Online Extra: Starbucks: A Bit Overheated?

If high expectations go unmet, that might stall the gourmet coffee chain's share price -- and give new investors a chance to buy in

By Amy Tsao

The BusinessWeek 50

To those who have a tall latte and cranberry orange scone every morning or gnaw on macaroons and sip herbal ice tea in the afternoon, Starbucks' (SBUX ) frothy year is no mystery. Despite a sluggish-feeling economic recovery, the coffee chain's patrons remain more than willing to fork over a few bucks for its pricey caffeine delights and pastry treats. "It's a simple way of rewarding yourself without spending a ton of money," says Sandy Sanders, consumer analyst at Boston-based Evergreen Investments.

Seattle-based Starbucks, with $270 million in net income and $4 billion in revenues in fiscal 2003, has benefited from consumers who are willing to buy $5 coffee drinks every day even if they're not yet ready to spend thousands on a new car. But more than that, innovations, store openings, and brand extensions are helping Starbucks outperform most retailers or restaurants. And they've helped put Starbucks into the BusinessWeek 50 ranking of top-performing companies at No. 25.


  "We have had tough comparisons for months, yet we're easily elevating comparable-store growth to new heights," says CEO and President Orin Smith. He also sees a longer and sharper growth trajectory: "Our view of how long we can grow [U.S.] stores has changed dramatically." His evidence: better-than-expected gains month after month in same-store sales comparisons (sales of stores open for more than one year).

For investors, the biggest potential problem would be if Starbucks falls short of those high expectations. The stock is trading at around $38, just a buck shy of an all-time high, and at a lofty price-earnings ratio of 37 times fiscal 2005 (ending Sept. 30) earnings of $1.03 per share. With the stock rallying 68% over the last 12 months, some analysts, while they believe in Starbucks' long-term growth prospects, see a pause ahead.

"It's hard to poke holes in the Starbucks story on a fundamental basis," says Glenn Guard, analyst at Legg Mason Wood Walker. But "the company will have to beat expectations for the stock to go higher." (Guard doesn't own shares personally. His firm makes a market in the stock.)


  Of course, a pause in Starbucks' trajectory could spell a buying opportunity for investors who want to caffeinate their portfolio. Analysts say despite the CEO's unguarded optimism, beating recent stellar sales performance could be tougher over the next year. In the spring months, same-store sales gains of better than 8% likely are doable.

"I'm concerned the market is looking for better than that," Guard frets. "What happens if they only do 8%?" And can Starbucks match last year's gains, when monthly same-store sales rose by 10% in June and for at least three straight months during December, January, and February?

The answer might be a sharp sell-off in Starbucks shares. "The stock has been an absolute champ in the last 12 months. I've got to think it should pause," says portfolio manager John Zielinski at Neuberger Berman. He likes it at $35. "On any kind of weakness, we'd be more enthusiastic." (Neuberger Berman owns the shares.)


  The stock is "a little overvalued" at its current price, says Carl Sibilski, analyst at independent stock research outfit Morningstar. But he adds that a company at this stage of growth typically trades at a high premium. Starbucks stock would be "reasonable" were it to dip to the high-$20 to low-$30 range, he says. "It's like McDonald's (MCD ) in the 1970s," Sibilsky says, noting Starbucks now has just 7,300 stores compared to the 30,000-plus for the fast-food giant.

That's not to say Starbucks doesn't have competition. Donut giant Dunkin' Donuts, a unit of Allied Domecq Quick Service Restaurants (ADQSR ) and McDonald's are both elevating their coffee offerings. So far, analysts see little to fear. Dunkin' Donuts has been mainly selling its new drinks in East Coast markets, where, Smith says, Starbucks stores continue to break sales records. "We will respond to whatever competitive threats we have," he says. "At this juncture we don't see any serious threat."

Besides coffee shops, Starbucks has plenty of other venues to expand in. Its coffee and merchandise are sold in 18,000 supermarkets in North America. "They're still in early stages of that," Guard says. This taps into customers who wouldn't normally drive to a Starbucks for coffee but might throw a pound-bag of beans in the shopping cart if it's part of the regular grocery trip. It's also in the beginning phase of selling its product through other food-service outlets. Starbucks has 6,000 deals of this kind, while its food-distributor partner Sysco (SYY ) has a massive 450,000 total food service accounts, Guard says.


  Starbucks' expansion plans -- up from 7,300 stores now to 14,000 in the next five years -- are ambitious and may not be perfectly executed. Even Chairman Howard Shultz noted in the February sales update that the "current high level of revenue performance is not sustainable." Longer term, 20% sales growth and 3% to 7% increases in monthly same-store sales are realistic, he advises.

Still, international stores are starting to perform better on the whole after some fits and starts. "The brand and concept have been accepted in every market with a lot of zeal," Smith insists. "There isn't any place we're not feeling pretty good right now." Even in café-savvy Europe, where Starbucks wasn't expected to convert connoisseurs, sales are on solid footing after a rocky start. It's reconsidering its Australia strategy, where it opened too many stores too quickly. Starbucks says it will post a profit for its international stores for the first time this fiscal year ending in September.

Even if Starbucks can't sustain the robust same-store sales gains, says Evergreen's Sanders, it's doing remarkably well by other measures. Customer spending should keep rising as people buy its latest pricey beverages. "They've been able to trade the consumer up," Sanders says. He points to rising free cash flow and improving return on capital. Margins should rise, he says, as Starbucks begins roasting and distributing operations overseas to support its international stores. (Evergreen owns Starbucks stock.)

Considering this bright long-term future, share-price pullbacks resulting from not being able to achieve high hopes could present buying opportunities for investors. That's something to savor over a cup of steaming java.

Tsao covers financial markets for BusinessWeek Online in New York

Edited by Beth Belton

Before it's here, it's on the Bloomberg Terminal.