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Get Off the SBUX Bandwagon Before It Crashes

Monday, March 12th, 2012

Be wary of advice from the bandwagon riders. They care more about getting more people in the bandwagon than anything else.

The Starbucks (SBUX) bandwagon is a big one. The large majority of analyst ratings are “buy” or “strong-buy”. Even the Motley Fools like the stock.

The main reason they all like the stock is: everyone else likes the stock and as long as it remains popular, the trend is your friend.

Clearly, I am not on the bandwagon and I recommend you jump off too before it runs over the valuation cliff. My reasoning in a nutshell: I doubt home brewing coffee will ever be as profitable as investment banking.

This is not my first Starbucks rodeo. In November of 2006, the Starbuck’s bandwagon was a raging party when I recommended investors sell/short the highly overvalued stock at nearly $40/share. The stock dropped steadily over the next two years to under $8/share as SBUX went from being everyone’s favorite to everyone’s dog.

The stock should not have gone as low as $8/share any more than it should have been at $40/share in 2006 or $50/share in 2012. But that is how the market works these days.

Stocks routinely get pushed well beyond reasonable highs and lows.  These are volatile and tricky markets.

Momentum investors have thrived over the last several years as their speculative strategies are well-suited for these kinds of markets. However, keep in mind that “speculation” is different from “investing”.

Speculation is a dangerous game. Once the momentum turns, it usually turns viciously. It is also dangerous because making the call to sell an expensive stock too soon can cost you some big bucks. Ergo, stocks get pushed higher and higher because people fear jumping off the bandwagon too soon. Remember the tech bubble?

Fundamentals do not seem to matter until they do – and then violently so.

My latest short call on SBUX was last fall when the stock was at $40. Now, it is over $50. Sure, I am taking my lumps from the bandwagon. But, I am not changing my “investing” opinion on SBUX.  The stock is even more overpriced now than it was last October.

My short call not doing well in the near-term does not change my analysis. I trust my analysis more than the bandwagon.

Don’t get me wrong. I like Starbucks as a company, just not as a stock. Mr. Schulz has led an incredible turnaround of the business. The shift in focus from building lots of stores to leveraging the brand across multiple (non-store) delivery platforms is excellent. He has built a much more profitable business model this time.

From 1998 through 2011, Starbucks has delivered very impressive NOPAT growth – 25% compounded annually. That is performing at a high level for a very long time.

At some point, the law of large numbers catches up, and the company’s growth will slow.

I am not saying Starbucks is a bad company, but it is a bad stock because it is too expensive. At $50/share, the current valuation implies the company will grow profits (NOPAT) at 15% compounded annually for 10 years.

In isolation and compared to its historical growth in NOPAT, those expectation may not seem that high. But they are.

15% compounded annual growth in NOPAT for another 10 years means Starbucks’ after-tax cash flow will, in 2022, be higher than the 2011 NOPAT for Goldman Sachs [s: GS], Morgan Stanley [s: MS] – two businesses that have built rather large franchises and substantial competitive advantages. Are you willing to bet that home brewing coffee will be as profitable as investment banking?

SBUX’s NOPAT would also be higher than 2011 NOPAT for Kraft [s: KFT], which has a slightly larger product offering than Starbucks. It would also be higher than 2011 NOPAT for 3M [s: MMM], Home Depot [s: HD], Eli Lilly [s: LLY] and Altria [s: MO]. Here are my ratings these stocks.

You get the point: SBUX is already priced to become one of the most profitable companies in the US. For an “investor” to own the stock at these levels, he/she must believe that the company’s cash flows will exceed the current expectations by a significant margin.

Maybe you believe Starbuck can do that, but I do not.

With all the cheap stocks in the market (e.g. Most Attractive Stocks), why would any investor want to place a bet that SBUX’s future profit growth would be better than what is already baked into the current stock price.

It is not as if SBUX has a monopoly on selling coffee. It has lots of competition. The more success the business has the more competition it attracts.

When I review the list of publicly-traded companies in the coffee-selling business, I think “wow, the coffee business is in boom times at a time when nothing else is booming. Investors in these stocks should be careful.” Here is a quick list of publicly-traded companies that focus on selling coffee.

I doubt anyone would attempt to argue that all of these companies will be more profitable than Goldman Sachs, Kraft, Home Depot, etc. Something has to give.

  1. Green Mountain Coffee [s: GMCR]
  2. Caribou Coffee [s: CBOU]
  3. Peet’s Coffee & Tea [s: PEET]
  4. Einstein Noah [s: BAGL]
  5. Dunkin Donuts [s: DNKN]

This list does not include three other major sources of coffee-selling competition: (a) home-made coffee, (b) local, private coffee shops, many of which offer excellent “atmosphere” and (c ) stores that sell coffee along with a host of other things, the best example of which is McDonalds [s: MCD], which get my Very Attractive rating. Here are my ratings on the other coffee stocks.

As I have stated before, SBUX cannot compete with the global brand and distribution capabilities of McDonalds. In home, single-serving coffee is not likely to be free of competition either. Firms that already have great household brands, such as Kraft, will get a piece of the action.

Bottom line: I recommend investors take the profits and run from SBUX. I cannot predict exactly when the stock will drop, but I am confident that it will.

I also recommend selling the following ETFs and mutual funds that allocate significantly to SBUX.

  1. Fidelity Select Portfolios: Leisure Portfolio [s: FDLSX] – 18% allocation
  2. Trust for Professional Managers: Smead Value Fund [s: SMLVX] and [s: SMVMX] – 8% allocation
  3. FundVantage Trust: Polen Growth Fund [s: POLRX] and [s: POLIX] – 7% allocation
  4. PowerShares Dynamic Leisure & Entertainment Portfolio [s: PEJ] – 5% allocation
  5. Advisors Series Trust: Chase Growth Fund [s: CHASX] and [s: CHAIX] – 5% allocation

My free stock screener which provides my ratings on 3000+ stocks updated daily, including all of those mentioned in this article, except for DNDK.

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Disclosure: I receive no compensation to write about any specific stock, sector or theme.

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3 Comments

  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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