Tag: sbux

It looks like those of you who read the blog regularly are in good company. It was brought to my attention yesterday that none other than those at the WS Journal have been keeping tabs on ValuePlays.

February 8, 2007, 1:03 pm

Blog Roll — Afternoon Edition

In a recent interview, SBUX CEO Jim Donald said a couple things that left me shaking my head. When asked about the effect that McDonald’s premium coffee will have on his business he said he expects it to be a benefit. The reason? Consumers who like McDonald’s premium coffee will likely migrate to SBUX’s super-premium. To quote Donald “we see that migration happening”. On it ‘s face the statement does make sense but when you take a step back and think about you have to wonder especially when you consider:

Consumer Reports recently compared coffees and came up with an interesting result. According to its tasters, Starbucks‘ (Nasdaq: SBUX) coffee was outdone by McDonald’s (NYSE: MCD) premium coffee offering.

Led by a professional tester and some employees of Consumer Reports‘ food testing unit, the team sampled medium plain coffees (with no sugar and cream, mind you), from two stores each of Starbucks, Dunkin‘ Donuts, McDonald’s, and Burger King (NYSE: BKC). The team of taste testers deemed McDonald’s premium coffee the best-tasting and the best value, at $1.40 a cup. It might surprise some people that the priciest cup of that size regular coffee actually came from Dunkin‘ Donuts, at $1.65. In the Northeast, McDonald’s sells Newman’s Own brand coffee (which is co-branded with Green Mountain Coffee Roasters (Nasdaq: GMCR).

Let’s take this one more step. If you want a cup of coffee in under 15 minutes do you go to Starbuck’s? Me either. Let’s be honest, getting coffee at a Starbuck’s is quite often a real pain in the ass. I still have nightmares about going to order a one for my wife with a cue card knowing that the omission or addition of a single ingredient would cause me to deliver to her a piping hot cup of bile (don’t think for a minute I did not notice the disapproving looks from the “barista” and those of you in line as I read the order off the card either). In McDonald’s you have arguably the world’s most efficient food and beverage distribution system. Now that machine is selling your main product and people really like it. This is good? Starbuck’s itself recognizes it’s production problems (remember, they blamed a summer earnings miss on them) which is why they are adding drive thru windows at many locations. To enhance their offerings, SBUX has added breakfast foods and I believe are considering doing the same for lunch. What would you think if McDonald’s said they viewed this as “good for our business”? Now, Starbuck’s does profit from the McDonald’s coffee in the Northwest as their Seattle’s Best coffee division supplies them, but there are no plans currently to expand this relationship. Earth to Starbuck’s here…

The switch to premium coffee is clearly working for McDonald’s. In the last couple conference calls they have given huge credit to their coffee for both their increase in sales and customer counts. Contrast this to Starbuck’s call in which they intimated their profit increases were mainly due to price increases on coffee and by selling customers more products once inside, not by increased customer counts. Translation, they are losing people to McDonald’s

This is what caused my jaw to drop. When asked about McDonald’s premium coffee in other parts of the country Donald said he “didn’t know the details” WHAT??!!??. Imagine the CEO of GM (GM) saying he was not aware of what Ford (F) was doing. Can you guess how fast WalMart’s (WMT) CEO Lee Scott would be fired if in an interview he said he “did not know” what Target was doing? The very fact that McDonald’s chose “Newman’s Own” branded coffee gave them instant credibility for it’s quality and is responsible for the immediate acceptance it has had . How can Donald not know this?

If I was currently a shareholder of SBUX this would make me very nervous and I would advise any new potential investor avoid these shares now.

The hard core Starbuck’s customer who garners much of their self worth from carrying that cup with the barely exposed green logo around will never abandon them, no matter how much they are forced to pay for their “vente soy non fat half caff white chocolate mocha latte with an extra pump”. However, the casual customer will and appears to be. I look at my wife and I (it is always a good idea when investing to look at yourself. No matter how unique you think you are, there are lots of people who think and act very similar to you). She was once a daily visitor for Mr.Donald and SBUX. Now, she runs a very successful law practice, has 3 children at home under 4 and a very tight schedule. She no longer has the 15 – 20 minutes it takes to park, go inside and get a cup of coffee at Starbuck’s. Instead, she has discovered that the cappuccino from the Christmas present her thrifty husband bought her is just as good. She can take it with her in her travel mug and avoid walking through the Massachusetts winter weather to get one (that cappuccino machine paid for itself in only 6 weeks). As for me, if I am driving around this winter and want a cup of coffee, rather than lug 2 four year olds out of their car seats andin wait in line for one, now that I can get a really good one from inside my car at McDonald’s while listening to them sing Brooks & Dunn’s “Hillbilly Deluxe”, why would I choose anything else? We can’t be the only two people out there like this and judging from McDonald’s coffee sales growth, we aren’t.

