A stellar earnings report from Starbucks ( SBUX) was unable to quell growing concerns about the java giant's high valuation going forward.

The fast-growing coffee shop chain reported record sales and earnings for the first quarter of its fiscal 2005 after the closing bell Wednesday, and raised its earnings outlook for the full year. Despite the upbeat news, its shares were recently falling $2.59, or 4.7%, to $52.75 in Thursday trading.

Thursday's slide is a continuation of a January selloff that had knocked 11.3% off of Starbucks shares through Wednesday's close -- consistent with the broader market's trend in early 2005 of making last year's winners this year's losers.

Some analysts point to Starbucks' gains in December -- it rose about 11% alone that month -- as evidence that portfolio managers were scooping up the stock at the end of the year for "window dressing" purposes, allowing them to disclose ownership of the stock in their literature sent to clients. Therefore, it would follow that these same managers would unload the stock in January to shore up their positions.

Lid on Growth?

Wall Street's negative reaction to such a glowing earnings report, however, underscores real concerns about the company's ability to maintain its growth rate.

"With top line growth coming in at the lowest level in six quarters, and the toughest same-store sales comps in roughly a decade coming up in the next three months, we think this growth stock's growth has peaked," H.D. Brous & Co. analyst Barry Sine said in a research note. (Sine discloses no position in Starbucks, but his firm does make a market in the company's stock.) "Starbucks reported a marked slowing in revenue growth suggesting that the previous fad-like popularity of the company's brand is now fading," Sine said.

Domestic retail sales growth slowed to 24.3% from 32.2% in the fourth quarter and 25.7% in the year-ago period. Domestic licensing revenue growth was cut in half at 19%, compared to the year before. Food service sales rose just 7.2%, down from the previous year's 21.3%, and its domestic operating margin was flat at 19.9%.

The implications are that Starbucks is approaching a saturation point in the U.S. in the coming years. Combined with uncertainty about the company's ability to meet its aggressive expectations for international growth, the results could mean that the stock's valuation should soon be lowered. But if Starbucks management continues to innovate the way it has in the past, the stock's steep premium could prove to be well worth it.

Starbucks shares have lost all of their gains from December, but the company still garners a towering valuation compared to its peers. At around $54, the stock trades at over 38 times earnings estimates through October of 2006. McDonald's ( MCD), by comparison, trades at roughly 16 times its earnings estimates for next year.

A fast-food chain like McDonald's might seem an odd comparison for a fashionable hangout for latte-drinking jazz-listeners like Starbucks, and in many ways it is. But both are ubiquitous brands that sell coffee. In fact, the results of recent efforts by McDonald's to emulate Starbucks and improve its coffee offerings demonstrates why Starbucks has earned its rich valuation on Wall Street. The coffee chain was unaffected.

It was likewise unaffected by similar moves from Dunkin' Doughnuts, a unit of Allied Domecq PLC ( AED), and its performance held its ground despite an 11% price hike in October -- a response to rising prices for coffee futures in the global marketplace.

"The message we got was that the power of the Starbucks brand allowed a modest price increase to take effect without any negative impact on transactions," said the company's chief executive-designate, Jim Donald, on a conference call with analysts following its earnings release.

Starbucks trades at a premium not only because it remains one of the fastest growing retail chains, but because it has demonstrated a wide economic moat protecting its competitive position. Furthermore, the company makes a convincing case that there is still plenty of room for more growth in the U.S. alone across several markets.

With a store count of 8,900, the company believes the market could support 15,000 stores in North America and 15,000 stores in international markets. Also, Starbucks appears to be only scratching the surface of opportunities in food service and other restaurant channels. It has only recently secured agreements with Kraft ( KFT ), Sysco ( SYY ), Dreyer's ( DRYR) and PepsiCo ( PEP), among others. Also, it has demonstrated an ability to expand product offerings with its Frappucino beverage line, a line of ice cream products and its Tazo tea line.

Quarter By the Numbers

Its first-quarter earnings rose 31% to $145 million, or 35 cents a share, up from $110 million, or 27 cents a share, in the same period a year earlier. The results beat Wall Street's expectations by a penny, thanks to continued growth and better-than-expected same-store sales, those at stores open for at least a year.

"Starbucks' first quarter was built around our holiday promotion, which included our popular seasonal beverages, strong customer response to Starbucks Christmas Blend, and relevant gift options ranging from Starbucks Cards to Starbucks Hear Music offerings," Donald said in a statement. "This exciting line-up resulted in our strongest holiday ever."

Donald was recently chosen by Starbucks to succeed president and chief executive Orin Smith, who has run the company since 2000. Smith plans to retire in March.

Sales at the Seattle-based java giant increased 24% to $1.6 billion from last year's $1.3 billion. The top line was powered by the opening of 642 new retail outlets during the quarter, along with an increase in same-store sales of 10%, compared to the year-ago period. That exceeds the company's target of 3% to 7% same-store sales growth.

Based on the strong results, Starbucks raised its earnings outlook for 2005 to a target range of $1.15 and $1.17 a share, excluding the impact from expensing stock options. Previously, the company was targeting an EPS range between $1.12 to $1.15, while Wall Street expected full-year earnings of $1.17 a share, according to consensus estimates reported by Thomson First Call.

In a conference call with analysts, the company's chief financial officer, Michael Casey, said it was in the process of assessing the effects of new accounting rules regarding the expensing of stock options. The rules will be adopted no later than the fourth quarter, and Casey plans to outline the effects of the changes sometime before then.

During the first quarter, the company said its operating earnings increased 30% to $227 million, compared to last year's $175 million. Operating margins increased to 14.3% of total net revenue, as strong revenue gains were only partially offset by higher retail store operating expenses.

In 2005, Starbucks expects to expects to open about 1,500 new stores on a global basis in fiscal 2005, with 550 new company-operated locations and 525 licensed locations in the U.S. and 100 new company-operated stores and 325 licensed stores in international markets.