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June 2007



Starbucks is Looking Mighty Attractive

June 18, 2007 – Comments (4)

Lately Starbucks has been knocked down to its lowest P/E ever since going public in 1992. I'm not buying the argument that the P/E should be much lower from where it is today, simply because management believes it can expand to 40,000 stores worldwide. Today there are approximately 14,000 Starbucks; so they basically believe they can triple their base of stores. If they open approximately 2,500 stores a year (in fiscal 2007 they're expecting to open 2,400), that will take a little more than ten years. So, expansion isn't close to coming to an end. I don't think the P/E will be getting much lower either, because Starbucks is a proven business and management believes they can keep expanding.

The stock has been knocked down because they have slightly missed earnings estimates, growth is slowing a bit, and also because people are worried that McDonald's is making a better cup of coffee. Growth eventually is going to slow, but I feel in the long run Starbucks will be a consistent grower. There are bumps in the road for every company, Starbucks included. People are simply questioning whether or not Starbucks can really keep expanding without diluting its current stores. It's a good thing to pay attention to, and I believe the fears aren't especially new. People have been asking where are new Starbucks going to be for years, and look at where we are today. There are plenty of areas and states that don't have any or many Starbucks today. Then you have the huge potential of international expansion. I don't think 40,000 stores worldwide is that unreasonable of an expansion target.

As for McDonald's, I honestly can't believe people are worrying so much about their entrance into the game. The two places are extremely different in terms of experience. Starbucks is a place where you feel invited to sit down for awhile and enjoy your cup of coffee. At McDonald's you get the coffee and leave, the store isn't real inviting to stay at. I'm sure McDonald's will snag some of the market, but in the long run I highly doubt that they will do much harm to Starbucks. Some people are worried that McD's coffee tastes better than coffee at Starbucks. This is a legit thing to worry about, but let's go back over many decades to Coke and Pepsi. Many people said and still are saying that Pepsi is better than Coke and vice versa. Both companies have done very well. Every person has his or hers preference, and I think over the long run people will prefer Starbucks over McD's. Fellow Fool Tom Engle (TMF1000) also makes an interesting point that Starbucks and McD's will actually have similar businesses in the next 10-15 years or so. Why? Starbucks is offering more and more sandwiches and food items while McD's continues to offer more coffee and healthier sandwiches, burgers, etc. So it won't be a huge surprise if they both have similar businesses. The question you have to ask is if people will prefer the McDonald's experience or the Starbucks experience. I think the majority of people will prefer Starbucks over McD's largely because of the experience.

Starbucks has an excellent strategy for expanding internationally. They team up with local coffee businesses; they get help from the people who know the area best. They don't just guess where they expand next in a country. I think this strategy will keep international expansion relatively steady and benefit shareholders in the long run very much. Starbucks is really just getting started internationally, especially in the BRIC countries (they're not even in India yet but will be expanding there soon). If they're received well, I wouldn't be surprised to see their total store count exceed 40,000. You look at a company like Wal-Mart who hasn't had the greatest success internationally and you realize that it's vitally important to know the area you're expanding to. Since Starbucks is partnering with local businesses and really understanding where they're expanding to, I think international expansion will go very well.

With Starbucks, you need to look beyond the current valuation (which at first glance does look quite high). Considering management plans to triple their store base, international expansion is still in its early stages, and the terrific track record of the company, it's not a huge surprise that the stock is trading at a high multiple. I believe that management will be able to expand earnings at a pace in the 15%-18% range over the next ten years. There are a few factors that make me believe this. The first is pretty obvious: there is still a ways before expansion starts slowing down. The second is that I believe this management team will continue to make the business more efficient (such as the stores, buying the coffee, etc.). I really believe in this management team and I think they are focused on creating shareholder value over the long run. I'm a big fan of Howard Shultz and am pleased that he is the largest shareholder and still very much involved with the company. I think the company and its shareholders are in good hands with the current people running the show.

One of the main worries swirling around these days is that Starbucks hasn't been focusing on its core values, or at least not as much as it should be. My personal feeling on this is that it isn't as big of a deal as it has been made out to be. I haven't noticed much change in the ones around my area that I've been to over the past few months, but everyone has their own feelings on it. What counts for the business is that the overall public is pleased with its experience and won't mind coming back in the future. So far I haven't seen anything that shows this is changing. I have faith that if management feels they have trended away from the core business/experience they will do something about it. I think Howard Shultz's infamous memo was actually more geared to keep executives/managers more aware of the "Starbucks values" going forward. The Starbucks experience is a huge driver behind customers coming back again and again, so I agree with people 100% that if that experience whithers away one way or another it wouldn't be good for the company. The thing is that I just don't think this is happening a whole lot right now. Management just needs to be aware of this going forward and do what they need to do to keep the experience intact.

