Alright, Will Ashworth, you win this round! One quarter ago, fellow Investopedia writer Will Ashworth took issue with me seeing limited appreciation potential in Starbucks (Nasdaq:SBUX) and laid out a case that Starbucks was still a good buy. With the stock up about 22% over the last quarter, blowing away other restaurants like McDonald's (NYSE: MCD) and other consumer stocks in general, there's little else for me to do but see where I got Starbucks so wrong and reevaluated where it can go from here.
Another Strong Quarter
Starbucks was a strong story in the fiscal second quarter, and it got stronger still in the third quarter. Revenue rose 13%, with retail revenue up 14% and specialty up 10%. Underpinning sales, Starbucks saw comp-store growth of 8% overall (transactions up 7%, ticket up 1%), with 9% growth in the U.S. and China/Asia Pacific and 2% growth in Europe.
With higher revenue also came better operating leverage. Gross margin improved more than a point from last year, while operating income rose 25%. That, in turn, led a point and a half of operating margin improvement.

SEE: The Value Investor's Handbook
Setting The Bar In QSR
In a nutshell, I went wrong on Starbucks in large part because I underestimated the momentum in the company's store base and the extent to which this isn't your regular quick service restaurant (QSR). Leading QSR McDonald's has seen same-store sales slow noticeably in the U.S., even with ongoing success in the McCafe concept. Even top-end QSRs like Panera (Nasdaq: PNRA) and Chipotle (NYSE: CMG) are seeing comps in the mid single digits, while another prime Starbucks coffee rival Dunkin' Brands (Nasdaq: DNKN) is comping at a 4% rate.

Then there's Starbucks with that 9% comp, with 7% growth in transactions. Simply put, people are not only not willing to give up their morning Starbucks fix, but they're going their more often than just in the morning (and/or more people are going … it's not really possible to do a “same customer” analysis from the outside). 
What's more, I can appreciate that Starbucks can continue to grow its same-store sales if by nothing more than making more products available in every store. It's still early in the process of integrating Teavana and La Boulange, but there is certainly potential for Starbucks to continue growing beyond its core/traditional footprint in premium coffee. Said differently, if Starbucks can get even just one-quarter of its regular customers to occasionally add a croissant or muffin to their coffee order, that's a meaningful improvement in both comps and margins.
Executing On The China Opportunity
I also think I underestimated the company's momentum in China. While Yum! Brands (NYSE: YUM) and McDonald's are suffering from image problems brought on by using antibiotics-contaminated chicken, not to mention public health and consumer spending issues, Starbucks is not. At 9%, Starbucks' China comps are likely at or near the top of the market, and there is still tremendous store growth potential in the market (to say nothing of markets down the line like India, Indonesia, Vietnam, and so on).
SEE: How To Analyze Restaurant Stocks

The Bottom Line
Maybe Starbucks is just basking in a new-found love affair for coffee on the part of investors. After all, Green Mountain Coffee Roasters (Nasdaq: GMCR) is also up almost 40% over the last three months, and coffee-centric stories like Kraft (Nasdaq: KRFT) and Dunkin are up pretty solidly as well. Likewise, there is still the risk that Starbucks' comp momentum fades and takes the margin leverage with it.
I'm not expecting that to happen. Even so, I think you have to make some pretty exceptional assumptions to get an attractive fair value on these shares. Let's say Starbucks can grow revenue at almost 12% a year for a decade, and improve its free cash flow by 20% a year. Should that occur, Starbucks will be at 90% of the annual revenue run rate projected for McDonald's in 2022, though the free cash flow margin will be a little lower. With the same discount rate I use for McDonald's, that leads to a $70 price target. So although I'm willing to take my lumps for missing the huge move in Starbucks, I still end up wondering just how this company will manage to continue to outgrow expectations.
Disclosure – At the time of writing, the author had no positions in any of the stocks mentioned.

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