Mr. Donald… Are you paying attention?

Yesterday I wrote about the valuation of Starbucks, a great company that is costing shareholders money not because of any management failing but because investors had bid up the price of SBUX shares to levels that are sure to disappoint. Now we turn to another high flyer, Google (GOOG).

After a 2004 IPO Google has exploded to the upside with shares going from $100 a share to the $489 they sit at today. Revenues and earnings have also jumped. Earnings grew 243% in 2005 and in 2006, it looks like earnings will grow about 75%. Revenues doubled from 2004 to 2005 and are up about 65% from 2005 to 2006. The stock was a world beater in 2005 jumping $222 (115%) but in 2006 just meandered along up only $17.92 for the year or a pedestrian 3.8%. It has a pe in the stratosphere at 62 times 2006 earnings.

Thinking of jumping on this ship? Please don’t. Why, you ask? Let’s look.

Google cannot continue to grow at this clip. The law of large numbers tell us that at a certain point, percentage growth cannot continue. At this rate Google will equal the $44 billion in revenue Microsoft took 17 years to achieve in the next 2. Won’t happen. But, Google’s stock is priced for this event. What happens when Google does not deliver this growth? The stock gets a haircut, not a trim but a haircut, who knows, maybe even a shave. Now, just because Google does not deliver this growth is not by any means an indictment of managements ability. Quite the contrary to take a company from $1.4 billion in revenue to approx. $10 billion in 3 years is quite a feat. To go from that $10 billion to $17 billion to justify the 65 pe ratio based on current growth would require a revenue increase in dollars equal to the increases in 2004 and 2005 combined! If we extend this current growth out to 2008, that would require 2008 earning to grow an additional $11.4 billion dollars (more that all the revenue from 2006).

Management is not really helping its cause here either. In 2004 when it went public Google had 277 million shares outstanding, now today we stand at 311 million. That is a 12% increase in the shares outstanding which further dilutes results on a per share basis. In this respect they are slowing their per share growth due to the dilution. These factors are headwinds working against share appreciation.

Managements actions have assumed an overvaluation of the shares. When a company believes its stock to be undervalued, they will take excess dollars and buy those shares back believing that to be the best use of that dollar. The true value of the dollar of stock is greater than the cost of one dollar. When they believe the stock to be inflated, they use it for acquisitions, the thinking being that a dollar of stock has more purchasing power than a dollar of currency due its inflated level. Google recently purchased You Tube in a $1.5 billion stock transaction.

What does all this mean? Simple, the growth rates for both revenues and earnings for Google must diminish very soon. When that happens the multiple that buyers of Google’s stock will pay will diminish with it. This will cause the price of Google’s stock to fall and fall hard from its lofty levels. I want to stress that Google is NOT expensive because it is $489 dollars a share, it is expensive because that $489 in relation to its earnings and future growth is just too much.

The average of the estimates I can find for Google for 2007 are in the range of $13.85 per share. when you consider 2006 looks to end up around $10.30 a share, kudos to management, they are delivering 33% growth. Here is your problem. The stock price has growth of 60% factored into it. What does this mean? If investors will pay 60 times earnings for a stock growing 60% a year, why would they pay that for a stock growing 1/2 that? Answer? They won’t……..

You should expect the multiple for Google to contract to a range commensurate with its growth rate. If that rate this year is around 30% expect the pe to shrink to about 30 times 2007 earnings. That give us a price for Google shares of about $450 a share. In other words, Google is overpriced. It is priced for its current growth rate, when that rate slows as it must (law of large numbers) its price will fall.

Google is a great company with a wonderful product, its stock is just too expensive.

First things first. When I discuss “price” I do not mean the “price per share”exclusively, I mean the price per share relative to the earnings per share. After all, aren’t earnings what really matters? For instance, take companies “A” and “B”. Company A earns $1 a share and trades for $14 dollars a share (PE ratio of 14). Company “B” earns 25 cents a share and trades for only $10 a share (PE ratio of 40). A cursory look would have people think that “B” is cheaper, a share cost less. But, what are you getting for the cost of that share? Let’s pretend rather than keeping the earnings, both companies pay out all of them to shareholders at the end of the year. Company “A” would give you $1 back for a earnings yield of 7.1% ($1 in earnings / $14 price). Now company “B” does the same thing, at the end of the year you get your quarter from them for a yield of 2.5% (.25 earnings / $10 price). Per share prices aside, which stock would you rather own? Think of it this way, in order to get the same $1 back from company “B”, you would have to buy 4 shares for every one of company “A”.

