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The Right Mug of Coffee for a Bright Portfolio

Monday - 7/1/2013, 4:29am  ET

When we think of Starbucks , an image of an exquisite coffee experience comes to our mind. The taste, the ambiance; all these just attract coffee lovers to its cafes over and over again. Starbucks has pleased investors, too, with an amazing return time and again, which is evident by the fact that over the last six months, the company’s stock has soared around 20%.

Starbucks understood that its menu would require more than just varieties of coffee to attract customers. Thus, in the beginning of 2012 it acquired La Boulange, a San Francisco-based bakery chain that enabled the company to add amazing pastries to its offerings. By the end of 2012, Starbucks acquired Teavana, which should help it go beyond its core area of coffee.

Further, the acquisition of Evolution Fresh in 2011 added super premium juices with great taste, flavor and, nutritional value in the Starbucks menu. As the consumers are getting more conscious about health the company has now decided to post calorie counts for its food items on its menus throughout the U.S. This is a good move as it now has an array of juices, energy drinks, and recently started wholesome Salad Bowls to attract people who count every calorie they eat.

Starbucks does not rely entirely on acquisitions for growth but is also expanding its customer base by opening new stores and penetrating newer markets. The company is confident about its growth potential, hence, while competitors are cutting down investments, it is looking to get stronger and plans to open 3,000 more stores in the next four years.

In order to penetrate a growing and emerging market, Starbucks entered the Indian market last October with a cafe in Mumbai and now it has a number of stores in other cities as well. China, too, has more than 3,000 Starbucks cafes and there are plans to open more stores with time. As the Asian population is more centered towards tea than coffee, a lot of Starbucks’ success depends on how swiftly it adds products to its menu using Teavana's acquisition.

Amidst competition

McDonald's is a well-known fast food destination across the globe and Starbucks' close competitor. McDonald's is also into coffee, coming in direct competition with the coffee maker. McDonald's McCafe is comparatively cheaper than Starbucks coffee and attracts pocket conscious buyers towards it.

Until now Starbucks' superior taste and experience has not let McCafe do any such damage to its business, but as McDonald's remodeled and upgraded the interiors of its outlets and brought Wi-Fi into its restaurants, things might slowly start affecting the coffee maker. Further, adding coffee and other beverages have only added to the margins of McDonald's which, in any case, is a boon for the company irrespective of whether it actually weakens Starbucks’ bottom line or not.

Another potential competitior to Starbucks is Dunkin' Brands Group . The company lacks the quality of coffee and ambiance compared to Starbucks, but lately, it has been expanding its geographic footprint tremendously. Initially, the company was concentrated in the north-east, but now, it is trying to grow in the western U.S. through its franchises. Dunkin's franchise should work well as people are willing to invest because of a lower start-up capital requirement.

Fundamentally speaking

Among the three companies, Starbucks still has the best growth potential as it has a five year expected PEG ratio of 1.61 whereas, McDonald's and Dunkin' Brands have a PEG ratio of 1.99 and 1.79 respectively. Further, Dunkin' Brands has a current P/E ratio of 46 times and a forward P/E of 24 times symbolizing earnings growth potential. However, since it is using debt to finance its expansion plans, it is pulling the company into a heavy debt load and weakening its balance sheet.

Starbucks has a P/E ratio of 33.5 times and McDonald's has a P/E ratio of 18.5 times, but its earnings grew 26% compared to McDonald's 0.30% YoY. Moreover, Starbucks has a superior revenue growth at 11.30% compared to McDonald's 0.90%. In short, Starbucks is trading at a premium over others which it has earned by consistence performance over time.

Final take

Starbucks is a well-managed company with a great household brand name which has helped its top line by not only sales through its cafes, but also through its K-Cups and Vermiso machines. The company has strong potential and balance sheet to help it achieve the desired expansion plans. As the company's shares have gained well since the beginning of this year, I believe a pull back from here should be seen as an investment opportunity.

This article was originally published as The Right Mug of Coffee for a Bright Portfolioon Fool.com

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