Why Starbucks Should Form a Key Part of an Investors' Portfolio

Warren Buffett (Trades, Portfolio) has always advocated a basic principle of investing which advises the investor to completely understand the business of the subject company. At its core, this is a very valuable advice and scores of investors have realized this over the years. One of the companies upon which this principle can be easily applied is Starbucks (SBUX) because its primary business model which involves selling coffee is both simple and highly sustainable.

Healthy diversification

While Starbucks' is still a devoted coffee shop, it has started out with juices, pastries etc. to develop the brand as an all-day restaurant that specializes in providing light and healthy items. A few years back and precisely in 2008-09, the company saw a massive dip in its revenue and net profits besides the continuously falling stock price. Though this was partly brought about by the great recession in 2008, it was more of management's bad decisions that completely ruined the brand. An unplanned and aggressive expansion strategy coupled with a quick introduction of new unnecessary offerings was hugely responsible for the steep fall in the value of Starbucks.

It is no doubt that the company has wonderfully rechristened itself over the last 5 years with revenue growth of 13% and comparable store sales growth of 9% in the recent quarter on a y-o-y basis. The company is now embarking on a similar journey as in 2008 under the leadership of CEO Howard Schultz who took the role of Chairman in 2000 and came back as a CEO in 2008 during the crisis. However, there are two stark differences between these periods, one of which is a much better U.S economy in terms of growth and sustainability with higher disposable income in the hands of people.

This time it's different

The other major difference is that Starbucks has been quite successful in restoring the eroded brand value and thereby gained immense customer confidence. In fact, this is a highly suitable time to work on expansion and innovation because there is fierce competition and since the company has once again become the favorite, it should adequately take leverage.

For instance, Starbucks recently launched in India, which is a big market for coffee and tea in partnership with Tata, and has displayed an impressive performance in the last year. Even though Starbucks has just commenced its operations in the country, it has achieved a commendable position in the market. However, it needs to constantly innovate and expand in order to face tough competition from home-grown companies like Cafe Coffee Day.

The success of K-Cups

It is quite obvious for a company to keep innovating because this enables it to stay put during severe competition and maintain existing market share. Starbucks has taken a right decision by implementing K-Cups coffee, which have been doing extremely well for the company as per reports. A few months back, Starbucks entered into a long term strategic partnership with Keurig Green Mountain, which owns the Keurig single serve brewing systems for the purpose of making and selling the hugely successful K-Cups.

Brewing in China

As I have already mentioned, Starbucks is putting in reasonable efforts to diversify into new offerings like food items and juices. Besides this, the company is also expanding its operations internationally and the next big market it is looking at is China. China will replace Canada to become Starbucks' second largest market by the end of 2014. The strategy employed by the company in this huge and complex market is noteworthy as it has achieved a good balance between tweaking the menu to suit the local taste but not overdoing it and losing the core significance of the brand.

For a company like Starbucks, business comes from customers who are willing to visit its outlet over and over again and for that it needs to deliver excellent customer experience. It is impressive to see that the company has understood the immense significance of customer satisfaction and worked on it after careful analysis of customer requirements. The U.S and Chinese markets are vastly different in terms of demographics as in the U.S., Starbucks is simply a coffee shop that serves brilliant coffee but in China, it is a place for social activities and largely attracts young people.

Reasonable valuation

Let us now talk about the valuation of Starbucks. Currently, the company has a PEG ratio of 2.2 and PBV ratio of around 10, which makes it slightly expensive as compared to the industry. It is important to understand that the markets have not yet discounted all the relevant growth factors like international expansion, improvement in technology among others, which will further push up the price.

Analysts have predicted an earnings growth of around 19% in the coming five years and assuming that the company will leverage its brand value to reduce the cost of capital and raise cheaper debt to fund its expansion plans, it will lead to a reasonable escalation in the share price. As of now, the company has a D/E ratio of 0.09, which suggests that it can take on some debt to fund its capital expenditure.

In conclusion, Starbucks has quite successfully come back on the growth track while maintaining strong brand value and enhancing customer satisfaction. Though a bit overvalued, this stock is still an ideal candidate for your portfolio.