Be A Contrarian, Buy This Undervalued Stock

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

Although it is always tempting to back company's that are well publicized as strong growers, you should take the time to do your own research. This could help you find the hidden value catalysts that the Street remains overly bearish about. I encourage investing in companies with stronger-than-recognized growth curves, especially when there are peers already trading at lofty multiples. The potential for either the multiple differential to be closed or for earnings to drive out performance outweighs the risk that the stock goes nowhere. Below, I consider Starbucks and GMCR to showcase my argument.

Starbucks (NASDAQ: SBUX) Vs. McDonald's

With McDonald's (NYSE: MCD) deciding to enter the bagged coffee market, Starbucks may be in for a rough ride ahead. I find that even if it grows at breathtaking rates of around 18% over the next 5 years, it should be a $30 billion company today and not a $37.1 billion company. While free cash flow growth has been dramatic over the past five years (growing from $387 million by the end of 2007 to $870 million today), this 17.5% CAGR during the past 5-years has started to plateau and even decline slightly over the past 2 years. This lower than 3% free cash flow yield does not bode well for new investors.

And yet analysts continue to rate the stock favorably--around a "buy." To their credit, Starbucks' earnings have fallen roughly in-line with consensus. The company recently decided to increase its share repurchase program by another 25 million shares, bringing the total count to 37.1 million. But the decision to use some of its limited free cash flow to acquire Teavana for $620 million has rightfully disappointed investors. Although 40% of the company's revenue comes from merchandising, Teavana will not generate meaningful revenue synergies given that Starbucks already has strong exposure to malls. On the other hand, it looks like Teavana is not as expensive as shareholders have made out--the board of directors for Teavana may be investigated for a possible breach in fiduciary duty.

All in all, I see Starbucks as more competitively strained than what the markets make out. For years, its products have been able to be sold at a premium by glad consumers looking for a relaxed experience. Today, however, consumers are more cautious in their spending and have more alternatives to choose from. Most recently, the growth curve will by challenged by McDonald's--particularly because of the company's strong presence in emerging markets. McDonalds' McCafé has caught on like wildfire abroad, and the coffee entry into grocery aisles will almost definitely limit much of Starbucks potential.

Green Mountain Coffee Roasters (NASDAQ: GMCR): A Possible Takeover With Stronger-Than-Recognized Growth

While GMCR may be in a similar market as Starbucks, its corporate story is entirely different. The stock was recently upgraded by Dougherty to a "buy" in light of slowing competition. While free cash flow has nosedived into negative territory during the last three years, it has started recover since June of last year.  And the stock still trades at a respective 11.3x and 9.8x past and forward earnings--well below Starbucks's 27.2x past earnings multiple.

This valuation differential is totally unwarranted. GMCR's net income curve has been substantial: growing from $13.3 million in the end of 2007 to $346 million today--a 92% CAGR. The net income CAGR for Starbucks has only been 15.4%--strong but nowhere close to GMCR's growth curve. Now, Starbucks has already saturated much of its market potential by cornering seemingly ever street of America. By contrast, GMCR has strong room for penetration in the packaged goods market, which, for potential competitors, is less inviting than setting up café shops. With a PEG ratio of 0.55, the future is being overly discounted.

Ironically, while it was David Einhorn of Greenlight Capital Management that caused the stock to plummet 65.5% from the 52-week high, it may be billionaire activist investor Carl Icahn that causes the stock to recover. Both investors have been known to challenge poor-performing management, so it wouldn't be hard for Icahn to come in and lobby for a takeover. With such a low price and an attractive balance sheet, a deal could be easily financed with minimal risk. In September 2011, Longbow had issued a "buy" rating on the Street with a $112 price target. A few months earlier, Argus was calling it a $130 stock. It currently is $24.50 stock. Thus the risk/reward and accretion potential for a business in the coffee space is quite  substantial.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's and Starbucks and has the following options: short DEC 2012 $21.00 calls on Green Mountain Coffee Roasters, short DEC 2012 $21.00 calls on Green Mountain Coffee Roasters, long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters, long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters, and short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Green Mountain Coffee Roasters, 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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