Forget Starbucks, Buy This Instead

The life cycle of a company follows four distinct steps. The last two are maturity and decline, and both are generally not the stages when you want to invest. The first is introduction and covers the period when a company is in its start-up phase and progresses to introducing some product or service on the market. The second is the growth stage and is the sweet-spot for investors. This stage covers a period of time when a company is expanding briskly and starts to throw off decent profits. It’s also where investors can make quite a lot of money…

Take coffee chain Starbucks (Nasdaq: SBUX), for example. The company is still growing in its own right, but shares trade for a lofty price-to-earnings (P/E) ratio over 25 and a free cash flow (FCF) multiple just over 25. After a rough stretch during the credit crisis, Starbucks is again growing briskly, but the rich valuation means much of this growth is already reflected in where the stock price is trading.

Starbucks now boasts nearly 17,000 stores across the globe. In the past 12 months the company reported sales of almost $12 billion, $1 billion in earnings and $1.3 billion in free cash flow. So while Starbucks is highly profitable and still growing respectably, its rapid-growth days are over. The company is well along the growth cycle of development. Additionally, its valuation is rich and high both compared to peers and based on its historical average range between 20 and 26 in the past four years.

In stark contrast, Caribou Coffee (Nasdaq: CBOU) operates a comparatively small amount of  stores, 534 to be exact, all of which are in the United States. In the past 12 months, total revenue was just shy of $300 million, even though it has grown by close to 20% annually in the past decade. A small existing store base means Caribou’s expansion prospects remain wide open.

In terms of profits, the company has reported cumulative losses of just over $71 million since it was founded in 2002. But Caribou may have turned a corner last year. On sales of $262.5 million, it reported $5.1 million in net income, or $0.26 per diluted share, compared with a $16.3 million loss in 2008, or $0.84 per diluted share. The profit was the company’s first since 2002.

Caribou has ambitious targets to increase new store openings to as much as 10% of its total store base annually and projects modest same-store sales growth between 2% and 4%. Much of this growth will stem from franchisees, which leads to lucrative royalty and franchise payments and should allow the company to leverage fixed costs, which means management can grow profits faster than sales.

Based on the $0.26 in trailing earnings, Caribou still trades at a lofty earnings multiple over 37. However, free cash flow came in at $12.6 million, or $0.63 per diluted share. This puts the free cash flow multiple at just over 15, which is quite reasonable in comparison to Starbucks’ 25 and also in absolute terms given the growth projections I estimate for Caribou.     

Action to Take –> I expect Caribou to continue growing sales at a 20% annual clip. The company has entered a period where it can consistently grow cash flow, which I project to grow 20% in each of the next five years, which, based on my discounted cash flow model, implies the stock is  undervalued more than 46% from current levels. Management projects long-term earnings growth of 25% and means my cash-flow targets could prove conservative. Overall, there is much upside for Caribou investors as it continues along the early and middle stages of its growth life cycle for at least the next five to 10 years.