Be Careful: Starbucks Is Priced for Perfection

Source: http://www.flickr.com/photos/peyri/

Source: http://www.flickr.com/photos/peyri/

There is probably little doubt in anyone’s mind that Starbucks (NASDAQ:SBUX) is a great company. It has developed its own market niche in the United States and in markets throughout the world, and as a result it has turned a $2 drink into a multi-billion dollar business. Even as one of the largest food service companies in the world by sales, profits, and market capitalization, it manages to continue to grow its surprisingly high margin business year after year.

Given this, it is no wonder that the stock is trading near an all time high and at a premium valuation with respect to the broader stock market. But herein lies the problem: the company is performing so well that the stock is priced for perfection, and any slip-up can lead to a significant decline in Starbuck’s share price.

While we haven’t seen these problems yet, they are always lurking, and this is why I think that the best strategy is for investors to wait for a pullback. Granted, this could be a consequence of bad news, but for a company as strong as Starbucks buying shares when people are somewhat fearful makes sense.

But what can drive the stock lower? Such things aren’t readily apparent for a company that is hitting on all cylinders. However, there are risks out there that can drive the shares lower.

First, while a morning cup of coffee is a staple for many people, we should keep in mind that Starbucks sells a luxury. A cup of coffee at Starbucks is far more expensive than it is at, say, 7 Eleven. If the economy weakens — and we saw signs of this in the first-quarter GDP figures — consumers may decide that they want to cut back, and one way of doing so is to cut back on one’s coffee expenses. This could mean making coffee at home or buying coffee at a less expensive establishment. Now, given that Starbucks coffee is an inexpensive luxury, I wouldn’t expect this to take too big a toll on the company’s sales, but as I mentioned above the shares are priced for perfection, and as a result even a small slow-down in sales growth could set the shares back 10 percent – 20 percent.

Second, the company could face rising input costs that could hurt its bottom line. We saw earlier this year that coffee prices soared due to drought fears out of Brazil and a reemergence of European demand. This sent coffee prices rising as much as 80 percent. While coffee prices have come down and while coffee prices don’t significantly impact the company’s input costs, another spike in coffee prices could have enough of an impact to hit this priced-for-perfection stock. We also need to consider that electricity prices could rise, especially now that the EPA is putting restrictions on coal plants. Coal accounts for about 70 percent of the nation’s electricity output, and this could increase electricity prices and hurt Starbuck’s profit margins.

Finally, one of the reasons that investors are willing to pay such a premium for Starbucks shares is that interest rates are so low. It follows that stocks are worth more because its earnings yields (i.e. the inverse of their price to earnings ratios) are high relative to interest rates. But if interest rates rise then earnings yields on stocks will likely rise as well, and Starbucks can be hit hard by this. Right now, Starbucks trades with a 3.3 percent earnings yield. Just a 1 percent increase in interest rates could send the new “fair value” to 4.3 percent, which in price-to-earnings terms comes to about 23 times earnings, and this would be more than 25 percent lower than the current valuation.

Ultimately, Starbucks is a great company, and I think it is going to be able to generate cash-flow and shareholder value for years to come. But the cat is out of the bag on this one. Everybody is familiar with the Starbucks story and there is very little bearish sentiment. Out of 28 analysts polled by Market Watch 21 have a “buy” rating, 3 have an “overweight” rating, and 4 have a “hold” rating. There are no “sells” on the stock. Maybe they are right, but at the current valuation I think there is more downside risk than the upside potential justifies taking, and I would avoid the stock at this time.

Disclosure: Ben Kramer-Miller has no position in Starbucks.

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