Still Room To Grow For The Coffee Shop King?

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

Starbucks (NASDAQ: SBUX) is known all over the world as not only being the biggest specialty coffee chain, but for offering a level of quality that is tough to match. Starbucks spent most of the 2000’s rapidly expanding their global footprint, and their favorite way to do this was to open several stores at a time, all within a few miles of one another. In effect, this allowed the company to instantly dominate new markets.

Just one case: I moved to Columbia, South Carolina for college in 2001, at which time there was not a Starbucks anywhere within 50 miles. Within 5 years, there were 8 separate locations that I could get to within a short drive. And let’s not forget the actual coffee shop on campus, which sold Starbucks products, or the two locations in the Barnes and Noble-run bookstores on or near campus.

A New Outlook

However, lately the company has shifted its strategy, choosing to evolve their existing business and slow down their expansion. Including their licensed stores (mostly in Barnes and Noble bookstores), Starbucks has more than 18,000 locations all over the world.

Since 2008, when the company reappointed Howard Schultz CEO, they have taken several steps to greatly improve the efficiency of their operations. Not only did they successfully curb their expansion rate, which was unsustainable, but they closed just under 1,000 underperforming locations, mostly in North America. They chose to still pursue aggressive expansion outside of the United States, where there is still considerable room for growth.

Valuation

Before I get into the actual P/E ratio or growth rate, it is interesting to note that Starbucks has done a tremendous job of improving its balance sheet since 2008. At that time, the company had a net debt of around $250 million. As of the end of 2012, the company has about $1.5 billion in net cash (cash-debt), a significant improvement in just a few years.

Anyways, at 26.4 times forward earnings, Starbucks may seem a little expensive at first glance. Bear in mind, however, that the consensus calls for earnings of $2.16 per share this year, growing to $2.62 and $3.14 in 2014 and 2015, respectively, for a very impressive 20.6% average forward earnings growth rate. This more than justifies the premium valuation, and even makes the stock seem cheap, provided the company can deliver on the ambitious projections.

Alternatives

There are several alternative ways to play the coffee industry. Arguably, the closest competitor to their café business is McDonald’s (NYSE: MCD), not so much in terms of product quality, but in that their other offerings, in addition to premium coffee drinks could steal a significant chunk of Starbucks’ business. A plus for investors is that McDonalds is more recession-proof than Starbucks, since its lower-cost menu items tend to do even better in a poor economy. Plus, their profits are not as dependent on commodity prices (the price of a pound of coffee beans can fluctuate pretty drastically).

I have written extensively about how McDonalds is the best way to play fast food, and it is certainly a viable alternative here, especially for those who may be willing to give up a little of the growth potential in exchange for more stability and a great record of performance.

The biggest threat to Starbucks’ take-home coffee business, in my opinion, is Green Mountain Coffee Roasters (NASDAQ: GMCR). I know that there are Starbucks K-Cups for sale, however this is a very small portion of Green Mountain’s sales, and Starbucks has tried (unsuccessfully) to capture significant market share with its own single-serve brewing system.

I love Green Mountain as a company, but in terms of an investment, my attitude has shifted to wait-and-see. Fears and uncertainty of the K-Cup patents expiring last year caused the stock to nosedive, trading as low as $17. With the market realizing that the fears were a bit overblown, and two good quarterly reports, shares have effectively tripled, and now may be a good time to head for the exits. Congrats to whoever bought near the lows, but I’m not sure that the upside potential in the intermediate term justifies the downside risk should a correction occur.

Conclusion

Starbucks is a great way to play the coffee business, and I absolutely love Howard Schultz’s vision for the company. Despite the high valuation, there is definitely massive potential for expansion abroad and many niche areas to explore domestically, such as their recent ultra-premium coffee offerings to coffee connoisseurs. While McDonald’s is definitely a great alternative, if you can stomach a bit more risk, Starbucks definitely could have another leg up from here!


Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Green Mountain Coffee Roasters, McDonald's, and Starbucks. The Motley Fool owns shares of 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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