Starbucks falling from favor

By Robert Walberg

Wall Street likes to see its growth superstars post consistently higher sales and earnings.

That's why Starbucks (SBUX, news, msgs) is falling from favor. The company no longer consistently beats consensus estimates, and that’s a real no-no for growth companies trading at premium multiples.

Today the company said it had earned 17 cents per share during its fiscal fourth quarter, up 6.3% from a year ago but merely meeting estimates. Worse, it forecast fiscal 2007 earnings of 87 to 89 cents, compared with Street estimates of 89 cents. Quarterly revenue rose 21% to $2 billion, shy of the consensus forecast of $2.1 billion. Its annual sales target of $9.36 billion fell short of projections by $140 million.

Losing its growth luster

There's no question that Starbucks is one of the great growth stories in American corporate history. In less than 20 years, it has grown from fewer than 100 coffee shops to more than 12,400, with a record 2,199 opening in fiscal 2006 alone. However, new stores are only one way to measure growth.

Investors are likely to take an increasingly dim view, considering the stock closed today's session trading at 44 times management’s most optimistic earnings projections. Starbucks shares were off 5.5% in after-hours trading.

The real culprit behind Starbucks' inconsistent earnings is the rising expenses associated with its incredibly rapid growth. The company continues to ramp up store openings in order to more than double the number of stores within a decade. Next year alone it plans to open a record 2,400 worldwide. Staffing costs are one reason operating expenses as a percentage of overall revenues continue to climb. As a result, operating margins fell to 9.9% last quarter from 11.8% a year ago.

The higher cost of coffee beans, increased utility and distribution costs, and a shift in demand toward products with lower margins than beverages also hurt, pushing the cost of goods to 41.7% of sales from 40.9%. The trend is troubling given the focus on selling more food items, which typically have lower margins.

Of course, if sales explode, then there's no problem. But when a company estimates sales lower than the Street consensus and then suggests that margins are being squeezed, that will cause some analysts to rethink their view of the stock.

Earnings are already growing at less than half the rate of sales, and any further compression is likely to put downward pressure on multiples.

Cannibalizing its own business

Starbucks talks about its vision of a store on every corner, a trend that could lead to cannibalization of sales. Same-store sales growth -- growth in sales at stores open at least one year -- almost has to trend lower if additional stores open within blocks of existing locations. If growth falls below 3% it will be very difficult to maintain the earnings and sales multiples that the stock has enjoyed over the past two decades. In 2007 the company forecast same-store sales growth of 3% to 7%.

Starbucks is an incredibly strong brand with an intensely loyal customer base that totally dominates its marketplace. Those factors alone explain why the stock deserves a premium multiple to the overall market. Yet there’s also no denying that top- and bottom-line growth are leveling off and that the high costs of the company’s aggressive expansion effort have increased earnings volatility.

As such, the stock doesn’t deserve to be trading at more than two times its growth rate any longer. A more reasonable valuation would be about 1.8 times growth, or 36 times forward earnings.

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

At the time of publication, Walberg did not own or control shares of Starbucks.