Starbucks is still a growth story

The coffee wars are far from over, but this company is still king of the hill -- and could grow even faster.

By StreetAuthority Nov 25, 2013 1:26PM
A Starbucks Corp., sign is displayed outside a coffee shop in London, U.K. / Chris Ratcliffe/Bloomberg via Getty ImagesBy Marshall Hargrave

The number of Starbucks coffee shops that flooded the market during the mid-2000s was almost comical. In 2008, there were more than 230 in New York City, with over 180 just in Manhattan.

There were literally Starbucks locations right across the street from each other. As a coffee lover and Starbucks fanboy, I didn't mind.

But rapid expansion and market saturation turned out to be an unsustainable business model, which led to a large number of underperforming stores. As a result, Starbucks brought back former CEO Howard Schultz in 2008, and the company closed a number of U.S. stores and ceased expansion efforts.

Yet half a decade later, Starbucks (SBUX) is back in full-blown growth mode.

Despite concerns that Starbucks might again be hitting a saturation point, the coffee company is still very much a growth story. Starbucks has a number of growth levers it can pull this time around beyond just rapid store expansion. These include the company's innovation on the food side and its single-serving products, Verismo and Teavana.

With the likes of McDonald's (MCD), Tim Horton's and Dunkin' Donuts all fighting for a piece of the market, the competition in the coffee market has increased over the past half-decade -- but Starbucks continues to set itself apart.

For a couple years there, it looked as though Starbucks and its chief rival, Dunkin' Brands (DNKN), were going to trade in lockstep forever. However, after upgrading its fourth-quarter guidance and announcing its partnership with Danone, Starbucks begin pulling away and appears to be leaving Dunkin' in the dust.
As mentioned, Starbucks has a partnership with Danone in the works for Evolution Fresh-branded Parfait Greek yogurt products. The rollout is expected to debut in Starbucks stores next year and in grocery stores in 2015.

New paths to growth

Innovation lies at the heart of Starbucks' growth story, and it appears to be on the right track, with a focus on tea, food, healthy offerings and at-home products. The tea business is large and growing, estimated to be a $40 billion market. Starbucks snatched up Teavana, a specialty retailer of tea that operates mall-focused stores. The growth initiative here is to open tea bars, serving customized tea beverages inside Teavana stores.

In the Americas, Starbucks is still ramping up store growth. But with Schultz at the helm, it's unlikely the company will push expansion to the point of saturation as in 2008. And beyond that, the true revenue growth with come from new products. Firstly, the company is consistently introducing new food products, which now accounts for over 30% of revenues, including adding bakery products from La Boulange (acquired last year) to its stores.

Fiscal fourth-quarter results showed that operating earnings per share (EPS) were up 37% year over year to $0.63, and revenue rose 13% on the back of a 7% increase in same-store sales. The really good news? All regions look to be in good shape, and thanks to the effects of falling coffee prices, operating margin rose to 17.6%.

With only 35% of revenue coming from outside the U.S., Starbucks is setting its sights on international markets. Starbucks has 500 stores in Latin American and plans to enter the Colombian market in 2014. It also expects China to soon become its second-largest market. The company expects to open about 1,500 stores next year: 600 in the Americas, 750 in Asia, and 150 in Europe, the Middle East and Africa.

Customer captivity at its best

The company already has a cultlike following, and its Starbucks loyalty program is only increasing its level of customer captivity. Nearly 1 out of every 3 transactions at U.S. Starbucks locations is made with a Starbucks card. What's more, about 10% of its transactions are made with smartphones.

It's looking to increase its customer captivity even more by expanding its loyalty program to include its channel development segment, which houses all the non-Starbucks stores products and sales. Starbucks plans to expand its loyalty program to include the purchase of packaged coffee at grocery channels and to allow the use of Starbucks cards at Teavana stores.

Starbucks has quickly built itself into the most recognizable name in the coffee business and is ranked by Forbes magazine as one of the world's most valuable brands. Let's not forget the 1.3% dividend yield and buyback program. Last quarter, Starbucks raised its quarterly dividend nearly 25%, to $0.26 a share, putting its payout ratio in line with its target of 40% to 45%.

Risks to consider:
The biggest risk to Starbucks is weak economic conditions. Its premium-priced products are easy to trade down from in a tough operating environment. Helping protect on the downside is the fact that many of Starbucks' consumers are less susceptible to economic downturns. On the commodity side, a sharp rise in coffee prices could strain Starbucks' margins.

Action to take:
Buy Starbucks for upside to $90. That's a multiple of about 28 on its consensus EPS estimates for fiscal 2015. Its price-to-earnings (P/E) ratio has ranged from 15 to 35 over the past three years. Considering that analysts expect EPS to grow at a compound annual growth rate of nearly 20% over the next five years -- which compares favorably with an expected rate of less than 13% for the specialty eateries industry -- it's easy to see why Starbucks deserves to trade at the high end of that range.

Marshall Hargrave does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of SBUX in one or more of its “real money” portfolios.

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