Load Up On This Restaurant Stock

Gaurav is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Following a mixed FY12 with many ups and downs, Starbucks Corporation (NASDAQ: SBUX) finally appears to have found its stride. From a sales standpoint, the company has recovered well in the latter half of the year after experiencing declines in the first half. Revenue growth of 3.3% in Q3 and 1.82% in Q4 as compared to a 7% decline in Q2 tells the story.

From the valuation standpoint, Starbucks looks like a good bargain at the current levels. Although Starbucks (with a forward PE of 19.5) is trading at a premium to McDonald’s (NYSE: MCD) which is trading at a forward PE of 15, it’s worth noting that the expected growth rate over the next five years for Starbucks (~18%) is more than double of that of McDonald’s (~8.5%). Moreover, the company is trading at a discount to Dunkin’ Brands (NASDAQ: DNKN), which seems unfair given that Starbucks has a better expected growth rate. Thus, I see strong upside potential in Starbucks as it has the lowest PEG ratio among these three. Starbucks’ same store sales trends as compared to McDonald’s and Dunkin’ Brands also support my view. Starbucks’s 6% global same store sales growth in Q4 stands out when compared to McDonald’s and Dunkin’ Brands which posted same store sales growth of 1.90% and 2.80% respectively in their recent quarter.

Acquisition of Teavana Holdings

Starbucks has recently announced its biggest acquisition in the form of Teavana Holdings (NYSE: TEA). The company is expecting the takeover to be closed by the end of the year and accretive in the first year itself by roughly $0.01 per share. The global tea market stands at $40 billion and is growing rapidly (at about 10% annually). In my opinion, with the acquisition of Teavana, Starbucks can unlock huge growth opportunities in countries in India and expand its revenue rapidly.

Growth Opportunities in Asia

Starbucks has seen remarkable success in China over the last few years and the brand is gaining tremendous popularity as it provides affordable luxury with high quality coffee experience. In my opinion, China still represents a robust development opportunity for Starbucks with improving unit economics, double-digit SSS, and broadening growth into Tier III and IV markets. Moreover, the company is eyeing to replicate a similar success story in India and has recently opened its first store in India. Though the Indian consumers are more price sensitive than the Chinese, I believe Starbucks’ strong brand awareness will lure customers and drive strong results in the region.

Margin Visibility

Starbucks has improved its gross margin (by 43bps) and net margin (by 59bps) in its recent quarter and I see a further scope for margin improvement. Coffee costs have represented a $0.43 EPS headwind over the past 2+ years. However, the falling coffee prices create good margin visibility. After absorbing 40c higher green coffee in FY11 and FY12, falling costs in FY13 (limited to 10c benefit due to contracting) and likely more in FY14 provide cost visibility.

Moreover, in a move to lure customers, Starbucks is providing an incentive to buy their Verismo System in the form of Gift Starbucks Gold Level Status. I think it’s a good move by the company as the sale of Verismo machines will further improve profitability over a long term. Verismo machines are priced lower than most of the direct competitors (Nespresso machines start at $129, but most are $199 and up; the next generation Keurig Vue is priced at $230). However, at $1 per capsule, Starbucks’ pod pricing is well above the competition (Nespresso capsules are just 60-65c per cup; Starbucks K-cups are 75+c and Vue packs for the new generation Keurig brewer are 90+c). If Starbucks pricing holds this premium level, this is at least at the high end of investor expectations and a positive for the profitability of his product.

There’s a lot to like about this company. Starbucks has been the strongest grower in large cap restaurants, with a longer-term sustainable growth rate of 15-20% and has multiple growth drivers. Asia represents a robust long term growth opportunity and the acquisition of Teavana further represents a huge revenue growth vehicle. The company has good margin visibility with falling coffee prices and premium pod pricing for Verismo. Moreover, the company looks attractively priced on a PEG basis with respect to its peers. Thus, I would rate it a buy.

gauravguru has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's, Starbucks, and Teavana Holdings and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend McDonald's and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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