I'm not sure what to expect in the way of earnings growth over the next five years. I think my previous expectations (from last year) of 20% are a bit high and probably won't be met. Instead, I'll go with an expectation of 18% earnings growth with a P/E of 30 in five years. The current EPS is $0.79.

.79 * (1.18^5) * 30 = 54.22

This would result in a double over the next five years, nicely beating the market average. I think the P/E could be closer to 35, but it's good to lean to the conservative side of things. As long as management's expansion goal remains steady and more stores are being opened, I think the stock will be trading with a P/E above 30 for quite a few years. Like I've said before, growth has its price. If earnings were to grow at 15% annually and the P/E fell down to 25, it'd look like this:

.79 * (1.15^5) * 25 = 39.72

20% annual growth with a P/E of 35:

.79 * (1.20^5) * 35 = 68.80

To be honest, I don't think 20% growth is very unreasonable, but I don't think it's going to happen. The company's putting a lot of money into expansion, so I don't think margins will be improving enough to give earnings that much of a boost. This is fine with me, because at this point I think that's where a lot of it should be going. What's surprising to me is that analysts are currently expecting 22% earnings growth over the next five years, but this will probably change with all the pessimism floating around.

I think Starbucks is still a tremendous business and I think we'll be seeing increasingly strong cash flow production over the next 10-15 years. I am very pleased with management and I think the company's future is in good hands. Starbucks has a strong customer base, a sound expansion strategy, and I feel they'll continue to innovate the stores and the business for the long-term benefit of shareholders. I see no good reason why the stock should be trading at the lowest P/E multiple it has ever been at since going public and have gladly taken advantage of the opportunity.   [more]



What Role Should the Economy Play on Your Investments?

June 09, 2007 – Comments (1)

The truth is that there will always be negative factors with the economy. Housing isn't doing well, people want interest rate cuts (which I don't understand why - companies have record amounts of cash, rate cuts aren't really necessary at this point, in my opinion), one could go on and on finding negative factors with everything. I believe it simply isn't worth trying to analyze the economy to figure out where it is going. It's also why investors shouldn't weigh too much on the economy to decide what their investments should be. Warren Buffett has stated that he and Munger don't let macro events affect their investment decisions. In other words, if they see a great business, they're not going to let speculation on interest rates or treasury yields keep them from investing or buying it. If you let the economy play too much of a role in your investing decisions, you might as well stick with bonds or a much more conservative, know-you-won't-lose money approach. The bottom line is that there will always be risk associated with the economy, it's never going to be perfect.

This is the main reason I don't follow economist Robert Shiller with as much interest as I once did. He is brilliant at gathering and analyzing economic data, but he is so darn pessimistic. He always finds some piece of data that shows the economy or stock market is in bad shape. In the latest edition of Irrational Exuberance (which I believe was in 2004), he states that he basically sees a lot of downside with stocks. He's been pessimistic on the market ever since that point, mainly because the P/E was leaning to the high side. He's great at finding data and explaining it, but he hardly looks at the other side of things. Over the past few years, companies have built up large amounts of cash, earnings have grown at a nice pace, I don't think a P/E on the higher side is unjustified as much as he thinks. If things for corporate America are going well (and as far as I know since 2004 they have), investors usually are willing to pay a premium for stocks. Sometimes they'll take it to the extreme in both directions, but generally if things are going well they are willing to pay a little more of a premium. Shiller has focused on the negative aspects on virtually everything, and as a result he's missed out on a nice run in the stock market over the past several years.

Over the past 100+ years, the S&P has returned approximately 12% annually going through a depression, several stock market crashes, economic downturns, two world wars, president assassinations and deaths, it goes on and on. We have been through so much, yet have recovered every time. That is why I think Peter Lynch is someone every investor should know about. He says that if you have money you can stash away for 10+ years, put it in stocks. He's absolutely right. The only ten year period at the start of each decade (1900, 1910, etc.) that stocks have underperformed bonds was 1930-1940. Basically, it took a depression, stock market crash, and a world war to make bonds the superior investment during that ten year period. In other words, if you have cash you can keep invested for at least ten years, when you put that money in stocks and keep it there for ten years, your odds of making money are very high. The part where people stumble is when they let short-term movements or impatience become a factor in their investing decisions. If you find a wonderful business trading at a reasonable price, if you buy the stock and hold it for ten years or more there's a very good chance you'll have satisfactory returns. People say they are long-term investors but if the stock hasn't done much after one year they decide to dump it. If the company is doing well yet the market currently isn't reflecting the performance in the stock price, it eventually will. Benjamin Graham said it perfectly:  [more]

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