reduced results by 2 cents a share.

Moreover, Starbucks raised its fiscal 2006 earnings forecast to 71 to 72 cents a share from its previous range of 68 cents to 70 cents a share. For the current third quarter, the company sees earnings of 17 cents a share, in line with analysts' mean estimate.

"We started the third quarter with strong 23% revenue growth in April and 6% comparable store sales growth -- near the top of our

long-term 3% to 7% target range," Starbucks said in a statement. "These results were driven by continued customer demand for our handcrafted beverages, with particular strength in our spring lineup of Green Tea beverages."

Starbucks has outperformed its long-term range for monthly comps so consistently that investors become disappointed when the company's results don't beat expectations. Wednesday was no different, but on a conference call with analysts, the company's founder and chairman, Howard Schultz, chided those who reacted negatively to the number.

"We were very pleased with 6% comps, and if anyone on the call is disappointed, you're off base," Schultz said.

So, when will Starbucks slow down? Alex Motola, a portfolio manager with Thornburg Core Growth Fund, wouldn't speak specifically about Starbucks, but he says most big growth stocks that start with a great concept and wide recognition end up growing at a high rate for much longer than many people expect.

"That can be a great period for stock-price appreciation," says Motola. "The stock gets added to major indices. It becomes a fashionable stock on Wall Street, and finally, it reaches a period where you're paying a big multiple for the company based on historical growth that they're probably not going to be able to continue delivering. That can persist much longer than you would expect, but usually some fundamental change eventually happens that annihilates the stock, and its valuation comes way down."

That's what happened to

McDonald's

(MCD) - Get Report

in the late 1990s, when its stock dropped from its all-time high near $50. Now, it's trading at around $35 at a multiple of about 14 times its earnings estimates through 2007. The fast-food giant is now focused on sprucing up its existing store base rather than growing at its levels of yesteryear.

Starbucks says its current base of 11,225 stores can grow to at least 30,000 stores worldwide.

"We haven't revisited that number recently, and we need to do that," Starbucks Chief Financial Officer Michael Casey said in an interview. "I don't think there's any doubt that we'll re-evaluate that number and set it higher."

The company plans to open 1,800 stores this year, and Casey says that number will increase in the future. If one assumes Starbucks could open an average of 2,000 stores per year for the next decade, it will take nine years for it to reach its current estimate for market saturation.

Meanwhile, Starbucks expects its profits to grow by 20% to 25% annually for the next three to five years. Assuming it could maintain that pace for nine years, the company will post annual earnings of about $3.92 a share as it reaches maximum store count.

If shares of Starbucks were valued at a more reasonable 15 times earnings as it reaches a global store count of 30,000, this highly optimistic and purely theoretical scenario would give its shares a price tag of about $59. At its current stock price around $37, that would give Starbucks a compounded annual rate of return of just 5.3%.

If the company found a new major concept to drive future growth, it might be able to retain a higher valuation even longer. The company has expanded its marketing efforts into movies and music, and just this week announced a partnership with the William Morris talent agency to help facilitate more deals.

"

Starbucks will continue to grow its retail space, but it's also a company that will continue to evolve through all these special channels," says Nicole Miller, analyst with ThinkEquity Partners LLC (she holds a buy rating with $41 price target). "The company has unyielding brand awareness and numerous growth opportunities."

Still, Zackfia calls Starbucks recent moves in the entertainment world "interesting, but probably not material in the grand scheme of things."

Casey declined to comment on the degree to which the entertainment items have bolstered the company's sales performance.

"Entertainment will always be an enhancement to the coffee and retail experience that we have today," says Casey. "But it wouldn't be a main line of business. ... The big opportunity for us beyond the big, and growing, business that we have here in the U.S. that everybody's familiar with is the other 5.3 billion people in the world. We have an equally receptive audience in China, Europe, the Middle East and elsewhere where we can grow our coffee business."