Friday, May 18, 2007

Starbucks: A Buy At What Price?

There have been a slew of articles the past week about the price of Starbucks (SBUX) shares and whether or not now is the time to buy them. Let's look closer. Currently Starbucks shares trade at $28 each for a PE ratio of 31 times this years 89 cents a share earnings estimate. Many people consider this a bargain saying "Starbucks shares have not traded at this level since Oct. 2005." But is Starbucks situation now the same as then?

In a word, no. If they hit their EPS growth goal, Starbucks will grow earnings this year 18% vs the 30% they grew them in 2005 and as each day goes by, that "if" becomes larger. A closer look at last quarters earning shed some light on upcoming difficulties. Earnings were met chiefly due to an unusually large $500 million share buyback that enabled Starbucks to gloss over the fact that margins continue to deteriorate. This buyback becomes even larger when you consider in all of 2006 only $695 million worth of shares were repurchased.

What has not been discussed is the dairy and coffee situation. Both are going to experience an explosion in prices this year and Starbucks did disclose on the recent earnings call that they are not able to "substantially" hedge against these increases because a buyer for the hedge on the other side is not available.

Translation? Everyone knows these prices are going up. So, other than additional prices increases to their customers, Starbucks has no way of avoiding these cost increases going directly to the bottom line. Add the fact that they only served 1% more people last quarter, you now have a recipe for accelerating margin decreases and slowing revenue growth.

This deteriorating margin picture may now begin to effect growth plans. When margins continue to decline, in order for Starbucks to retain it's over ambitious growth, it will need to rely increasingly on debt. Note that in the recent quarter $488 million net in debt was issued which was more than twice the sum total of the past 6 years.

So what price then? Shares have to fall substantially from here before anyone should consider them. As the chart below illustrates, Starbucks has traditionally sold at a slight premium PE (1.25 to 1.5 times) to it's growth rate.

eps % PE ratio
1996 20 50
1997 50 49
1998 22 46
1999 27 50
2000 29 47
2001 28 45
2002 22 39
2003 21 36
2004 41 40
2005 27 43
2006 20 46

Of the times it did sell at more than that (2+ times), the following year featured increasing growth "justifying" that "froth". The aberration in the PE vs. growth rates trend has been from 2006 on. 2006 featured dramatically slowing growth for the third consecutive year and an increasing PE over the same time span. This was the genesis of my original post and shares since then have acted accordingly down 20%.

With that rate at this year at MAYBE 18%, its current 31 PE has shares grossly over valued. A price range of $22 to $27 put us in a historic PE to Earnings Growth range. Now, that also assumes they hit the 18% EPS growth this year which I am doubting more as each day passes.

With all the uncertainty surrounding the company at this point, I could not even begin to consider shares at any price other than the lowest end of the range, $22 or another 21% lower than current prices as I expect EPS growth to slow more.

Disclaimer: I have no nor have I ever had any position in Starbucks

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