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.

Related Articles
  1. Stock Analysis

    Starbucks: Profiting One Cup at a Time (SBUX)

    Starbucks is everywhere. But is it a worthwhile business? Ask the shareholders who've made it one of the world's most successful companies.
  2. Stock Analysis

    How Medtronic Makes Money (MDT)

    Here's the story of an American medical device firm that covers almost every segment in medicine and recently moved to Ireland to pay less in taxes.
  3. Investing News

    Latest Labor Numbers: Good News for the Market?

    Some economic numbers are indicating that the labor market is outperforming the stock market. Should investors be bullish?
  4. Investing News

    Stocks with Big Dividend Yields: 'It's a Trap!'

    Should you seek high yielding-dividend stocks in the current investment environment?
  5. Investing News

    Should You Be Betting with Buffett Right Now?

    Following Warren Buffett's stock picks has historically been a good strategy. Is considering his biggest holdings in 2016 a good idea?
  6. Products and Investments

    Cash vs. Stocks: How to Decide Which is Best

    Is it better to keep your money in cash or is a down market a good time to buy stocks at a lower cost?
  7. Investing News

    Who Does Cheap Oil Benefit? See This Stock (DG)

    Cheap oil won't benefit most companies, but this retailer might buck that trend.
  8. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  9. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  10. Investing News

    Today's Sell-off: Are We in a Margin Liquidation?

    If we're in market liquidation, is it good news or bad news? That party depends on your timeframe.
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center