Now, typically those who are invested in company “B” will say that the growth prospects for “B” are better than “A”. That while “A” may be a better value that “B” now, “B” will grow so much faster that not only will it close the gap , but the share price appreciation that will accompany this will make “B” a superior investment down the road thus it deserves the high valuation. They will cite you many examples from the 90’s where stocks like Microsoft, Cisco, Amazon, Dell and Google today and others trounced boring old companies that were bought at fair valuations. You then have to ask what happens when the music stops and the explosive growth becomes… normal?

Let’s look at how high valuations can lead to hard times for investors:

Starbucks (SBUX):

Starbucks has been one of the best performing stocks of the past 10 years. It’s growth has been extraordinary and its logo and coffee have become American icons. They provide health insurance for all their employees, use recycled paper for their cups and buy “free trade” coffee beans. In short, their is nothing not to like about the company. The stock however is another story. This past summer all was well for shareholders. The stock hit an all time high of $39 and the future looked very bright. Then a bump. The company announced its same store sales would fall well short of estimates because it had problems implementing ice new iced drink offerings during the hot summer. Rather than wait outside in line, people sought coffee from other places. Trading at over 50 times earnings at the time, investors panicked and acted first before they asked any questions and took the stock down to $29.55 a share for a 25% loss. The stock has since recovered half the loss and trades at $35 a share. Those who bought before the summer swoon are stuck holding the stock of a great company at a loss to their purchase price. Those who did not own SBUX but after the summer drop bought it are sitting on a 17% gain. Two investors, two very different situations. What happened? In a word:Fear. When you pay that much for the company, at the first sign of bad news you sell just in case the other shoe drops and that news is worse. That is what happened to SBUX. What did SBUX actually say? They had problems serving all those people fast enough. They didn’t say that there were no lines, that people only wanted the cheapest coffee they had, that they were losing market share.They only said that they could not make coffee drinks fast enough for all the demand. Now you have doubt in the stock. What if there are other problems? What else is there? Are people tired of Starbucks coffee? Despite earnings estimates for 2007 from the company that are in line with analyst’s expectations, investors are only paying 38 times 2007 earnings now (still too much). That means the stock price is falling as people are not willing to pay over 50 times earnings now that they realized SBUX is not perfect. Another misstep, not matter how trivial will lead to its multiple to shrinking again and its stock dropping more. Has anything fundamentally changed about the company? No…. It is the mindset of investors that has. If you were not smart and overpaid for SBUX, you now own a piece of a wonderful company purchased at an awful price.

Sherwin-Williams (SHW)

In a word: BORING!!. They make paint, so what? No Hollywood actors carry their cups around and you really cannot look cool ordering a gallon of red semi-gloss no matter how hard you try. Their shares have always seemed to trade in a pe range of 10 to 15 times earnings. In early 2006, a Rhode Island jury found that SHW was a “public nuisance” due to lead paint they stopped producing 50 years earlier. A judge ruled they had to share the cost of cleanup of lead paint in homes and estimates ran up to $4.5.billion in costs. Instant memories of asbestos came to investors minds and the share were punished 22% over the coming days. Investors feared a landslide of lawsuits from lead paint poisoning. After cooler head prevailed, people realized that there have only been about 2,000 cases of lead paint poisoning EVER. Once the asbestos analogy was diminished the shares resumed their normal trading at around a pe of 14 times earnings. Shares have not only recovered but are up 56% from their post Rhode Island ruling low as they have followed the earnings.

Why the difference? Valuation. SHW shares are fairly priced, bad news only effects them to the extent of the news. SBUX shares are overpriced, bad news effects them by illiciting fear and uncertainty and investors react to uncertainty by selling. Look at the two situations, SBUX is down 10% from its peak due to rather benign news, they just could not make enough coffee fast enough to satisfy the hoards. SHW is up 17% from its high water mark before the ruling, a ruling that has significantly more impact to the bottom line at SHW than SBUX’s news does. Had you paid 50 times earnings for SHW (like many did for SBUX) shares before the bad news, you would have been paying about $200 per share and would be in the hole on this stock now too. Two good companies, two negative events but for investors, two very different outcomes because of the price they paid for their shares.

Those stocks I mentioned earlier? Since 2000, the approximate top of their valuations: Dell (-44%), Amazon (-42%), Micrsoft (-45%) and Cisco (-52%) have all been losers for those who bought in…

Oh Yeah..Boring old Sherwin-Williams, whose investors never overpaid for it ? UP 240%

Buy stocks in great companies, just do not pay too much for them.