Streetwise: Starbucks still can brew positive results

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Wall Street can be an indecisive animal if ever there were one. First it practically pleads with the Federal Reserve to halt a seemingly never-ending string of interest rate increases.

No sooner does the Fed grant the wish than the Street is worrying that the Fed's action points to slower economic growth, which in turn can only mean lower corporate profits, thereby sending stock prices lower once again. Furthermore, rising energy prices and rising wages have the Street believing that additional interest rate increases are likely down the road. If I were to hazard a guess, I would say by October at the latest.

So where does that leave the individual investor? The nugget of information to be gleaned from the ranting on Wall Street and the reams of macroeconomic data regurgitated by the media is that the continual rise in energy prices, in combination with rising wage pressures and lower productivity, will take its toll on the economy. Yes, the economy will continue to expand but at a reduced rate for sometime, probably well into next year.

As a result, companies are going to see their income statements go on a bit of diet. Does the quality of a company deteriorate because it has a smaller slice of a smaller pie? As a rule the answer is no. However, competition will become fiercer and marginal firms are likely to go out of business.

For example, last week Toll Brothers, a luxury home builder, reported lower third-quarter sales. In addition, signed contracts fell by 50 percent. Toll Brothers still reported home-building revenue of $1.53 billion, despite a drop of 0.5 percent. Yet, the company's share price fell more than 6 percent.

However, on the same day, my local paper wrote that an area builder with more than 500 homes to his credit, including 123 homes sold in 2005, sold only four this year and is closing down.

Unfortunately, Wall Street rarely takes into account the reason for lower revenues and/or earnings before pummeling a company's share price. That is why bargains often abound, the number of which will only increase in the short term.

One of the best examples of a bargain is Starbucks [Ticker: SBUX]. When I last wrote about the company a year ago, its shares were trading at $25 after adjusting for the 2-for-1 split of Oct. 21. Last week the price was $30 per share for a gain of 20 percent.

However, the shares recently suffered their largest one-day drop in six years after the company released its weakest monthly same-store sales increase since 2001. Starbucks said sales at coffee shops open at least 13 months rose 4 percent in July, the smallest increase for any month since December 2001.

Starbucks' now famous statement -- that heavy demand for cold drinks such as the new Banana Coconut Frappuccino slowed service and reduced sales -- made for good press. Yet, the real reason is probably that higher gasoline prices and interest rates are beginning to take their toll.

So is Starbucks still a viable investment candidate? In my opinion, the company merits careful consideration. For its fiscal third quarter ended July 2, Starbucks reported revenues of $2 billion, an increase of 23 percent, and net earnings of 18 cents per share, compared with 16 cents a year ago.

The earnings-based intrinsic value of the shares, using a growth rate of 20 percent and a discount rate of 11 percent (average return on the S&P 500) is $40.30 per share. A free cash flow to the firm model yields an intrinsic value of $37.07.

My 2007 earnings estimate for Starbucks is 90 cents per share. Assuming that the multiple or P/E ratio remains relatively constant, the shares should be trading at around $36 in the next 12 to 15 months for a gain of about 20 percent. Even with a 50 percent error, you still have a 10 percent gain.


Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com or 5 Gulf Manor Drive, Venice, FL 34285. (941) 351-0508. Phone calls accepted between 9 AM and 3 PM. For back columns see RuddReport.com .


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