Cold coffee: Why Starbucks' stock is down

By Robert Walberg

When investors are worried about rising interest rates, high energy prices and an impending economic slowdown, it’s not a good idea to disappoint Wall Street.

That’s just what Starbucks (SBUX, news, msgs) did Friday morning, though, when it announced that same-store sales in June rose by 6%. The Street was expecting a gain of 7% to 8%. Analyst David Palmer of UBS Securities, one of the guys looking for 8% growth, responded to the miss by lowering his rating on the stock to neutral from buy, trimming earnings estimates for the quarter by one cent and lowering his same-store sales estimates for the current quarter from 8% to 6%.

The stock responded to news of the miss and the downgrade by tumbling more than 5%. I warned investors back on May 4 that the stock was overpriced and ripe for a correction, so I can’t say I’m surprised or disappointed by Friday's action. Starbucks is down 7.4% since my original report.

Good growth, bad trend

Now, there were some on Wall Street quick to dismiss Friday's miss as no big deal. Bulls point to Starbucks’ enviable record of strong sales and earnings growth as reason for continued optimism. The company is, after all, expected to post revenue and earnings growth of 23% and 18%, respectively.

On the surface, those growth rates are impressive. But what’s missing from those numbers is context. Earnings growth is slipping from 27% last year to 18% this year. That’s a noticeable decline, especially when you consider that sales growth is actually expected to be two percentage points higher than last year.

This dichotomy underscores one of the concerns raised in my May article: the rise in Starbucks’ operating expenses. Increased payroll and operating costs associated with the company’s rapid expansion plan are beginning to be felt on the bottom line. Given that the company would like to more than double its current store count over time -- adding nearly 1,300 stores this year alone -- pressure on profit margins is apt to continue. If it does, that will spell trouble for the stock.

A Grande stock price

Another ongoing concern with Starbucks from an investment standpoint: The stock, like its coffee, is expensive. Even after the recent pullback, the stock still trades at 50 times estimated 2006 earnings, or 2.8 times the projected rate of growth. By contrast, companies in the S&P 500 stock index trade at an average 1.4 times their estimated growth rates. Assuming even a modest retrenchment in its premium, to say 2.4 times its expected growth rate for 2006, Starbucks has downside to the $31 area, from its current $36.

Starbucks is one of those great lifestyle companies with a management team that has proven time and again that it knows how to successfully manage growth. However, given the relatively tight labor market, the rise in energy prices and the company’s ambitious growth strategy, the timing isn’t right to be buying the stock.

Margins are being compressed and sales might not live up to expectations. If the stock were trading at discounted valuations, these problems might not seem so big. But with Starbucks still sporting historically rich multiples, the risk-reward ratio remains decidedly bearish. I’ll maintain my short on the stock, with a minimum downside objective of $32 to $31.

Robert Walberg is a financial writer based in Chicago, Ill. He was formerly chief equity analyst at Briefing.com. He is a regular guest on CNN's Moneyline and CNBC's Power Lunch. Mr. Walberg ran for Congress in Illinois in 1994.

At the time of publication, Walberg did not own or control shares of companies mentioned in this column.